September 25, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
Mail Stop 5-1
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Disclosure of Order Routing and Execution Practices; File No. S7-16-00
The Cincinnati Stock Exchange ("Exchange" or "CSE") respectfully submits the following comments on the Securities and Exchange Commission's ("Commission") proposed rules governing the disclosure of order routing and execution practices ("Proposed Rules").1 The Exchange commends the Commission for proposing rules that increase the disclosure of order execution quality intended to promote fair and vigorous competition among broker-dealers and market centers, as well as to offer investors relevant information regarding the handling of their orders. The Exchange believes that the disclosure approach is certainly preferable to the other more intrusive approaches proposed by the Commission earlier this year in its Concept Release on Market Fragmentation ("Fragmentation Release").2 In rejecting the other approaches at this time, the Commission correctly recognized the potentially deleterious effects of mandating price/time priority across competing markets.3 The Exchange agrees with the Commission and most of the Fragmentation Release commenters that with sufficient disclosure of indicia investors find relevant with respect to their order executions, markets will become more efficient and effective in providing best execution.
The Exchange believes, however, that the Proposed Rules set forth a disclosure framework that may distort the execution quality of certain market centers to their competitive disadvantage. Formatting the disclosure matrix in a manner that predetermines the importance of specific inputs prejudges the outcome of any evaluation of such data. The Exchange believes that the Commission's Proposed Rules disregard the natural differences between markets by requiring the disclosure of arbitrary terms such as the "average realized spread," which will invariably and unfairly reflect negatively on dealer-oriented markets.
Instead, the CSE proposes, subject to a provision that would avoid redundant reporting, that each market center as defined in the Proposed Rules publish the entire processing history of each order beginning from order arrival at each market center's trading system until execution. In this way, all information relating to execution quality -- information that is currently captured by the CSE and is or will soon be readily available to all markets, which need such data to fulfill their self-regulatory obligations -- will be published without any prejudicial influences. If the information available under the Proposed Rules is not immediately desirable or useful to investors as admitted by the Commission, the CSE sees little merit -- indeed, sees significant harm -- in arbitrarily constraining the information prior to its analysis by industry professionals. The CSE believes that the only way to fairly provide uniform execution quality data is to publish information related to the life of an order for review and analysis by the industry.
To summarize CSE's comments:
CSE Proposal - The CSE proposes that entire order histories be made available to the public. In addition, the CSE proposes that the Commission mandate reduced time frames for trade reports, quotation updates, and ITS commitment processing within the national market system, which will help restore the integrity of the NBBO.
CSE Proposal - The CSE proposes that the Commission: (1) segregate order sizes of 500 to 999 shares from order sizes of 1000 to 1999 shares in the bucketing of order sizes, and (2) eliminate the use of "average realized spreads" from the statistical measurements required under the Proposed Rules. In the alternative, the CSE proposes that entire order histories by made available to the public.
The Exchange is primarily concerned with the fundamental fairness of any proposal requiring disclosure of order execution information. The Exchange fully supports complete disclosure of order processing information: it does not support disclosure that is bias towards one particular market structure or another. In Section 11A(a)(1)(C) of the Act, Congress found that, "it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure: (ii) Fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets."4 (emphasis added) The Exchange believes that the framework of the Proposed Rules does not promote fair competition among exchanges.
In particular, the Exchange believes that several elements in proposed Rule 11Ac1-5, "Disclosure of Order Execution Information," may distort the execution quality statistics. These elements include: (1) basing execution quality on the NBBO, (2) combining within a single order size category orders of 500 to 1999 shares, and (3) use of the term, "average realized spread." As discussed in detail below, should these elements be adopted as proposed in the final rule, the Exchange will be placed at a competitive disadvantage.
Use of the NBBO
The definition of "covered order" in paragraph (a)(8) of proposed Rule 11Ac1-5 clarifies that the rule applies only to market orders or limit orders that are received by a market center during the time that a consolidated best bid or offer is being disseminated.5 The term "consolidated best bid or offer" is defined in paragraph (a)(7) as the highest firm bid and the lowest firm offer for a security that is calculated and disseminated on a current and continuous basis pursuant to a national market system plan.6 Because nearly all statistical measures envisioned by the Proposed Rules are based on the consolidated best bid and offer, or NBBO, at the moment of order receipt, the accuracy of the NBBO becomes fundamental to the relevance of the statistical data.
The CSE contends, however, that the accuracy of the NBBO is suspect because of the time frames permitted by exchanges and Nasdaq to report trades, update quotations and process Intermarket Trading System ("ITS") commitments. The ITS, 7 Consolidated Tape ("CT"),8 and Consolidated Quotation ("CQ")9 Plans permit time frames that were established over 20 years ago, and the resultant slowness and non-sequential nature in processing trades and updating quotations detract from the accuracy of the disseminated
NBBO, which no longer accurately reflects the current state of the market.10 If the NBBO is not accurate, then judging the quality of order execution based on the NBBO at time of order receipt will distort the true quality of order processing. An example of this problem can be seen in trade data from August 31, 2000 in Loral Space and Communication, LOR.
Example: ( time, quotes, and sales for LOR from August 31, 2000):
10:03:12 NBBO (NYSE) quote equals 7.8125 at 7.9375 90 x 110
10:03:27 NBBO (NYSE) quote changes to 7.8125 at 7.875 90 x 15
10:03:27 CSE sends ITS commitment to NYSE to buy 800 shares
10:03:31 CSE commitment executed, tape print of 800 at 7.9375
10:03:38 NBBO changes to 7.8125 at 7.9375 90 x 101
The print representing an ITS execution at 10:03:31 of 800 shares at 7.9375 is outside the NBBO.
Under the Proposed Rules, the execution quality of the customer order in LOR will be based on a NBBO that was not honored. Indeed, this order would be classified as price disimprovement under the Proposed Rules. CSE specialists are required by best execution principles to seek the best price for customer orders, however, when they do so their execution quality statistics will be negatively impacted due to the antiquated ITS time frames.
In addition, should CSE Specialists use ITS to route orders to an exchange with the best quoted price, the one or two minute time delay will significantly harm the speed of execution statistics in the Proposed Rules. This effect is the opposite for other exchange specialists that route ITS commitments to CSE because CSE offers automatic execution to inbound ITS commitments. In effect, CSE specialists will be precluded from use of the ITS system because they will not wish to degrade their execution quality statistics while specialists on other exchanges will have their statistics improved through ITS commitments routed to the CSE.
The CSE believes that these time frame and execution disparities will distort the execution quality statistics proposed by the Commission. As long as CSE specialists are subject to automatic executions through ITS while other market specialists may wait one or two minutes; and as long as CSE specialists are subject to instant quote changes while other market specialists may delay trade reports for up to 90 seconds and quote changes for up to 60 seconds after executions, the CSE believes that reliance on the NBBO for market-wide order execution quality measurements will not accurately reflect a particular market's order processing quality.
The CSE suggests that the Commission mandate reduction in the time frames of CT, CQ, and ITS order processing, which every exchange is technically capable of accomplishing tomorrow if it chooses to do so. In this way the national market system could recapture the integrity of the NBBO as a measurement of the current state of the market and allow the NBBO to be useful as an order execution quality benchmark.
Order Size Bucketing and Effective Spreads
The CSE also is concerned with the proposed categorization of order sizes as defined in paragraph (a)(4) of Rule 11Ac1-5. The term "categorized by order size" means dividing orders into separate categories for sizes from 100 - 499 shares, from 500 - 1999 shares, from 2000 - 4999 shares, and 5000 or greater shares. The CSE's particular concern is with the 500 - 1999 share size bucket. The Exchange believes that this bucket will distort the execution quality statistics of order sizes between 500 and 999 shares -- order sizes that generally reflect retail customer orders -- through the inclusion of generally professional or institutional order sizes of 1000 to 1999 shares.
CSE specialists handle in large measure retail order flow with a predominant amount of that order flow being orders under 1000 shares. The Commission acknowledges that different market centers with different order flow characteristics will have different "average effective spreads," a term defined as double the amount of difference between the execution price and the midpoint of the consolidated best bid and offer at the time of order receipt.11 As the Proposing Release states: "if the orders executed by one market center primarily consisted of small orders in the most actively traded stocks, its average effective spread across all orders likely would be relatively small. Conversely, if the orders executed by a second market center primarily consisted of larger orders in less actively traded stocks, its average effective spread across all orders likely would be substantially higher than the first market center."12 The Exchange believes that by bucketing order sizes of 500 shares to 1999 shares in one bucket, the Commission may have sought to combine the order processing statistics of distinct order sizes for the benefit of market centers with both retail and institutional order flow. The Commission may have hoped to improve the average effective spread characteristics of large order size processing by including smaller retail-oriented order flow in the same bucket.
However, the CSE believes that its specialists provide superior service to retail order flow and that the 500 to 1999 share bucket will mask that performance. Should the Commission determine to go forward with the Proposed Rules after review of industry comments, the Exchange urges the Commission to establish order size buckets of 500 to 999 shares and 1000 to 1999 shares.
Average Realized Spread and Adverse Selection
Another concern for the Exchange contained in the Proposed Rules is the term "average realized spread."13 The average realized spread is defined in pertinent part as, "the share-weighted average of realized spreads for order executions calculated, for buy orders as double the amount of difference between the execution price and the midpoint of the consolidated best bid and offer thirty minutes after the time of order execution. . ."14
The Commission appears to consider this statistical measurement significant for both market orders and non-marketable limit orders. The Commission represents that for non-marketable limit orders, "the average realized spread is a measure of adverse selection costs - the extent to which limit orders on average tend to be executed when the market is moving significantly against them."15 The Commission goes on to contend that the frequency and skill with which local trading interest at a market center may step in front of limit orders exacerbates adverse selection as measured by the average realized spread.
For market orders, the Commission contends that average realized spread measures the extent to which "informed" and "uninformed" orders are routed to different market centers. Informed orders -- those submitted by persons with better information with respect to stock movements -- present greater risk for liquidity providers than uninformed orders, which the Commission states are "often small orders."16 Apparently, the Commission believes that if uninformed orders are executed at prices established by markets with a substantial volume of informed order flow, they may generate increased trading profits for liquidity providers and that the average realized spread will highlight the extent to which the market centers receive uninformed orders.
The CSE strongly objects to the inclusion of average realized spreads in the Proposed Rules. Indeed, the Exchange believes that the use of average realized spreads might disadvantage dealer-oriented markers in general. Because of the natural differences between dealer and agency auction market structures, average realized spreads, as defined in the Proposed Rules, may be used inaccurately by auction markets to claim superior execution quality.
For non-marketable limit orders, the Commission argues that average realized spreads will measure the "last mover" advantage of local trading interest. Because dealer-oriented markets will predominantly entail executions of limit orders by specialists or market makers as principal (local trading interest), average realized spread statistics for customer executions would invariably capture movement away from the execution price over the course of thirty minutes.
For agency auction markets, customer limit orders generally will be executed against other customer orders. In this case, one customer will profit from the subsequent price movements while the other customer will suffer adverse selection. The sum of adverse selection for both customers, however, will net to zero.
If adopted as proposed, average realized spreads by definition would be greater for dealer-oriented markets than for agency auction markets. Should average realized spreads become part of brokers' best execution regular and rigorous review, order flow routing arrangements may be impacted because brokers would have to consider average realized spreads or face possible regulatory action by the Commission or the brokers' self-regulatory organizations. Such a biased measurement of order execution quality could lead to brokers withholding order flow from dealer markets. Clearly, such a result would subject the CSE to unfair competition in violation of Section 11A of the Act.
Moreover, the CSE believes that the Commission's concept of adverse selection with respect to limit orders is overly simplified. The Commission believes that dealers step ahead of limit orders on their books when they know that the stock will quickly trade higher so the dealer can profit. When the dealer knows that the stock is going lower, the dealer either allows inbound orders to trade against the limit orders or executes the limit orders as principal. Being so prescient should make trading very easy.
When a customer submits a limit order, the customer has expressed an interest in buying or selling at the limit price. As the Commission stated: "[w]ith non-marketable limit orders, the most significant risk is that they will not be executed and will miss the market."17 The Commission has demonstrated that limit order fill rates on the CSE exceed that of other exchanges, including the NYSE.18 However, average realized spread statistics would have investors believe that CSE limit order fill rates may be of less quality because such statistics are unfairly represented as measuring the risk of adverse selection.19 If the CSE's high limit order fill rate ameliorates the most significant risk for limit orders -- i.e, not being filled -- the fact that CSE specialists act as principal in executing customer limit orders should not be permitted to detract from order execution quality statistics. For these reasons, the CSE believes that the term "average realized spread" should not be included in any disclosure rules.
As an alternative, the CSE proposes that each market center provide data regarding the entire life of orders beginning at order arrival into its system until execution. The Exchange believes that this approach, which would contain more information than the Commission's proposed approach and therefore provide greater disclosure, would not be prejudiced by the disclosure elements discussed above.
Pursuant to the Exchange's proposal, market centers should provide at a minimum the time (to the second) of order receipt, type of order, limit price, size of order, time of order execution, price of execution, cancellation, whether the order was routed to another venue, the identity of that venue, and the price executed at that venue. Because this data is readily available to the CSE pursuant to its surveillance procedures, the cost of accumulating and formatting the data would be minimal. Indeed, the CSE believes that most market centers should have this data readily available in order to properly perform their regulatory functions. In addition, the CSE could publish this data for its specialist/market centers rather than having them produce their own data, thereby reducing redundant disclosure and cost that would likely be passed on to customers.
The Commission expressed concern in the Proposing Release that, for the order execution quality information to be meaningful, there should be uniformity in the underlying data and statistical measures, including uniform procedures, data formats, and calculations. The concern with publishing order-by-order data is that there will be a lack of uniformity and that the data will be difficult to understand. The CSE believes these concerns can be overcome without mandating statistical measures that bias the evaluation outcome. By stipulating the format and content of order information that must be published and made readily accessible to interested parties, the Commission could resolve the uniform data issue
Moreover, the Commission contemplated using private industry to make the data produced under its proposal useful to investors. The Commission recognized that most individual investors would not be interested in receiving and digesting the data matrix of the Proposed Rules.20 The Proposing Release states: "the information will need to be summarized and analyzed before it is helpful to investors in general. The Commission anticipates that independent analysts, consultants, broker-dealers, the financial press, and other market centers will analyze this information and produce summaries that respond to the needs of investors."21 If the Commission believes that industry professionals must summarize the data matrix set forth in the Proposed Rules in order to make such data relevant to investors, the CSE sees little to be gained and much to be lost by predetermining the relevant statistical measurements. Instead, allowing industry professionals to work with complete order history information provides a clean slate upon which to determine order execution quality statistics, without the prejudicial effects of the Commission's proposed data matrix.
The CSE fully supports the Commission in its effort to provide greater disclosure of order execution quality. The CSE believes that the more investors understand about the quality of executions on the CSE, the more they will demand the routing of their orders to CSE specialists.
For the reasons stated above, however, the CSE objects to the statistical measurements included in the Proposed Rules unless the Commission takes action to eliminate the time frame and order processing disparities contained in the national market system and removes those statistical measures that are biased against dealer-oriented markets. In the alternative, the CSE believes that the Commission can accomplish its disclosure goals with less cost, and certainly, with less market structure impact, by requiring disclosure of full order history data for analysis by interested parties.
Jeffrey T. Brown
Vice President Regulation and
cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner
Annette L. Nazareth, Esq., Director
Division of Market Regulation
Robert L. D. Colby, Esq., Deputy Director
Division of Market Regulation
Belinda Blaine, Esq., Associate Director
Division of Market Regulation
Elizabeth King, Associate Director
Division of Market Regulation
1 Securities Exchange Act Release No. 43084 (July 28, 2000), 65 FR 48406 (August 8, 2000) ("Proposing Release").
2 See Securities Exchange Act Release No. 42450 (February 23, 2000), 65 FR 10577. To address the apparent market fragmentation issues, the Commission proposed in the Fragmentation Release six alternative options including the disclosure requirements discussed in this letter. The other proposals were restricting internalization and payment for order flow, requiring exposure of market orders to price competition, adopting an intermarket prohibition against market markers trading ahead of previously displayed and accessible investor limit orders, providing intermarket time priority for limit orders or quotations that improve the national best bid or offer ("NBBO"), and establishing a price/time priority for all displayed trading interest.
3 Id. at 48407. To more fully evaluate the concerns expressed in the Fragmentation Release and to determine whether further steps are necessary, the Commission is conducting a study of trading of equities qualified for inclusion in The Nasdaq Stock Market, Inc. ("Nasdaq") and equities listed on the New York Stock Exchange, Inc. ("NYSE"). The study is based on what the Commission considers a "matched" sample of 200 equities trading on both markets. Because the study does not include order execution data from the CSE, the Exchange remains concerned that the Commission may determine to propose further limitations on internalization without obtaining factual evidence that fragmentation and internalization have harmed pricing efficiency or detracted from a customer's ability to obtain the best execution of his or her order on the CSE. Trading on Nasdaq is not a surrogate for trading on the CSE. Consequently, Nasdaq order execution data must not be a basis for rules that may limit the market practices of CSE members.
4 15 U.S.C. 78k-1(a)(1)(C)(ii).
5 Proposed Section 240.11Ac1-5(a)(8). Supra note 1 at 48432.
6 Proposed Section 240.11Ac1-5(a)(8). Id.
7 The ITS Plan requires that the sender of a commitment choose either a one minute or two minute time frame for the receiving exchange to interact with the inbound commitment. See ITS Plan, Section (b)(i)(H). The CSE is the only ITS participant that automatically executes inbound ITS commitments rather than holding, as do other ITS exchange specialists, an option on the execution of the inbound commitment for one to two minutes. At an October 1999, ITS Operating Committee meeting, the CSE proposed reducing the time frames to immediate execution. The ITS Operating Committee rejected the proposal.
8 The CT Plan requires that each Participant "establish and maintain collection and reporting procedures and facilities such as to assure that under normal conditions not less than 90% of such last sale prices will be reported within that period of time (not in excess of one and one-half minutes) after the time of execution . ." See Second Restatement of, and Amendment to CTA Plan, Section VIII, Collection and Reporting of Last Sale Data, (a) Responsibility of Exchange Participants.
9 The CQ Plan requires Participants to "establish and maintain collection and reporting procedures and facilities such as to insure that on the average and under normal conditions, the bids and offers with respect to Eligible Securities required to be made available by such Participant . . . will be furnished to the Processor within approximately one minute of the time such bid or offer is communicated to such Participant. See Second Restatement of, and Amendment to, CQ Plan.
10 As recently as the February 2000 CTA/CQS Operating Committee meeting, the CSE proposed reducing both the CT trade reporting time frame and the CQ quote update time frame to 30 seconds. The CTA/CQS Operating Committees rejected these proposals.
11 See proposed Section 240.11Ac1-5(a)(2).
12 See Proposing Release; supra note 1 at 48411.
13 See proposed Section 240.11Ac1-5(a)(3).
15 See Proposing Release; supra 1 at 48415.
17 See Proposing Release; supra note 1 at 48410.
18 Limit order fill rates on the CSE exceed those of the NYSE across the board. Indeed, "for quote improving limit orders, there is a striking difference in the probability of execution among the exchanges. On the CSE, over 90% of quote improving limit orders are filled, while on the NYSE this number is 79%." See SEC, Report on the Practice of Preferencing (April 11, 1997) at Table v-17.
19 On the CSE, for example, specialists are required to provide limit order protection and fill orders on their books should a particular security trade at the limit order price on the primary market. Thus, limit orders on the books of CSE specialists may be executed against contra-side customer order flow received by the specialists, through inbound ITS commitments, or by specialists acting as principal pursuant to the limit order protection rule. See CSE Rule 11.9(u), Interpretations and Policies .02.
20 Id. at 48413.