Securities and Exchange Commission

17 CFR Parts 200, 230, 240, 242, and 249

[Release No. 34-49325; File No. S7-10-04]

RIN 3235-AJ18

Regulation NMS

Agency: Securities and Exchange Commission.

Action: Proposed rules and amendments to joint industry plans.

Summary: The Securities and Exchange Commission (“Commission”) is publishing Regulation NMS for public comment. In addition to redesignating the existing national market system (“NMS”) rules adopted under Section 11A of the Securities Exchange Act of 1934 (“Exchange Act”), Regulation NMS would incorporate four substantive proposals that are designed to enhance and modernize the regulatory structure of the U.S. equity markets. First, the Commission is proposing a uniform rule for all NMS market centers that, subject to certain exceptions, would require a market center to establish, maintain, and enforce policies and procedures reasonably designed to prevent “trade-throughs”—the execution of an order in its market at a price that is inferior to a price displayed in another market. Second, the Commission is proposing a market access rule that would modernize the terms of access to quotations and execution of orders in the NMS. The third proposal would prohibit market participants from accepting, ranking, or displaying orders, quotes, or indications of interest in a pricing increment finer than a penny, except for securities with a share price of below $1.00. Finally, the Commission is proposing amendments to the rules and joint industry plans for disseminating market information to the public that, among other things, would modify the formulas for allocating plan net income to reward markets for more broadly based contributions to public price discovery.

Dates: Comments must be received on or before May 24, 2004 .

Addresses: To help us process and review your comments more efficiently, comments should be sent by hard copy or e-mail, but not by both methods. Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Comments also may be submitted electronically at the following e-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-10-04. Comments submitted by e-mail should include this file number in the subject line. Comment letters received will be available for public inspection and copying in the Commission’s Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549. Electronically submitted comment letters will be posted on the Commission’s Internet web site (http://www.sec.gov).¹

For Further Information Contact: Trade-Through Proposal: Heather Seidel, Attorney Fellow, at (202) 942-0788 and Jennifer Colihan, Special Counsel, at (202) 942-0735; Market Access Proposal: John S. Polise, Assistant Director, at (202) 942-0068, Patrick M. Joyce, Special Counsel, at (202) 942-0779, and Ann E. Leddy, Attorney, at (202) 942-0795; Sub-Penny Quoting Proposal: Kevin Campion, Special Counsel, or Ronesha Butler, Attorney, at (202) 942-0744; Market Data Proposal: Sapna C. Patel, Special Counsel, (202) 942-0166; Regulation NMS Proposal: Yvonne Fraticelli, Special Counsel, at (202) 942-0197; all of whom are in the Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-1001.

Supplemental Information:

Table of Contents

1. Preliminary Statement
2. Objectives for Rule Proposals
1. Promote Equal Regulation of Market Centers
2. Update Antiquated Rules
3. Promote Greater Order Interaction and Displayed Depth
3. Trade-Through Proposal
1. Executive Summary
2. Background and Discussion
1. Foundation of Our National Market System
2. Intermarket Price Protection
1. History of Intermarket Price Protection
2. Existing Intermarket Price Protection Regime
3. Strains on Existing Intermarket Price Protection Regime
3. Proposed Trade-Through Rule
1. Markets Subject to the Proposed Rule
2. Types of Securities Subject to the Proposed Rule
3. Types of Orders Subject to the Proposed Rule
4. Bids and Offers to Be Protected
5. Required Policies and Procedures
6. Access Standards
7. Duty of Best Execution
4. Exceptions to the Proposed Rule
1. Opt-Out Orders
1. Request for Comment on Automated Execution Alternative
2. Opt-Out - Order-by-Order Consent
3. Opt-Out - Provision of National Best Bid or Offer
2. Automated Order Execution Facility Exception
1. Definition of “automated order execution facility”
2. Operation of the Exception
3. Allowable Trade-Through Amount
3. Other Exceptions
5. Interaction with Existing Plans/Rules
6. General Request for Comment
7. Paperwork Reduction Act
8. Consideration of Costs and Benefits
9. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation
10. Consideration of Impact on the Economy
11. Initial Regulatory Flexibility Analysis
4. Market Access Proposal
1. Access to Equity Markets in the NMS
1. Current Access Framework
2. Nonlinked Markets
3. Access Fees
2. Proposed Access Standards Under Regulation NMS
1. New Terms
2. Access to Published Bids and Offers
3. Access Fees
1. How Access Fees Cause Distortion in the Markets
2. Regulatory Alternatives With Respect to Access Fees
3. Proposed Solution: A de minimis Fee Standard
4. Locked and Crossed Markets
3. Proposed Amendments to Fair Access Standard of Regulation ATS
4. General Request for Comment
5. Paperwork Reduction Act
6. Consideration of Costs and Benefits
7. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation
8. Consideration of Impact on the Economy
9. Initial Regulatory Flexibility Analysis
5. Sub-Penny Quoting Proposal
1. Introduction
2. Decimals Conversion
1. Background
2. Impact of the Decimals Conversion
3. Sub-Penny Concept Release
1. Market Depth
2. Price Clarity and Flickering Quotes
3. Execution Priority Rules
4. Short Sale Regulation
5. Quote Rounding
6. Automated Systems
4. Nasdaq Rule Proposal and Petition for Commission Action
1. Proposed Rule Change
2. Petition for Commission Action
1. Two-Tiered Market
2. Disparate Quoting and Trading Conventions
3. Stepping Ahead of Limit Orders
4. Potential Impact on Regulatory Requirements
5. SEC Staff Research on Sub-Pennies
6. Discussion of Proposed Rule
7. General Request for Comment
8. Paperwork Reduction Act
9. Consideration of Costs and Benefits
10. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation
11. Consideration of Impact on the Economy
12. Initial Regulatory Flexibility Analysis
6. Market Data Proposal
1. Introduction
2. Consideration of Alternative Models
1. Deconsolidation Model
2. Competing Consolidators Model
3. Hybrid Model
3. Allocation of Network Net Income
1. Current Plan Formulas
2. Proposed New Formula
1. Security Income Allocation
2. Measures of Trading and Quoting
1. Trading Share
2. Quoting Share
3. NBBO Improvement Share
4. Plan Governance
5. Proposed Amendments to Rules 11Aa3-1 and 11Ac1-2
1. Independent Distribution of Information
2. Consolidation of Information
3. Display of Consolidated Information
6. General Request for Comment
7. Paperwork Reduction Act
8. Consideration of Costs and Benefits
9. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation
10. Consideration of Impact on the Economy
11. Regulatory Flexibility Act Certification and Initial Regulatory Flexibility Analysis
7. Regulation NMS Proposal
1. Introduction
2. Discussion of Proposed Regulation NMS
1. Rule Numbering
2. Rule 600—NMS Security Designation and Definitions
1. Transaction Reporting Requirements for Equities and Listed Options
2. “NMS security” and “NMS stock”
3. Changes to Current Definitions in the NMS Rules
1. “Covered security”
2. “Reported security”
3. “Subject security”
4. “Consolidated system”
5. “National securities exchange”
6. “OTC market maker”
7. “Vendor”
8. “Best bid,” “best offer,” and “national best bid and national best offer”
9. "Bid" or "offer," "customer," "Nasdaq security," and "responsible broker or dealer"
4. Definitions in the Proposed New Rules
3. Proposed Changes to Other Rules
4. Exemptive Authority
3. General Request for Comment
4. Paperwork Reduction Act
5. Consideration of Costs and Benefits
6. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation
7. Consideration of Impact on the Economy
8. Regulatory Flexibility Act Certification
8. Statutory Authority
9. Text of Proposed Amendments to the CTA Plan, CQ Plan, and Nasdaq UTP Plan
10. Text of Proposed Rules

I. Preliminary Statement

The Commission is publishing for public comment proposed Regulation NMS, which incorporates a set of four, broad substantive rule proposals on market structure, along with the procedural rule proposal to create Regulation NMS. We recognize that, if ultimately adopted, the rule proposals would effect fundamental innovations in the nation’s equity markets. Today’s action is intended to advance the dialogue on these vitally important market structure issues.

Giving the public an opportunity to comment on specific rule proposals is the logical next step in the deliberate and systematic review of market structure that the Commission has undertaken in recent years. The central objective of this review is to determine how the regulations governing the U.S. equity markets should be modernized. Our markets are continually evolving because of such factors as innovative trading technologies, new market entrants, and changing investment patterns. We believe that one of our most important responsibilities is to monitor these changes and to ensure that the U.S. regulatory structure remains up to date. In this way, we can help our markets retain their position as the deepest and most efficient in the world – markets that offer a fair deal to all types of investors, large and small.

By publishing the proposals, the Commission does not intend to suggest that its market structure review is complete and that final decisions have been reached on any of the rule proposals’ provisions. The issues undoubtedly are complex. Reaching good decisions requires a firm grasp of the relevant facts, an understanding of the often subtle ways in which the markets work, and the balancing of policy objectives that sometimes may not point in precisely the same direction. To inform its thinking, the Commission repeatedly has sought the views of market participants and the public. Thus far, our review has included multiple public hearings and roundtables, an Advisory Committee, four concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives, and a constant dialogue with industry participants and investors. The information and data generated by these steps has formed the basis for the development of the rule proposals.

The Commission believes that focusing comment on specific rule proposals is the essential next step in achieving the best possible regulatory initiatives. In this regard, in addition to seeking written comments, we will hold one or more hearings in the coming months to expand the opportunity for dialogue on the rule proposals themselves and on the issues they address. The Commission will reflect the insights gained from this open process in its final rulemaking.

II. Objectives for Rule Proposals

The Commission is publishing four substantive rule proposals that are designed to enhance and modernize the national market system, along with a procedural rule proposal to create a new Regulation NMS. The rule proposals include the following regulatory initiatives:

(1) a uniform trade-through rule for all NMS market centers that would affirm the fundamental principle of price priority, while also addressing problems posed by the inherent difference in the nature of prices displayed by automated markets, which are immediately accessible, compared to prices displayed by manual markets;

(2) a uniform market access rule with a de minimis fee standard that would help assure non-discriminatory access to the best prices displayed by NMS market centers, but without mandating inflexible, “hard” linkages such as the Intermarket Trading System (“ITS”);

(3) a sub-penny quoting rule establishing a uniform quoting increment for NMS stocks to promote greater price transparency and consistency;

(4) amendments to the arrangements for disseminating market information that would reward self-regulatory organizations ("SROs") for their contributions to public price discovery, as well as implement many of the recommendations of the Commission’s Advisory Committee on Market Information; and

(5) Regulation NMS, which would modernize and restructure the Exchange Act rules governing the NMS to promote greater clarity and understanding of the rules.

If adopted, the proposals collectively would constitute a significant upgrade of the NMS regulatory framework and address a variety of issues that have arisen in recent years. The NMS needs to be enhanced and modernized, not because it has failed investors, but because it has been so successful in promoting growth, efficiency, innovation, and competition that many of its old rules now are outdated. Since the NMS was created nearly thirty years ago, trading volume has exploded, competition among market centers has intensified, and investor trading costs have shrunk dramatically. Each of the major milestones in the development of the NMS – including the creation of the consolidated system for disseminating market information in the 1970s, the incorporation of The Nasdaq Stock Market, Inc. ("Nasdaq") securities into the NMS in the 1980s, and the adoption of the Order Handling Rules in the 1990s – has successively generated enormous benefits for investors.

In the 2000s, improvements to the NMS have continued to benefit investors. In particular, the rescission of New York Stock Exchange, Inc. ("NYSE") Rule 390, trading in penny increments, and public disclosure of order execution quality have set the stage for exceptionally vigorous competition among market centers, particularly to provide the best prices for orders of less than block size (10,000 shares). Since November 2001, for example (the first month for which all markets were required to disclose their execution quality), the effective spreads paid by investors seeking liquidity in the NMS have declined steadily across all markets by a cumulative total of more than 40%.² In November 2003 alone, these reduced spreads resulted in cumulative investor savings of more than $340 million, or more than $4.0 billion on an annualized basis.³ Importantly, small investors seeking direct participation in the U.S. securities markets have shared fully in these savings, and indeed likely have been the biggest beneficiaries of NMS improvements.

The proposals published for public comment today are intended to help assure that the NMS continues to serve investor interests in the future. The particulars of the proposals are described in more detail below. The balance of this overview places the proposals in the context of the Commission’s historical approach to market structure and summarizes the goals that the proposals are designed to achieve.

The objectives for the NMS set forth in the Exchange Act are well known – efficiency, competition, price transparency, best execution, and direct interaction of investor orders. Each of these objectives is essential, yet they sometimes conflict with one another in practice and can require delicate balancing. In particular, the objective of market center competition can be difficult to reconcile with the objective of investor order interaction. We want to encourage innovation and competition by the many individual market centers that collectively make up the NMS, while at the same time assuring that each of these parts contributes to a system that, as a whole, generates the greatest benefits for investors – not their market intermediaries.

The Commission therefore has sought to avoid the extremes of, on the one hand, isolated market centers and, on the other hand, a totally centralized system that loses the benefits of vigorous competition and innovation among market centers. To achieve the appropriate degree of integration, the Commission primarily has relied on two tools: (1) transparency of the best prices through the consolidated display of quotes and trades from all NMS market centers; and (2) intermarket “rules of the road” that establish a basic framework within which competition among NMS market centers can flourish on terms that ultimately benefit investors. Today’s proposals are intended to continue this strategy.

In particular, the proposals are designed to address a variety of problems that generally fall within three categories:

(1) the need for uniform rules that promote equal regulation of, and free competition among, all types of market centers;

(2) the need to update antiquated rules that no longer reflect current market conditions; and

(3) the need to promote greater order interaction and displayed depth, particularly for the very large orders of institutional investors.

A. Promote Equal Regulation of Market Centers

Not that many years ago, the NMS could be divided fairly clearly into groups of stocks, each with its own particular mix of market centers. The traditional auction exchanges – NYSE and the American Stock Exchange LLC ("Amex") – dominated trading in their listed stocks, with some dealer participation on the regional exchanges and in the third market. Market makers dominated trading in Nasdaq stocks.

Today, these historical divisions are disappearing. For Nasdaq stocks, automated quote-driven market centers (such as Nasdaq's SuperMontage, the Archipelago Exchange,⁴ and Inet ATS, Inc. ("Inet")) have captured more than 50% of share volume. For Amex stocks (for which approximately 39% of share volume now is represented by two extremely active exchange-traded funds (“ETFs”) -- the QQQ and SPDR), Amex now handles approximately 27% of the volume, with the remaining balance split among Archipelago, Inet, and others. The NYSE has retained approximately 75% of the volume in its listed stocks, but other market centers are attempting to raise the level of competition and increase their share of trading. Moreover, the NYSE and Amex have sought to add automated facilities that are integrated with and complement their traditional exchange floors.

The intensified competition, or threat of competition, in the NMS in recent years has benefited investors by reducing trading costs and prompting better, more efficient services. The rules that govern the NMS, however, need to be updated to reflect the new market conditions. Many rules, for example, were developed separately for listed markets and the Nasdaq market. This disparity makes little sense today when the level of trading volume and the identity and character of participating market centers are becoming more similar for both listed and Nasdaq securities.

Section 11A(c)(1)(F) of the Exchange Act grants the Commission rulemaking authority to assure equal regulation of all markets for NMS securities. Today, in many respects, the same rules apply across all U.S. equity markets. For instance, all broker-dealers have an obligation to seek to obtain best execution for their customers’ orders – specifically, to seek to obtain the most favorable terms available under the circumstances.⁵

In other respects, however, there is disparity in rules across markets, and the Commission believes the proposals set forth in Regulation NMS will help further the statutory objective of assuring equal regulation of all markets for NMS securities. For example, the market for listed securities currently has a trade-through rule affirming the principle of price priority, while the market for Nasdaq securities does not. The proposed trade-through rule would address this disparity. In addition, certain market centers currently charge substantial fees for access to their displayed quotes, while other market centers are not permitted to assess such charges. The proposed access rule would address this disparity. Finally, some market centers currently engage in sub-penny quoting, while others do not. The proposed sub-penny rule would establish a uniform quoting convention.

B. Update Antiquated Rules

The NMS was created in the 1970s. Although the fundamental policy objectives that guided its creation remain as valid as ever, some of the NMS rules and facilities no longer adequately address current market conditions. For example, some were written long before technological innovation opened the door for new types of services, such as automatic execution and order routing services.

The proposals would modernize older NMS rules that have become antiquated. The proposed market access rule, for example, could be implemented using indirect market linkages that have been enabled by improved communications technology, rather than a hard linkage like the one incorporated into the ITS. The market data proposal would update formulas for allocating income to the SROs that were adequate many years ago when a single market dominated each group of securities, but much less so now when volume is split among different market centers whose contributions to the public quote and trade streams can vary considerably.

C. Promote Greater Order Interaction and Displayed Depth

A significant strength of the current NMS is the competition among market centers that encompass a variety of trading models, from traditional exchanges to electronic communications networks ("ECNs") with automated limit order books to automated market maker systems. This competition particularly has benefited retail investors, for whom a primary component of execution quality is spread costs.

Conversely, perhaps the most serious weakness of the NMS is the relative inability of all investor buying and selling interest in a particular security to interact directly in a highly efficient manner. Little incentive is offered for the public display of customer orders – particularly the large orders of institutional investors. If orders are not displayed, it is difficult for buying and selling interest to meet efficiently. In addition, the lack of displayed depth diminishes the quality of public price discovery.

The seriousness of this weakness has been voiced frequently in recent years by institutional investors. For large institutional orders (generally greater than 10,000 shares and often substantially greater), price impact costs are a more significant component of execution quality than spread costs. For example, assume that an institution decides to sell 100,000 shares of a stock when the best bid is $20, but winds up selling the stock for an average price of $19.80 because the price declines in response to the institution’s selling interest. In this case, the 20-cent per share price impact cost is likely to greatly exceed the spread costs in the stock that are associated with smaller orders. Institutional investors have indicated that they need more effective ways to interact directly with large size trading interest on the other side of the market. The limited data on institutional trading costs that is publicly available tends to support their complaints. For example, one recently published analysis of worldwide institutional trading costs found that such costs for NYSE and Nasdaq stocks rose, respectively, by 25.1% and 29.6% for the period from 1999 through the second quarter of 2003.⁶

A variety of factors other than market structure (such as the decline in average stock prices) could be significant contributors to an increase in institutional trading costs. Nevertheless, these costs appear to have risen substantially during the same time period that smaller order execution costs have dropped dramatically. Given the troubling nature of this trend, we cannot afford to be satisfied with the status quo as regards the efficiency of the NMS. A critically important goal of the proposals is to enhance opportunities for the direct interaction of investor buying and selling interest and to improve the depth of public price discovery.

For example, the trade-through proposal, by modifying the existing listed market trade-through rule to accommodate the differing nature of quotes displayed by manual and automated markets, is intended to assist those institutions that seek direct and efficient interaction with contra trading interest. Similarly, the market access proposal would help assure that all investors have non-discriminatory access to the best prices for a security, no matter where they are displayed in the NMS. The sub-penny quoting proposal would address the practice of “stepping-ahead” of displayed limit orders for trivial amounts, which disadvantages those investors who are willing to contribute to quoted depth by publicly displaying their trading interest. Finally, the central objective of the market data proposal is to reward those market centers whose quotes reflect the best prices for the largest sizes and thereby contribute the most to public price discovery.

III. Trade-Through Proposal

A. Executive Summary

Changes in the equities markets in recent years have raised the issue of whether a trade in one market should be executed when a quote at a better price is displayed in another market. Rules limiting trading at an inferior price have been in place since 1978 in the markets for NYSE and Amex securities, but no such intermarket rules exist in the markets for Nasdaq securities. Over the years, dramatic changes have occurred in each of these markets, and trading in Nasdaq, NYSE, and Amex securities has spread across an increasing variety of market centers, including “alternative” highly automated markets, many of which provide for almost instantaneous executions of matching buy and sell orders within their systems. Various markets, including the NYSE, Amex, and Nasdaq, have deployed new automation systems to make their markets more efficient. Moreover, advances in technology have led to sophisticated order routing and execution systems that can provide extremely fast routing and execution capabilities among competing multiple markets. Finally, the minimum pricing variation in equity securities is now a penny instead of an eighth, resulting in narrower spreads, at least for many actively traded stocks. At the same time there is decreased depth at the best quote, and rapid quote changes - often many times within a second.

The Commission believes that these changes require it to revisit the issue of trading at inferior prices across markets.⁷ Clearly, in a fully efficient market with frictionless access and instantaneous executions, trading through a better-displayed bid or offer should not occur. Yet the Commission believes that even in the current markets with linkages between markets and a range of execution speeds and fill rates, there is value in protecting a displayed price from trades occurring at inferior prices in other markets. This “price protection” encourages the display of priced orders and fosters the execution of customer orders.

The Commission therefore is proposing a rule intended to preserve the benefits of price protection across markets, while addressing the tensions in the operation of the current ITS trade-through rule. The proposed rule would require an order execution facility (as defined below), national securities exchange, and national securities association to establish, maintain, and enforce polices and procedures reasonably designed to prevent the execution of a trade-through in its market. The proposed rule would apply to all incoming orders in “NMS Stocks” – all Nasdaq, NYSE, and Amex-listed stocks - and to any order execution facility that executes orders internally within its market, whether or not that market posts its best bid and offer in the consolidated quote system.⁸

The proposed rule would have two major exceptions. One would allow customers (and broker-dealers trading for their own accounts) to “opt-out” of the protections of the rule by providing informed consent to the execution of their orders, on an order-by-order basis, in one market without regard to the possibility of obtaining a better price in another market. The other exception would take into account the differences between the speed of execution in electronic versus manual markets by providing an automated market with the ability to trade-through a non-automated market up to a certain amount away from the best bid or offer displayed by the non-automated market. The Commission believes that the proposed rule would promote competition and order interaction between markets, provide an incentive for the use of limit orders and aggressive quoting, facilitate the ability to achieve best execution and help reduce the effects of fragmentation.

B. Background and Discussion

1. Foundation of Our National Market System

Amendments to the Exchange Act made almost three decades ago formed the basis for the modern market structure in the U.S. – a national market characterized by a system of competing markets, rather than one centralized market. Section 11A of the Exchange Act, enacted as part of the Securities Act Amendments of 1975 (“1975 Amendments”), sets forth Congress’ findings regarding the nation’s securities markets and directs the Commission to facilitate the development of an NMS in keeping with the principles set forth by Congress. 9 Specifically, Congress found that it is in the public interest and appropriate for the protection of investors and the maintenance of a fair and orderly market to assure:

• the economically efficient execution of securities transactions;
   
• fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets;
   
• the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities;
   
• the practicability of brokers executing investors’ orders in the best market; and
   
• the opportunity, consistent with the provisions in the first and last bullets above, for investors’ orders to be executed without the participation of a dealer.¹⁰

Congress also found that the linking of all markets for securities will “foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors’ orders, and contribute to best execution of such orders.”¹¹ In short, Section 11A of the Exchange Act envisions a market structure characterized by full transparency where competing markets are linked together to provide the ability to effectively and efficiently execute customer orders in the best available market. It is these core principles that have shaped the Commission’s actions to foster the development of a true NMS.

Although Congress set out broad principles to govern the development of an NMS, it did not dictate a specific form that it should take. Instead, Congress envisioned that competitive forces, to the extent feasible, would shape the structure of our markets, and granted the Commission broad authority to oversee the implementation, operation, and regulation of an NMS.¹² In keeping with Congress’ mandate, the Commission believes that its central role is to facilitate the development of an NMS, not to dictate the precise form that the NMS will take.¹³

Within the framework of this philosophy, the Commission has over the years helped to guide the development of our NMS. For instance, the Commission, working with the various SROs, has taken numerous steps to implement the basic structure upon which our existing NMS is built. For example:

• In the late 1970s the Commission issued several policy statements outlining its vision of an NMS, including a belief in the importance of attaining nationwide protection for customer limit orders.¹⁴
   
• In the late 1970s the Commission adopted a rule requiring the exchanges and the National Associations of Securities Dealers (“NASD”) to report quotations in certain securities, and approved an NMS plan established by the SROs relating to the reporting of quotations in exchange-listed securities (the Consolidated Quotation or “CQ” Plan).¹⁵
   
• Rule 11Aa3-1 (proposed to be designated as Rule 601), which requires SROs to implement a transaction reporting plan for the collection, processing and dissemination of last sale transaction reports in reported securities, was adopted in 1972.¹⁶
   
• In 1979 the Commission approved an exchange plan to link the various markets trading exchange-listed securities (the “ITS Plan”). ¹⁷
   
• Rule 11Ac1-2 (proposed to be designated as Rule 603), which was adopted in 1980, imposes minimum requirements regulating the manner in which securities information vendors display transaction and quotation information.¹⁸
   
• In response to the Commission’s continuing concerns regarding intermarket price protection, in 1981 the ITS participants proposed amendments to the ITS Plan and to their own rules requiring participants to avoid the execution of a trade at a price worse than the best price displayed on another participant market.¹⁹ In 1981 the Commission approved the amendments to the ITS Plan, including a model trade-through rule upon which the SRO trade-through rules were based.²⁰ In 1981 and 1982, respectively, the Commission approved the exchanges’ and NASD’s trade-through rules.²¹
   
• In 1990 the Commission approved on a pilot basis a proposal by several of the SROs governing the collection, consolidation and dissemination of quotation and transaction information for Nasdaq national market securities listed and traded on Nasdaq and traded on exchanges pursuant to unlisted trading privileges.²² The Nasdaq UTP Plan now applies to all Nasdaq securities.²³
   
• In 1996, as part of its Order Handling Rules initiative designed to enhance transparency and competition in the market place, the Commission adopted Rule 11Ac1-4 under the Exchange Act (proposed to be designated as Rule 604) (the “Limit Order Display Rule”), which requires certain exchange specialists and over-the-counter (“OTC”) market makers to publicly display customer limit orders that better the specialist’s or market maker’s displayed price and/or size.24
   
• The Commission also amended Rule 11Ac1-1 under the Exchange Act (proposed to be designated as Rule 602) (the “Quote Rule”) at the same time to require a specialist or OTC market maker to publicly display its best-priced quotations and customer limit orders for any listed security when it is responsible for more than 1% of the aggregate trading volume for that security, and to make publicly available any superior prices that the specialist or market maker privately quotes through certain ECNs.25
   
• In June 2000 the Commission issued an order that established the framework for the SROs to convert their quotation prices from fractions to decimals.²⁶ The order allowed the SROs to select a uniform minimum pricing variation for stock quotes of no greater than $.05 and no less than $.01.²⁷ In July 2000 the SROs submitted a Decimals Implementation Plan that set the minimum pricing variation for equity stock quotations at one cent, and each SRO established rules setting the minimum quoting increment for equity securities in its market at one cent.²⁸

These and other actions resulted in a solid foundation for our NMS. For NYSE, Amex, and Nasdaq securities, the best bids and offers of each national securities exchange and registered OTC market maker are collected and made available to market participants. The last sale prices for NYSE, Amex, and Nasdaq securities are collected and disseminated through a central reporting facility to market participants. All national securities exchanges and registered OTC market makers that trade “ITS eligible” securities (including any ECN registered as an Intermarket Trading System/Computer Assisted Execution System (“ITS/CAES”) market maker) are able to access each ITS participant’s top-of-book through the ITS linkage, and are subject to existing trade-through provisions that require ITS participants’ members to seek to avoid trading at a price in one market that is inferior to the price displayed in another market. Alternative markets to the traditional floor-based auction markets have developed within the existing national market system, bringing added competition to our markets.

2. Intermarket Price Protection

The Commission believes that one of the most important goals of an NMS is the encouragement of the display of limit orders and aggressive quotes, which provide the basis for all price discovery in the markets. When trades occur at prices that are inferior to displayed limit orders or quotes, it could discourage their display because market participants may be less willing to display limit orders or to quote aggressively if they believe it likely that such orders and quotes will be bypassed by executions in other markets at prices that would be advantageous to them. A rule that effectively prevents one market from executing an order at a price that is inferior to a better price displayed on another market, especially in an NMS characterized by multiple competing markets, may encourage market participants to use limit orders and to quote aggressively, which in turn can improve the price discovery process and contribute to increased liquidity and depth. Moreover, such a rule, coupled with adequate access among markets, also could help reduce the effects of fragmentation and promote order interaction among competing markets by providing that trades would not execute in each individual market without reference to quotes and orders displayed in other markets.

In addition, when trades occur at prices worse than the displayed quote, it gives an impression of unfairness in our market system, especially to retail investors who see their orders executed at the inferior prices. Trade-through rules facilitate broker-dealers’ ability to achieve best execution for their customers’ orders. Pursuant to a trade-through rule, if a broker-dealer routes an order to a market that is not showing the best bid or offer at the time of order execution, that market should not execute the order at a price that is inferior to the price displayed on the other market, unless an exception applies.

a. History of Intermarket Price Protection

In the late 1970s, following the adoption of the 1975 Act Amendments to the Exchange Act, the Commission expressed its desire to move forward to achieve nationwide protection for customer limit orders, calling for industry efforts to be concentrated on achieving nationwide protection of public limit orders based on the principle of price priority.²⁹ With regard to the trading of exchange-listed securities, the Commission believed that the ITS participants should be given time to enhance ITS as a way of providing intermarket price protection for customer limit orders.³⁰ Although its focus was on providing protection for public limit orders, in its 1979 Status Report the Commission also stated its belief that nationwide price protection, if it was to be accomplished “in a fair manner consistent with the Act,” ultimately should protect all buying and selling interest displayed by a market center as part of its current bid and offer as well as all displayed public limit orders away from the best market that were also superior to the price of the proposed trade.³¹

In 1981 the participants in the ITS Plan proposed amendments to the ITS Plan that stated that certain market participants should not execute orders at a price worse than the best price displayed by another participant market in the public quote.³² The proposal included a model trade-through rule.³³ The Plan participants also proposed amendments to their own rules to institute trade-through rules patterned after the model ITS rule requiring their members to avoid trading through a better price displayed on another market.³⁴ In 1981 the Commission approved these amendments to the ITS Plan and ITS exchange participant trade-through rules.³⁵ Several years later, the NASD become an ITS Plan participant and instituted its own trade-through rule that applies to each of its members that is a registered market maker in exchange-listed securities (an “ITS/CAES” market maker).³⁶

b. Existing Intermarket Price Protection Regime

The NYSE and Amex markets, and the Nasdaq market, have adopted different approaches to intermarket price protection. With regard to NYSE- and Amex-listed securities, the ITS trade-through rule requires members of an exchange, when purchasing or selling, either as principal or agent, a security traded through ITS on the exchange or by issuing a commitment to trade through ITS, to avoid initiating a trade-through (unless an exception applies).³⁷ The ITS rule defines a trade-through to occur when a member initiates a purchase (sale) on the exchange of a security traded through ITS at a price that is higher (lower) than the price at which the security is offered (bid for) at the time of the purchase (or sale) in another ITS participant market as reflected in the offer (bid) then being displayed on the exchange from the other participant market.³⁸ Each SRO requires its members, when purchasing or selling any ITS security, either as principal or agent, on its market or when sending a commitment through ITS, to avoid initiating a trade-through unless an exception applies.³⁹ The SRO trade-through rules also include extensive procedures for “satisfying” an order that is traded-through.⁴⁰

The existing trade-through rules apply to exchange members and registered OTC market makers that trade NYSE or Amex-listed securities, but not to block positioners that operate in the OTC market without registration as OTC market makers.⁴¹ Thus, OTC block positioners generally are not restricted by the existing trade-through rule from trading outside the best bid and offer. Nor do the trade-through rules apply to alternative trading systems (“ATSs”) that trade NYSE or Amex-listed securities in the OTC market unless they are required to (or choose to) post quotes in the consolidated quotation system through an SRO.⁴² When an ATS displays its best bid or offer in the consolidated quotation system through an SRO, it becomes subject to that SRO’s trade-through restrictions (and thus the ITS Plan trade-through restrictions). For example, the NASD requires any ATS that intends to display its quotes in NYSE or Amex securities in the OTC market to register as an ITS/CAES market maker and thus become subject to the NASD’s (and ITS Plan’s) trade-through restrictions.⁴³

In contrast, the Nasdaq UTP Plan as approved by the Commission does not contain any trade-through provisions, and no intermarket trade-through rules currently exist with regard to the trading of Nasdaq securities.⁴⁴

c. Strains on Existing Intermarket Price Protection Regime

While the Commission continues to believe that a trade-through rule can encourage the use of limit orders, facilitate best execution, and reduce the effects of fragmentation, the Commission is concerned that developments in the markets over the last few years have called into question the continued viability of the existing system for achieving intermarket price protection in NYSE and Amex stocks.

The structure of the U.S. securities market is quite different now than when the ITS trade-through provisions were adopted. At the time when the existing rules were put in place, order routing and execution facilities were slower, there was less vigorous intermarket competition in NYSE, Amex, and Nasdaq securities, and the minimum trading increment was 1/8th of a dollar. By contrast, in today’s market, rapid advances in technology have provided a variety of means to efficiently route orders to multiple markets. “Alternative” markets that provide almost instantaneous executions by automatically matching buy and sell orders have emerged, as has the use of “smart” order routing and execution systems by broker-dealers and other market participants. Stocks are quoted in pennies instead of 1/8ths, which has led (in many instances) to narrower spreads, less depth at the top-of-book and rapidly changing quotes. It also may reduce the cost of a trade-through to the investor.

Because competing market centers currently offer different speeds and levels of certainty of execution, the challenge of providing price protection across these diverse markets has grown. In recent years some market participants have argued that the restrictions imposed by existing trade-through rules for NYSE and Amex securities impede the efficient operation of “non-traditional” automated markets that operate by automatically, and nearly instantaneously, matching buying and selling interest resident in their systems.⁴⁵ These market participants say that if an electronic market is subject to existing trade-through rules, the market must slow down or forego an execution in its system in order to send an order to another market displaying a better price to attempt to access that better priced order, or risk having to satisfy the better-priced order if it is traded-through. Although the trade would occur at an inferior price, these market participants say that some customers prefer the speed and/or certainty of execution over price.

Many automated markets argue that requiring them to provide this outbound access to a non-automated market to reach the better price displayed on that other market, no matter how marginal that better price is and how long it takes the other market to execute the order (if at all), not only compromises the basic structure of their markets but also effectively grants an option to that slower market during the time period before the order is executed. This option has value, as there is a risk that the market for the stock may move before the order is executed, especially if a significant amount of time passes before the order is executed.⁴⁶ In addition, market participants argue that there is no guarantee that the order will even be executed at the price that was showing at the time that the order was sent, given the rapid quote changes that exist for some securities today.⁴⁷

A trade-through rule like the current ITS trade-through rule effectively prevents a market center from executing an investor’s order immediately at an inferior price, even if that is what the investor desires. Thus, such a rule impacts an individual investor’s ability to direct the manner in which its order will be executed. In today’s environment characterized by rapidly changing quotes, narrow spreads, and less depth at the inside, some investors may believe that best execution is fulfilled by instructing their broker that speed and/or certainty of execution is more important than the possibility of a small amount of price improvement.

With respect to transactions in certain high-volume, derivatively-priced ETFs – QQQs, SPDRs and Diamonds – that are widely traded by electronic markets, the Commission in August 2002 issued an order to ease the restrictions of the trade-through rules by granting, on a temporary basis, a three-cent de minimis exemption to the trade-through provisions of the ITS Plan.⁴⁸ The exemption allows participants to execute orders in these ETFs at prices no more than three cents away from the best bid or offer displayed in the consolidated quote at the time of execution.⁴⁹ The Commission, in issuing the exemption, stated its belief that the exemption would, on balance, provide investors with increased liquidity and increased choice of execution venues while limiting the possibility that investors would receive significantly inferior prices.⁵⁰

In light of the Commission’s three-cent de minimis exemption for the QQQs, SPDRs, and Diamonds, the ITS participants held many discussions regarding ways to revise the trade-through requirements in the ITS Plan. The participants were not able to reach consensus on a course of action (amendments to the ITS Plan must be unanimous under the existing plan provisions). The Commission also notes that not all market participants affected by the operation of the current trade-through rules have a direct voice in the administration of the ITS Plan, and are therefore unable themselves to directly influence or affect any changes to the trade-through provisions of the ITS Plan.

With respect to the market for the trading of Nasdaq securities, there are no intermarket trade-through rules and no mandatory intermarket linkage other than the telephonic access required among markets trading Nasdaq stocks under the Nasdaq UTP Plan and the access requirements for participants in the NASD’s Alternative Display Facility (“ADF”).51 Over the past few years, however, a number of new markets have begun trading Nasdaq stocks. Nasdaq stocks are traded on Nasdaq’s National Market Execution System (more commonly known as “SuperMontage”), all of the largest ECNs, the PCX (through its equity trading facility the Archipelago Exchange), the Amex, the BSE, and the NSX. In addition, Nasdaq stocks are traded among participants in the ADF. Nasdaq market makers and other registered broker-dealers also continue to trade Nasdaq securities outside of SuperMontage or the ADF. As a result, trading now extends beyond the Nasdaq’s SuperMontage system where displayed prices are protected. Broker-dealers trading in the Nasdaq market rely on best execution obligations. Yet, even without a trade-through rule, the Nasdaq market does not appear to lack competitive quoting in the most actively traded securities.

C. Proposed Trade-Through Rule

The Commission believes there is value in having a rule that provides a measure of price protection for limit orders across markets, if the rule is designed to accommodate the current structure of our NMS. Like the current ITS trade-through rule, a Commission trade-through rule would encourage the use of limit orders, aggressive quoting, and order interaction and help preserve investors’ expectation that their orders will be executed at the best displayed price. The Commission therefore is proposing its own trade-through rule that would apply not only to the trading of NYSE and Amex securities but also to the trading of Nasdaq securities.

The Commission’s proposed trade-through rule would require markets, with regard to the trading of NMS Stocks - NYSE, Amex, and Nasdaq securities - to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution of trade-throughs in their markets. The proposed rule includes two exceptions to the basic requirement that are designed to address issues that have been raised regarding the current ITS trade-through rule. One exception would allow customers (and broker-dealers acting for their own account) to provide informed consent to having their orders executed in one market without regard to prices in other markets. The other exception would allow an automated market to trade through a non-automated market up to a certain amount. The proposed rule is intended to respond to the current criticisms of the existing rule and accommodate different marketplace models, while still preserving important customer and market integrity protections. As discussed in more detail in Section III.C.7. below, the Commission emphasizes that the proposed rule is not intended to, and would not, in any way alter or lessen a broker-dealer’s best execution obligations.

1. Markets Subject to the Proposed Rule

The proposed rule would require an order execution facility,⁵² national securities exchange and national securities association to establish, maintain, and enforce policies and procedures reasonably designed to prevent the purchase or sale of an NMS Stock at a price that is inferior to a better price displayed on another market.⁵³ The intent of the proposed rule is to prohibit the execution of any trade-through by any order execution facility, national securities association or national securities exchange, absent one of the specified exceptions. Nevertheless, the Commission recognizes the unavoidable “false-positive” and “false-negative” trade-throughs that occur because quotes are updated and orders are executed more rapidly than information can be communicated. The Commission does not believe that an order execution facility should be held responsible for protecting a better-priced quote that it cannot see because it has not yet received the quote. Specifically, in an environment where quotes can change numerous times within a fraction of a second, an order execution facility should not be required to protect a best bid or best offer of another order execution facility disseminated within the same second during which the order execution facility executed the order but which was not the best bid or best offer that the executing market saw at the instant that it executed the order. The Commission requests comment on whether drafting the rule to require order execution facilities, national securities exchanges, and national securities associations to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution of trade-throughs in their markets is sufficient to effectively deter and prevent trade-throughs. Should the Commission instead, or in addition, explicitly prohibit trade-throughs absent an exception?

The Commission is proposing to define “order execution facility” broadly to include all national securities exchanges and national securities associations that operate a facility that executes orders, ATSs, exchange specialists and market makers, OTC market makers, block positioners and any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.⁵⁴ The Commission believes that including broker-dealers that do not post quotes or orders in the public quote but that nevertheless execute orders internally is important because otherwise those markets would have an advantage over markets that display their best quotes and orders in the public quote. Given the availability of best bid and best offer information, the access standards proposed by the Commission today, ⁵⁵ and the advanced technology that currently is available for the routing of order flow, the Commission does not believe that including “non-quoting” markets within the scope of the proposed rule would impose any undue hardships on such markets. The Commission requests comments on the advisability of including “non-quoting” markets within the scope of the rule, including whether there are any practical difficulties or other costs that would not justify the benefits of requiring them to comply with the rule. The Commission also requests comment on the extent of any positive or negative impact of including these markets within the scope of the rule.

2. Types of Securities Subject to the Proposed Rule

The proposed trade-through rule would apply to the trading of all NMS Stocks, which means that it would apply to the trading of all Nasdaq, NYSE, and Amex stocks.⁵⁶ Applying a trade-through rule to the trading of Nasdaq securities would represent a change from the status quo. The Commission believes that it may no longer be possible to identify a distinction between Nasdaq stocks and other NMS Stocks for purposes of imposing trade-through protections.

The Commission requests comment on applying the protections of the proposed rule to the trading of Nasdaq securities. The Commission also requests comment on the practical impact of implementing a trade-through rule for Nasdaq securities, including specifically what system, technical, or other changes would be needed to implement the proposed rule.

3. Types of Orders Subject to the Proposed Rule

The proposed rule would apply to any purchase or sale of an NMS Stock during regular trading hours. Accordingly, the proposed rule would apply to orders for the account of a broker-dealer as well as for the account of a customer.⁵⁷ The Commission believes that excluding orders for the account of a broker-dealer would undermine the purpose of the proposed rule to provide price protection to displayed better-priced limit orders and quotes, because the broker-dealer orders would be able to trade-through the better prices. However, a broker-dealer (as well as a customer) may choose to opt-out of the rule’s protections with regard to orders for its own account, pursuant to the opt-out exception proposed below. The Commission requests comment on whether broker-dealer orders should be included within the scope of the rule.

4. Bids and offers to Be Protected

The proposed rule would require an order execution facility, national securities exchange, and national securities association to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution of an order at a price that trades through the best bid or best offer of any order execution facility that is disseminated pursuant to an effective national market system plan. Currently, bids and offers that are disseminated pursuant to an effective national market system plan include, with respect to NYSE and Amex listed securities, the best bid and best offer of each national securities exchange that trades a particular NYSE or Amex listed security, as well as the best bid and best offer of each individual registered market maker and ATS (registered as an ITS/CAES market maker) that provides its best bid and best offer to the NASD for a particular NYSE or Amex listed security.⁵⁸ The current ITS trade-through rule protects the best bid and best offer of each national securities exchange and the “ITS/CAES BBO,”⁵⁹ which is one best bid price and one best offer price (with aggregate size) for all ITS/CAES market makers, but not the best bid and best offer of each individual ITS/CAES market maker.⁶⁰ With regard to the trading of Nasdaq securities, bids and offers that are disseminated pursuant to an effective national market system plan include the best bid and best offer of each national securities exchange that trades a particular Nasdaq security, the best bid and best offer of each registered Nasdaq market maker or ATS that provides its best bid and best offer in a particular Nasdaq security to Nasdaq, and the best bid and best offer of each ADF quoting market participant that provides its best bid and best offer in a particular Nasdaq security to the NASD.⁶¹

The Commission requests comment on the extent to which the best bid and best offer of each individual market maker and ATS that would be protected pursuant to the proposed rule is available to all order execution facilities that would be subject to the proposed rule, and the extent to which the accessibility of those bids and offers would be impacted by the proposed access standards and market data amendments proposed today.⁶² The Commission also requests comment as to the scope of the bids and offers that should be protected pursuant to the proposed rule. In particular, should the best bids and best offers of each individual registered market maker and ATS be protected, as proposed? Or should the proposed rule protect only the best bid and best offer of each national securities exchange and the aggregate best bid and best offer of each non-exchange “market” (i.e. one best bid price and one best offer price with aggregate size for all ITS/CAES market makers with respect to the trading of NYSE and Amex securities otherwise than on an exchange, a best bid price and best offer price with aggregate size for the Nasdaq market with respect to the trading of Nasdaq securities, and a best bid price and best offer price with aggregate size for the ADF with respect to the trading of Nasdaq securities)? Further, if the proposed rule did not protect the best bid and best offer of each individual market maker and ATS, the Commission requests comment as to whether there should be just one best bid price and best offer price, with aggregate size, for the trading of Nasdaq securities other than on an exchange, or whether there should be a separate best bid and best offer for trading on Nasdaq and a separate best bid and best offer for trading on the ADF.

As noted above, the proposed rule would apply only to the best bid and best offer of any order execution facility that is disseminated pursuant to an effective national market system plan. It would not apply to other limit orders or quotes that are also priced better than the order being executed but are not disseminated pursuant to an effective national market system plan. To expand the price protection beyond the best bid and best offer for each market would entail the Commission requiring quoting market centers to make available, and provide access to, their entire depth of book to other markets. Although the Commission believes that from a policy viewpoint it would make sense to provide protection to any better-priced quote or order displayed in another quoting order execution facility, not just the top-of-book of each quoting order execution facility, the Commission questions whether protecting all displayed limit orders and quotes at this time would be feasible. The Commission, however, requests comment on whether it should expand the scope of the proposed rule to include trade-through protection beyond the best-displayed bid and offer. For example should the scope of the proposed rule include protection beyond the best displayed bid and offer in the circumstance where a market center voluntarily provides depth-of-book information through the facilities of an effective national market system plan?

Current SRO rules regarding block trades in NYSE and Amex securities, adopted pursuant to the ITS Plan (as well as the provisions of the ITS Plan itself) allow block trades to be executed at an inferior price as long as the party executing the block executes any better priced order(s) displayed on another market(s) at the block price.⁶³ In the proposed rule, the Commission is not proposing to treat large “block-sized” trades any differently than non-block trades. Thus, an order execution facility could not execute a block trade at a price inferior to the best bid or offer displayed on any other order execution facility unless the order execution facility sent an order to trade at the price of the better-priced order.⁶⁴ The Commission believes that an exception for block trades may not be necessary because its proposed exception to the trade-through rule to allow a customer, or broker-dealer trading for its own account, to provide informed consent to having its order executed without the protection of the rule would be available to a customer or broker-dealer that wishes to execute a block trade.⁶⁵

The Commission requests comment on whether this is the appropriate way to handle block trades under the proposed rule. The Commission requests comment on the extent to which treating block trades in the same manner as other trades, combined with the proposed opt-out exception, would impact a broker-dealer’s or customer’s ability to execute a block trade, if at all. The Commission also requests comment on whether a block exception would be necessary if the proposed opt-out exception were not adopted.

5. Required Policies and Procedures

The proposed rule would require each order execution facility, national securities exchange, and national securities association to develop policies and procedures reasonably designed to prevent the execution of a trade-through in its market. ⁶⁶ While the exact nature and extent of the policies and procedures would therefore depend upon the type, size, and nature of the order execution facility, national securities exchange, and national securities association, these procedures must be designed to forestall trade-throughs from occurring other than pursuant to an exception. Among other things, the policies and procedures of an order execution facility, national securities exchange, and national securities association should provide for the monitoring of quotations in other markets and prevent a trade from being effected in its market at a price inferior to a bid or offer that was apparent to the order execution facility in another market.

The Commission believes it is important for each order execution facility, national securities exchange, and national securities association to include a reasonable process in its required policies and procedures for specifically identifying and handling “false positive” and “false negative” trade-throughs. Given the speed with which the quotes update in certain stocks, there may well be instances of “false-positive” trade-throughs, where a market participant took all reasonable precautions and legitimately did not think it was trading through the best bid or best offer of any other market center disseminated pursuant to an effective national market system plan at the time of execution but, because of rapid-fire quote changes in the stock (or possibly inconsistent records as to the time of execution), it appears in hindsight that the order execution facility did in fact trade through another market. As discussed above, the Commission does not believe it reasonable to require a market center to protect a bid or offer that has not yet been received by it and that the market center, therefore, cannot see at the instant that an order is executed. The Commission recognizes that these issues already exist under the current trade-through rules. The Commission requests comment on specific procedures that could be implemented to prevent and identify instances of “false-positive” and “false-negative” trade-throughs.

The Commission also requests comment on the minimum standards to which an order execution facility, national securities exchange, and national securities association should adhere when establishing, maintaining, and enforcing its required policies and procedures

6. Access Standards

The Commission recognizes that it would not be reasonable to impose trade-through restrictions that prohibit an order execution facility from executing an order at a price inferior to the best bid or offer displayed in another market(s) unless the order execution facility can see and have fair and efficient access to those prices. Therefore, the Commission believes that an effective linkage between markets must be in place before implementing a trade-through rule, whether it is a “hard-wired” linkage or required minimum access standards. This is especially true for the market for Nasdaq stocks, where trading has expanded to multiple markets and where there is no existing “hard-wired” linkage or minimum access standards, other then the telephonic access required by the Nasdaq UTP Plan and the minimum access standards of the ADF.⁶⁷

The Commission believes that the access standards it has proposed today would provide the necessary levels of access.⁶⁸ The Commission requests comment on whether existing access in the markets for Nasdaq, Amex and NYSE securities is adequate to support the proposed trade-through rule, in light of the advances in technology and the proprietary linkages already in place today. If current access is not adequate, the Commission requests comment on what access standards would be needed as a prerequisite to implementing the proposed trade-through rule.

Under the proposed access rules, an SRO would not be permitted to post quotes or orders for another market center (such as an ATS or market maker) through its facilities unless it has first made a determination that the market center has provided adequate access to its quotes and orders under the proposed access standards.⁶⁹ The Commission believes that this requirement is necessary to protect against inaccessible markets becoming part of the consolidated quote.

7. Duty of Best Execution

The Commission emphasizes that the proposed trade-through rule, including the automated market exception, in no way alters or lessens a broker-dealer’s duty to achieve best execution for its customers’ orders. A broker-dealer still must seek the most advantageous terms reasonably available under the circumstances for all customer orders. A broker-dealer must carry out a regular and rigorous review of the quality of market centers to evaluate its best execution policies, including the determination as to which markets it routes customer order flow. A broker-dealer cannot merely assume that because the market(s) to which it sends its customer orders is subject to the proposed rule, the broker-dealer can abdicate its responsibilities for evaluating the execution quality of that market. Moreover, broker-dealers that execute customer orders internally would continue to be evaluated against the best bid and offer (or better bid or offer, if available) for best execution purposes, regardless of whether these orders were executed automatically or manually. The proposed trade-through rule does not justify a market maker executing retail orders internally at prices inferior to the best quote, even if executed automatically.

D. Exceptions to the Proposed Rule

To provide flexibility for market centers with different market structures and to give investors more control over how their orders are executed, the proposed rule would include an exception allowing customers to “opt-out,” and an exception allowing an automated market to trade through a non-automated market in limited circumstances. The Commission also is seeking comment on an alternative to these exceptions that would require market centers to provide automated access to displayed quotations.

1. Opt-Out Orders

Some investors may, at times, value speed and/or certainty of execution over the possibility of obtaining a slightly better price on another market, especially prices that may be as little as one cent per share better. These investors may want the ability to trade immediately in the market to which they send an order without having any delay from routing the order to another marketplace with a slightly better price, particularly a non-automated market that does not provide the same speed or certainty of execution as the market to which the investor sent its order. Such order routing decisions by an investor are facilitated by execution data now available for orders of less than 10,000 shares that can help guide investors in their investment decisions regarding where and when to execute their orders.⁷⁰ Large traders may also want the ability to execute a block immediately at a price outside the quotes, to avoid parceling the block out over time in a series of transactions that could cause the market to move to an inferior price.

A further benefit of providing investors with the flexibility to choose whether their orders should trade through a better quote is that it might create market forces that would discipline markets that provided slow executions or inadequate access to their markets. If investors were not satisfied with the level of automation or service provided by a market center, they could choose to have their orders executed without regard to that market’s quote, thus putting pressure on the market to improve its services.

The Commission therefore is proposing an exception to the trade-through rule to allow an order execution facility to execute an order at a price that trades through a better-displayed bid or offer on another market if the person for whose account the order is entered (e.g. a broker-dealer for its own account or a customer for the customer’s account) makes an informed decision to affirmatively opt out of the trade-through rule’s protections with regard to that order.⁷¹ The proposed exception strives to preserve the usual customers’ expectation of having their orders executed at the best displayed price, but allows a choice for those investors whose trading strategies may benefit from an immediate execution priced outside the national best bid and offer (“NBBO”). Broker-dealers, of course, would not have to permit their customers the ability to opt out of the trade-through rule’s protections. The Commission requests comment on whether the proposed opt-out exception is needed to enable informed traders to design their own trading strategies appropriate to their particular circumstances.

While the opt-out exception would provide greater execution flexibility to informed traders, the Commission recognizes that the opt-out exception is inconsistent with the principle of price protection for limit orders because it would allow investors to choose to have their orders executed without regard to better-priced orders displayed on other market centers. If limit orders frequently remain unexecuted after trades take place at inferior prices, investors may be discouraged from entering limit orders, thus reducing price discovery. In light of this concern, the Commission requests comment on the extent to which limit orders would remain unexecuted after a trade-through, and the impact on investors’ use of limit orders, if the opt-out exception were to be implemented.

If used frequently, the proposed opt-out exception also might undermine investor confidence that their orders will receive the best price available in the markets, when they see trades frequently occurring at prices inferior to better prices displayed on other markets. The Commission therefore requests comment on whether the opt-out exception would undermine the principle of price priority and, if so, the anticipated impact of this exception on the principle of price priority.

a. Request for Comment on Automated Execution Alternative

To the extent that the need for trade-through flexibility is caused by the inability to trade efficiently with published quotations, this problem could be addressed more directly by requiring all market centers to provide an automated response to electronic orders at their quote. As discussed in Section IV below, the Commission historically has not dictated the means of execution provided by competing market centers. Nonetheless, if the Commission were to adopt an automatic execution requirement, such action may allay to some extent investors’ concerns over their inability to quickly access manual markets and control their own executions.

In addition, to the extent that trade-through flexibility is needed to facilitate block trading, an automatic execution requirement in conjunction with the proposed trade-through rule’s provision for simultaneously routing and trading may enable block trades to avoid trading through without moving the market. Because the proposed trade-through rule would allow a market participant to route orders to the displayed quotes and then trade at a price that would otherwise be a trade-through, a block trader could use automatic execution to simultaneously access the existing displayed quotes and then execute the remainder of the block at a discount, without violating the rule.

An automatic execution requirement may well deal with two of the potential serious flaws with the proposed opt-out exception. First, to the extent that the opt-out exception is inconsistent with the principle of price protection for limit orders, an automatic execution requirement at the best bid or offer for limit orders avoids this problem. Under such an alternative, investors would not be discouraged from entering limit orders, and price discovery would be enhanced.

Second, an automatic execution alternative also supports the principle of price priority. It would not allow trades to occur at inferior prices, as could happen under the proposed opt-out exception. Such an alternative could maintain investor confidence that their orders will receive the best bids and offers displayed in any market.

For these reasons, the Commission requests comment on whether there is a continued need for the opt-out exception if it were to adopt an automatic execution requirement. The Commission also requests comment if there is a continued need for the proposed automated market exception, if the Commission were to adopt an automatic execution requirement, because all market centers would be required to provide the same basic level of automatic execution functionality, and thus there would be no distinction for purposes of the proposed rule between manual markets and automated markets.

In the access discussion in Section IV, the Commission requests comment on whether, if it were to require automatic execution, it would need to set performance standards governing the use of the automatic execution functionality to which all markets would be required to adhere. The Commission specifically requests comment as to whether it should set minimum execution performance standards that would require that market participants’ systems respond to orders from other markets within certain time frames.⁷² Would minimum performance standards be essential to any consideration to not adopt an opt-out exception? The Commission also requests comment on whether, as discussed earlier, even if the Commission were to adopt an automatic execution requirement, the Commission should retain the proposed opt-out exception in order to provide a market and competition-driven incentive for different markets to provide and maintain a high level of service.

b. Opt-Out - Order-by-Order Consent

If a broker or dealer were to provide investors the ability to opt out, the proposed rule would require the broker-dealer to obtain informed consent from each investor who chooses to opt out of the protections of the proposed rule on an order-by-order basis. The Commission is not proposing to allow consent on a global basis, either by a written agreement or otherwise, because of a concern with the potential for abuse if consent can be obtained on a basis other than for each particular order. Requiring an investor to provide informed consent on an order-by-order basis, based upon its execution preference at the time of placing the order, is intended to help protect against less sophisticated customers, such as retail customers, consenting without fully understanding to what they are consenting or the effect of such consent. Specifying whether or not the order is “opted-out” could become another facet of the order handling instructions given to the broker-dealer at the time of execution, and indeed consent could be obtained electronically for those systems where orders are sent electronically to broker-dealers.⁷³ Nonetheless, in view of the time involved in communicating the consent, the Commission requests comment on the anticipated impact of the requirement to obtain informed consent on an order-by-order basis on the order handling and execution processes of each broker-dealer, and whether this requirement would be expected to significantly slow down that process. The Commission also requests comment on whether it is necessary to restrict consent to a trade-by-trade basis for parties that enter into agreements authorizing opting out, and if so, how such global consent should operate. Finally, the Commission requests comment on whether the ability to opt out should be available only to institutional or sophisticated investors, who may be better qualified, or in a better position to understand, the implications of opting out then retail investors. If so, how should the Commission define an institutional or sophisticated investor?

The requirement to obtain informed consent in order to allow an opt-out would apply to any broker-dealer that receives order flow from a customer or another broker-dealer even if that broker-dealer would not be considered an order execution facility under the proposed rule.⁷⁴ Although the way in which a broker-dealer would obtain informed consent consistent with any fiduciary obligations arising from the particular relationship with an investor may differ from investor to investor, a broker-dealer at a minimum should explain in clear and concise terms to any customer from whom it accepts consent, for each order, that: (1) the customer’s order would be executed in the market to which it is sent without regard to prices displayed in other markets, even if those prices are better; (2) the customer affirmatively would be agreeing to forego the possibility of obtaining a better price that may be available in another market at the time its order is executed; and (3) this could result in the customer’s order receiving an execution at a price that is inferior to the best bid or offer displayed at the time his or her order is executed. Each time a customer consents, the broker-dealer must be confident that the customer fully understands this disclosure and the nature of the consent. The Commission solicits comment on whether there are any particular disclosures that a broker-dealer should be required to make prior to obtaining informed consent.

The Commission requests comment on how a broker-dealer would fulfill this obligation to obtain informed consent with respect to orders it receives from other broker-dealers, when it has no interaction or relationship with that broker-dealer’s customers. The Commission also requests comment on how, if at all, broker-dealers would fulfill this obligation with respect to retail customers who lack complete information about comparative market quality, current market data from all markets, and the willingness to undertake individual market routing decisions. Further, the Commission requests comment on whether different issues are raised when an order execution facility receives order flow directly from customers for execution.

The Commission realizes that market participants that handle customer or broker-dealer orders and that choose to provide these entities the ability to opt out likely would have to make changes to their order handling and execution practices to accommodate this exception. Likewise, an order execution facility receiving the order from another order execution facility, a broker-dealer, or directly from a customer for execution would need to ensure that its systems could distinguish between opted-out and non-opted-out orders for purposes of execution. Broker-dealers receiving orders from their customers and other broker-dealers likely would need to amend their order handling procedures to accommodate those who choose to opt out, as well as their own orders for which the broker-dealer opts out. The Commission requests comment on order handling, systems and other changes broker-dealers that route orders, and order execution facilities that execute orders, would have to make before they would be able to implement the requirements of this proposed exception.

c. Opt-Out - Provision of National Best Bid or Offer

The Commission also is proposing to require a broker-dealer to disclose to its customers that have opted-out the national best bid or offer, as applicable, at the time of execution for each execution for which a customer opted out.⁷⁵ If the order were a purchase, the broker-dealer would be required to provide the national best offer at the time of execution and if the order were a sale, the broker-dealer would be required to provide the national best bid at the time of execution.⁷⁶ Such disclosure would be required to be given as soon as possible, but in no event later than one month from the date on which the order was executed. The bid or offer that would be required to be disclosed to the customer pursuant to this exception would need to be displayed in close proximity to, and no less prominently than, the execution price for the applicable transaction that is provided to the customer pursuant to the requirements of Rule 10b-10 under the Exchange Act.⁷⁷ The required disclosure could be made on the confirmation for the transaction sent to the customer pursuant to Rule 10b-10 under the Exchange Act, or the monthly account statement relating to that trade sent to the customer pursuant to applicable SRO rules. Alternatively, the broker-dealer could provide the bid or offer information on another form of disclosure document, as long as it is clear to which transaction the bid or offer information refers (i.e., the bid or offer must be displayed in close proximity to, and no less prominently than, the execution price for the relevant transaction).

The Commission intends this requirement to help ensure that customers who opt out of the proposed rule’s protections are informed of the consequences of opting out, and are able to compare the execution they received to the best-displayed bid or offer at the time of execution. This disclosure would provide the customer with valuable execution quality information upon which to base future determinations as to whether to opt out of the proposed rule’s protections.

The Commission requests comment on the extent to which this information would be useful to investors. The Commission also seeks comment on whether this requirement should apply when the “customer” is another broker-dealer. The Commission further requests comment on whether there would be any practical difficulties in implementing this requirement. In particular, the Commission requests comment as to how this requirement would, or should, apply to transactions that are reported to the customer on an average price basis. Further, the Commission seeks specific comment as to the monetary costs of system or other modifications necessary to provide this information to customers who choose to opt out.

2. Automated Order Execution Facility Exception

The Commission is proposing to permit an automated market to execute orders within its market without regard to a better price displayed on a non-automated market, within certain price parameters. This exception is designed to reflect the comparative difficulty of accessing market quotes from non-automated markets, and to adjust the trade-through requirement to these differences. The Commission believes this would enhance the ability of individual markets with different market structures to compete more fairly with each other. The Commission is not attempting to favor either form of market.

a. Definition of “automated order execution facility”

This proposed exception contemplates two categories of order execution facilities - an “automated order execution facility” and a “non-automated order execution facility.” The Commission proposes to define an “automated order execution facility” as a order execution facility that provides for an immediate automated response to all incoming orders for up to the full size of its best bid and offer disseminated pursuant to an effective national market system plan, without any restrictions on executions. A restriction would include, for example, a limit on the number of orders for the account of the same individual or beneficial owner that could be sent to the market for execution within a certain time frame, or a limit on the size for which an automated response is available, other than the full size of the best bid or offer displayed by the market. The Commission has proposed to narrowly define “automated order execution facility” to exclude market centers that turn off their automatic execution systems or otherwise limit the ability to access their quotes or orders on an automated basis (other than in accordance with federal securities laws, rules, and regulations), to ensure that market participants can readily access these prices. A “non-automated order execution facility” would include any order execution facility not qualified as an automated order execution facility.

The Commission requests comment generally on these definitions and categories, and specifically whether there are any restrictions that a market center should be allowed to impose and still be considered “automated” under the proposed definition of automated order execution facility. For example, should a market still be considered “automated” under the proposed definition if it were to provide an exception to the operation of its automated functionality when an order would otherwise be executed at a price that would cause a trade-through? How should an order execution facility’s response to incoming orders with special handling instructions be treated for purposes of whether an order execution facility would be considered automated, i.e. are there any types of orders with special handling instructions or conditions that an order execution facility should be allowed to exclude from the operation of its automated functionality and still be considered “automated” for purposes of the proposed trade-through rule? For instance, should a market still be considered “automated” even if its automatic execution functionality does not accept orders to sell short? The Commission also requests comment on how such an automated market exception would work in practice for a market that provides an automated response to its top-of-book but otherwise operates as a manual market. Should the definition of “automated order execution facility” exclude a market that has the ability to, and does, implicitly or explicitly “turn off” its automated functionality to allow for manual executions of orders on the market?

The Commission requests comment on whether the Commission, a third party, or each individual market center should determine which market centers qualify as automated order execution facilities, and how such determination should be communicated to the order execution facilities who must comply with the proposed rule. Further, the Commission requests comment on whether it should specify what “immediate” means in terms of providing an automated response, and if so, whether it would be appropriate to impose a minimum performance standard with respect to response times. Specifically, the Commission requests comment on whether it should require that an order execution facility’s system that provides automated functionality have the capability to respond to an order from another market participant within a certain limited time period. If commenters believe that the Commission should specify a performance standard for “immediate,” what should that standard be? Should the performance standard require that a certain percentage of all incoming orders receive an execution within a very short time frame, and allow a longer time period for the remaining percentage? For instance, should the performance standard require that 98% of orders receive execution in less than one second, and all orders receive an execution in three seconds? Or should the performance standard require that all orders receive an execution within the same time frame? If so, should that time frame be within one or two seconds after order receipt? Or should another similar standard be used? The Commission also solicits comment on the anticipated competitive effects of the proposed exception on automated and non-automated order execution facilities.

b. Operation of the Exception

An automated order execution facility would be able to trade through the price of a non-automated order execution facility up to the “trade-through limit amount” (as defined below). An automated order execution facility would not be allowed to trade through the prices of other automated order execution facilities. A non-automated order execution facility would not be allowed to trade through any other market, whether or not it is automated. Given the structure of non-automated markets, in particular the time it takes to manually execute an order (which is necessarily greater because of market maker and crowd participation), the Commission does not believe that there is a particular need to provide a non-automated market an exception to the proposed trade-through rule on the basis of execution speed. The Commission requests comment on the proposed operation of this exception. The Commission also requests comment as to the continued need for the proposed automated market exception if it were to adopt an automatic execution requirement.⁷⁸

c. Allowable Trade-Through Amount

The Commission believes that the amount by which an automated order execution facility should be allowed to trade through a non-automated order execution facility should relate, to the greatest extent possible, to the value of the option that must be given to the other market when attempting to access a better price. Where price protection is the goal, order execution facilities (and their subscribers, customers or members) generally should not be compelled to access another market unless the apparent price improvement from doing so successfully is greater than the estimated cost of attempting access. In short, the allowable trade-through amount should reflect the cost (including time value) of attempting to access the other market.

The calculation of option value is based on several variables, including the volatility and price of the security. Higher volatility means more potential price movement and greater option value, while lower volatility means less potential price movement and less option value. Assuming volatility and other variables as constant, the value of an at-the-money option is proportional to stock price. In granting the three-cent de minimis exemption from the trade-through provisions of the ITS Plan for QQQs, SPDRs and Diamonds, the Commission estimated the option values of attempting to access a better price through ITS to be between one and two and a half cents per share.⁷⁹ This calculation took into account price and volatility and the fact that ITS commitments are irrevocable for a minimum of thirty seconds. The Commission does not believe, however, that it would be practical to calculate the estimated option value for each NMS Stock that would be subject to the proposed trade-through rule based upon the individual volatility and price of each security. The Commission therefore proposes to calculate the allowable “trade-through limit amount” by using the values of a thirty second option on stocks with a range of volatilities, and estimates such options to have values of approximately five to ten basis points.⁸⁰ Specifically, the Commission proposes the following “trade-through limit amounts”: for a bid or offer up to $10, the allowable amount would be one cent; for a bid or offer between $10.01 to $30, the allowable amount would be two cents; for a bid or offer between $30.01 and $50 the allowable amount would be three cents; for a bid or offer between $50.01 and $100, the allowable amount would be four cents; and for a bid or offer above $100, the allowable amount would be five cents.

The Commission requests comment on the feasibility and usefulness of this approach, and the reasonableness of the proposed trade-through limit amounts. The Commission also requests comment on other possible alternative approaches to determining the amount(s) by which an automated market should be allowed to trade through a non-automated market. The Commission further requests comment on whether the proposed rule should provide for one trade-through limit amount, such as three cents, that would apply to all NMS Stocks, rather than tiered amounts as proposed.

3. Other Exceptions

Section (b)(7) of the proposed trade-through rule would provide an exception in those instances where an order execution facility sends an order to execute against a better-priced order displayed on another market at the same time or prior to executing an order in its own market at an inferior price.⁸¹ Specifically, the exception is intended to apply when the market that wants to execute the inferior priced order (Market A) sends an order, at the same time or prior to executing the trade-through, to execute against any better-priced bid or offer of another market (Market B) that is disseminated pursuant to an effective national market system plan, where such order is priced equal to or better than the price of Market B’s better-priced bid or offer and is for the number of shares displayed for that better-priced bid or offer.⁸² If the better-priced bid or offer is still available when Market A’s incoming order reaches Market B, the incoming order should execute against the better-priced bid or offer. This exception therefore continues to provide protection to the better-priced bid or offer. The Commission emphasizes, however, that if the order sent by Market A to Market B is executed against Market B’s better-priced bid or offer, the broker-dealer executing the inferior-priced order, or the broker-dealer on whose behalf the order is being executed, still must fulfill its duty of best execution to its customer with regard to that order, by providing the customer order the better price. Thus, this exception would not alter a broker-dealer’s duty to provide best execution for its customers’ orders.

The proposed rule also would incorporate other exceptions to the current trade-through prohibitions. Specifically, the proposed rule would include exceptions under the following circumstances: (1) the order execution facility displaying the better price was experiencing a failure, material delay or malfunction of its systems or equipment when the trade-through occurred;⁸³ (2) the order execution facility that initiated the trade-through made every reasonable effort to avoid the trade-through but was unable to do so because of a systems or equipment failure, material delay or malfunction in its own market; (3) the transaction that constituted the trade-through was not a “regular way” contract;⁸⁴ (4) the bid or offer that is traded-through was displayed by an order execution facility that was, or whose members were, relieved of their obligations under paragraph (c)(2) of Rule 11Ac1-1 under the Exchange Act (proposed to be designated as paragraph (b)(2) of Rule 602) with respect to such bid or offer pursuant to paragraph (b)(3) of Rule 11Ac1-1 under the Exchange Act ( proposed to be designated as paragraph (a)(3) of Rule 602);⁸⁵ (5) the transaction that constituted the trade-through was an opening or reopening transaction by the order execution facility; and (6) the transaction that constituted the trade-through was executed at a time when there was a crossed market.⁸⁶

The Commission believes the proposed exception for opening and re-opening transactions is appropriate because the process for executing orders at the open, and after a trading halt, involves the queuing and ultimate execution of multiple orders at a single price or several prices, making it difficult to apply the restrictions of the proposed trade-through rule to each individual order to be executed. For example, it would be very difficult for a market center that is attempting to open a security to determine which of the multiple orders it has to execute at the open would receive a better price displayed on another market. It also could be problematic for the market center opening the stock to be able to match the better price, or access the other market to obtain the better price, when that away market price may change during the time period when the market center opening the stock is making its determination as to what price at which to open the stock, and thus not be the current market displayed when the market actually determines the price at which it will open? The Commission recognizes that the opening process in the OTC market for Nasdaq stocks is different than for the listed market, and that the application of the restrictions of the proposed trade-through rule at the opening may make sense in a market that does not have a single-price opening. The Commission requests comment as to when, if at all, the execution of orders at the opening and re-opening after a trading halt should be subject to the proposed trade-through rule.

The Commission also requests comment on the appropriateness of the proposed exception for where the order execution facility that initiated the trade-through made every reasonable effort to avoid the trade-through but was unable to do so because of a systems or equipment failure, material delay or malfunction in its own market. What are the types of situations in which this proposed exception would appropriately apply? In other words, when would it be reasonable to allow a market that is not able to execute orders in compliance with the trade-through requirements because of systems problems to continue to execute orders without complying with the proposed rule?

The Commission also requests comment on whether it should continue to include an exception for when a market participant executes a trade-through at a time when the market participant executing the order, and other market participants in its market, were relieved of their firm quote obligations pursuant to the “unusual market” exception of the Quote Rule, provided that unless another exception applies, the market participant executing the order made every reasonable effort to avoid trading through the best bid or offer of any other market participant not so relieved of its firm quote obligations under the Quote Rule.⁸⁷

Although included in the current ITS trade-through rule, the Commission proposes not to include an exception from the trade-through prohibition in cases where the bid or offer that is traded through has caused a locked market.⁸⁸ If an exception were allowed for a better-priced locking bid or offer on another market, the order that is being executed would miss the opportunity to be executed at the better price. Also, requiring a market to attempt to access a better-priced locking bid or offer may help to unlock the market more quickly than if the market could trade through the locking bid or offer. The Commission also notes that the proposed access standards discussed in Section IV below would include provisions to deter market participants from locking or crossing the market, and thereby lead to fewer instances of locked markets. Nevertheless, the Commission requests comment on whether it should include an exception for locked markets to the proposed trade-through rule. The Commission also requests comment on whether it should include an exception for locked markets in the trade-through rule if the proposed access rule were adopted without the proposed provision that would require every SRO to establish and enforce rules requiring its members to avoid locking or crossing the quotations of quoting market centers and quoting market participants?⁸⁹

The Commission also notes that the proposed rule, unlike the current rule, does not include an exception for trading through a 100-share bid or offer. The Commission is concerned that a de minimis exception, such as the 100-share exception, would provide an opportunity for market participants to circumvent the requirements of the proposed rule.⁹⁰ Nevertheless, the Commission requests comment on whether it is necessary to include an exception for a de minimis size, such as for 100 shares. Finally, the Commission requests comment on whether there should be any other exceptions, or whether any proposed exception should not be included.⁹¹

E. Interaction with Existing Plans/Rules

As noted above, no intermarket trade-through rules currently exist with regard to the trading of Nasdaq securities. With respect to NYSE and Amex securities, the ITS trade-through rule provides that a member should avoid trading through a better price available in another market, subject to certain exceptions detailed in the SROs’ rules. The ITS trade-through rule does not include an opt-out or automated market exception. Therefore, unless the ITS Plan and SROs’ rules were amended to incorporate the flexibility of the Commission’s proposed rule with regard to the proposed opt-out and automated market exceptions, they would remain more restrictive than the proposed rule with regard to those two exceptions. In addition, the proposed rule would eliminate certain of the existing exceptions to the ITS trade-through rule. If adopted, these more restrictive provisions of the Commission rule would, of course, control.

At this time, the Commission is not proposing to amend the ITS Plan or the SROs’ trade-through rules on its own initiative to reflect more permissive terms of any trade-through rule that the Commission may ultimately adopt. The Commission believes that market participants should be able to agree, on a voluntary basis, to provide higher levels of protection to each other’s prices. And, if the Commission’s trade-through and access proposals were adopted, any participant that no longer wanted to be subject to more restrictive trade-through provisions in the ITS Plan could withdraw from the plan, as long as it could comply with the proposed access standards discussed in Section IV below. However, if the proposed trade-through rule were adopted as proposed, the ITS participants would be required to amend the ITS Plan and their trade-through rules where they conflict with more restrictive provisions in the Commission’s proposed rule.

The Commission requests comment on whether the it should require that the ITS Participants amend the ITS Plan and their trade-through rules to implement the proposed trade-through rule in its entirety, if it were adopted, even where the Commission rule would be more permissive than the existing rules. The Commission also requests comment on whether the Commission should amend the ITS Plan and SRO trade-through rules on its own initiative if the proposed trade-through rule were adopted.

F. General Request for Comments

The Commission seeks comments on the trade-through proposal described in this section III. In addition to the specific requests for comment above, the Commission asks commenters to address whether the proposed rule would further the NMS goals set out in Section 11A of the Exchange Act⁹² and, in particular, the goal of assuring “the practicability of brokers executing investors’ orders in the best market.”

The Commission also requests comment on several alternative regulatory approaches to intermarket price protection as outlined below. One alternative would be to adopt the proposed trade-through rule with the automated market exception but not the opt-out exception. Another choice would be to adopt the proposed rule without the automated market exception and extend the existing three-cent de minimis exemption to all securities covered by the proposed rule, either with or without the proposed opt-out exception.

Another alternative would be to maintain the existing ITS trade-through rule and allow the three-cent de minimis exemption for certain ETFs (QQQs, SPDRs and Diamonds) to expire. This approach would not address the fundamental problems identified with the operation of the existing rule, although it likely would provide operational continuity for the ITS Plan participants. A variation on this alternative would be to maintain the existing rule, allow the de minimis exception to expire, and add an opt-out exception to the existing rule. Another option would be to maintain the existing rule and approve on a permanent basis the three-cent de minimis exemption for the QQQs, SPDRs and Diamonds. This alternative would not address the issues with the current operation of the ITS trade-through rule with respect to securities other than the QQQs, SPDRs, and Diamonds, although it would provide operational continuity while still providing relief for those three actively-traded ETFs. Two other choices would be to maintain the existing rule and extend the three-cent de minimis exemption either to: (1) all ETFs subject to the ITS Plan; or (2) all securities subject to the ITS Plan. A variation on this latter approach would be to extend the de minimis exemption to all securities subject to the ITS Plan but impose a cap on the size of quotations that could be traded-through. Each of these approaches that would include an extension of the current de minimis exemption would provide some degree of operational continuity.

Another approach would be to eliminate the existing ITS trade-through rule and rely solely upon the principles of best execution. The Commission invites comment on the need for price protection in NYSE, Amex, and Nasdaq securities in today’s market, and whether the NMS goals and objectives could be achieved without a trade-through rule. In light of the advent of penny spreads, more efficient executions, active competition between markets trading like securities and a broker-dealer’s duty of best execution, in the absence of a trade-through rule, would accessible better-priced limit orders remain unexecuted if trades were occurring at inferior prices? Would the occurrence of trade-throughs weaken customer confidence in the fairness or efficiency of the market? What would be the competitive effect of removing the trade-through rule from the markets trading NYSE and Amex securities? If price protection is not required, and better-priced limit orders can be ignored, would limit orders be displayed less often?

The Commission requests specific comment on the costs and benefits, and the viability, of each alternative outlined above.

The Commission also requests comment on the feasibility of the proposed trade-through rule. In light of the active trading and frequent quote changes in the markets, would the trade-through rule as proposed impede the efficient execution of orders and raise opportunity costs? Is access between markets efficient enough today to support a trade-through rule? Would this access be adequate if the Commission’s proposed access rule – discussed in Section IV - were adopted? How should the proposed trade-through rule reflect access fees charged by market centers? Would the Commission’s proposed access fee cap minimize access fees sufficiently that they need not be addressed in the trade-through rule? If the Commission does not ultimately adopt a $.001 standard for access fees, should there be a trade-through rule exception applicable to quotes with access fees of more than a specific amount? If so, should this amount be $.005, $.003, or $.001, or some other amount?

The Commission requests comment as to whether, and if so, to what extent, the proposed trade-through rule would have the desired effect of preventing trade-throughs. Commenters are also asked to comment on the proposed exceptions to the general rule, and whether these exceptions would permit adequate protection of customer orders or, alternatively, undermine the intended effect of the proposed rule. Finally, the Commission requests comment on whether, if it were to adopt the proposed trade-through rule, a phase-in period would be necessary or appropriate to allow market participants time to adapt to its provisions. If so, what aspect(s) of the proposed trade-through rule should be phased-in, and what would be the appropriate phase-in period?

G. Paperwork Reduction Act

Certain provisions of the proposed rule contain “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995,⁹³ and the Commission has submitted them to the Office of Management and Budget (“OMB”) for review in accordance with 44 U.S.C. 3507(d) and 5 C.F.R. 1320.11. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information, unless it displays a currently valid OMB control number. The Commission is proposing to create a new information collection entitled “Trade-Through Rule” which would be Rule 611 of proposed NMS under the Exchange Act. OMB has not yet assigned a control number to the new collection of information imposed by proposed Rule 611 under the Exchange Act.

1. Summary of Collection of Information

a. Establishment of Policies and Procedures

The proposed trade-through rule would require an order execution facility, national securities exchange, and national securities association to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution of a trade-through in its market. The nature and extent of the policies and procedures that an order execution facility, national securities exchange, and national securities association would be required to establish to comply with this requirement would depend upon the type, size, and nature of the order execution facility, national securities exchange, and national securities association.

b. Disclosure Necessary to Obtain Informed Consent for Opt-Out Exception

The proposed rule includes an exception that would permit investors to give informed consent to the broker-dealer to whom they route their order(s) to “opt-out” of the protection provided by the proposed rule on an order-by-order basis. If a broker-dealer chooses to provide investors the ability to opt-out, a broker-dealer would need to, consistent with any fiduciary obligations arising from its relationship with the investor, provide to an investor sufficient disclosure regarding the impact of opting out prior to the investor making a determination whether or not to opt out so that the investor can make a fully informed decision.

c. Disclosure of National Best Bid or Offer in the Event of a Customer Opt-Out

If a broker-dealer chooses to provide customers the ability to opt-out, and in the event a customer chooses to opt-out for a particular order, the broker-dealer to whom the customer routed the order would be required within one month of the date of execution of the order to disclose to the customer the national best bid or offer in the security, as applicable, at the time of execution of the order. The broker-dealer could choose how it would provide such disclosure as long as such disclosure complies with the proposed rule’s requirements. For instance, the broker-dealer could include such disclosure on the confirmation sent to the customer pursuant to Section 240.10b-10,⁹⁴ on the account statement for the account sent to the customer pursuant to applicable SRO rules, or it could provide the national best bid or offer information in another form of disclosure that is in compliance with the proposed requirements.

The Commission does not believe that any other market participants would be subject to a requirement under the proposed rule to collect information in addition to what they are already required to collect under existing rules.

2. Proposed Use of Information

a. Establishment of Policies and Procedures

The proposed requirement for each order execution facility, national securities exchange, and national securities association to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution of a trade-through in its market would help ensure that the order execution facility, national securities exchange, or national securities association and its customers, subscribers, members, and employees, as applicable, generally avoid trade-throughs, as contemplated by the proposed rule’s requirements.

b. Disclosure Necessary to Obtain Informed Consent for Opt-Out Exception

The need for a broker-dealer to provide an investor sufficient disclosure regarding the impact of choosing to opt out of the proposed rule’s protections prior to the investor making an informed determination whether or not to opt out would be necessary to help ensure that each investor, especially a retail customer, makes a fully-informed decision whether to forego the protections afforded by the proposed trade-through rule. The Commission notes that this requirement would only apply to broker-dealers who choose to provide investors the ability to opt-out.

c. Disclosure of National Best Bid or Offer in the Event of a Customer Opt-Out

The proposed rule’s requirement that a broker-dealer provide a customer that has opted out of the proposed rule’s protection with respect to the execution of a particular order with the national best bid or offer for that security displayed at the time of the execution of the order, would help ensure that customers are informed of the consequences of opting out by enabling customers to compare the execution price they receive with the national best bid or offer for the security displayed at the time of the execution. The Commission believes that such information would be useful for customers in making future decisions as to whether to opt out of the rule’s protections. The Commission notes that this requirement would only apply to broker-dealers who choose to provide investors the ability to opt-out, and whose customers do in fact opt-out.

3. Respondents

a. Establishment of Policies and Procedures

The proposed requirement for each order execution faci