|1||Trading volume dropped in 1988 to 40.8 billion shares, however, following an all-time high of 47.8 billion shares for 1987. Annual trading volume for 1988 still was higher than in 1986, when 35.7 billion shares were traded. See New York Stock Exchange Fact Book (1989) at 71.|
|3||For example, the average daily share volume on NASDAQ, the primary OTC market, has grown from 11 million shares per day in 1978 to 122.8 million shares per day in 1988, a 1,116% increase. See NASDAQ Fact Book (1989) at 7. In the standardized options market, contract volume for 1987 and 1988, in comparison to 1978, was, respectively, 497%and 319% larger. See SEC Monthly Statistical Review, April 1981 at 5 and February 1989 at 4.|
|4||See Division of Market Regulation, The October 1987 Market Break (Feb. 1988) Ch. 1, at 1-7 for description of some of the basic trading strategies that employ basket trading ("Market Break Study").|
|5||Id. at 3-17.|
|6||Prior to the automated of the markets, orders to purchase or sell exchange-listed securities generally were processed in the following manner. A customer would place an order with his or her registered representative at a branch office of a broker-dealer who, in turn, would telephone the order to the broker-dealer's order desk. The order desk would then route the order by telephone or pneumatic tube to the firm's trading booth on the exchange floor and the firm's floor trader would take the order to the applicable specialist post for execution. If the order was not executable (e.g., a non-marketable limit order), then it was given to the specialist and transcribed by hand onto the specialist's book for future execution. See Special Study of Securities Markets, Report of the Securities and Exchange Commission (1963), reprinted in H.R. Doc. No. 95, 88th Cong., 1st Sess. (1963), Pt. 2 at 41-42 ("Special Study Report"), and Market Break Study, supra note 4, ch. 7 at 16. Orders for OTC securities were handled in a manner similar to exchange-listed securities except that once they reached the broker-dealer's trading desk, they could be filled out of the firm's inventory (principal transactions) or through telephone negotiations with other broker-dealers (agency transactions). See Special Study Report, Pt. 2 at 552.|
|7||The NYSE and the American Stock Exchange ("Amex") have developed automatic order routing systems, termed DOT and PER, respectively, that permit orders to be routed directly from member firm branch officers to the applicable specialist post, thereby by-passing the member firm's trading desk and floor broker. After orders are executed, DOT and PER generate and transmit execution reports to the member firms and other automated systems that disseminate market information. For a more complete description of these systems and their enhancements, see Market Break Study, supra note 4, ch. 7 at 16-21 and 24-25. The Boston, Midwest, Pacific ("PSE"), and Philadelphia ("Phlx") Stock Exchanges have developed systems called BEACON, MAX, SCOREX, and PACE, respectively, that automatically route and execute small orders (generally up to 1,099 shares). These four systems basically operate in the same manner. After an order is routed to the system, it is priced based on the best bid or offer displayed on the Intermarket Trading System ("ITS") at the time the order was received by the system, and then routed to the applicable specialist post. The order is then displayed on a video terminal at the post for 15 seconds to permit the specialist and/or trading crowd to improve upon the assigned ITS execution price. If no floor trader intervenes within 15 seconds, the order is automatically executed against the specialist at the predetermined price. Under the PACE system, however, orders are executed once priced and are not displayed for price improvement. The four systems also transmit transaction reports to members and market data vendors. For a more complete description of these systems, see Market Break Study, supra note 4, ch. 7 at 26-28 and Adkins & Ruder, Appendix to "Automation of Information and Trading in the U.S. Securities Markets" at 6-13 ("Annenberg Forum Paper") (paper presented by Chairman Ruder to the Annenberg Washington Program's 1989 Forum, "Technology and Financial Markets," on February 27, 1989). See also "Automation in U.S. and Foreign Securities Markets: A Report by the Division of Market Regulation of the United States Securities and Exchange Commission" (September 1989).
The Amex and the Chicago Board Options Exchange ("CBOE") have developed automated order execution systems, termed RAES and Auto-Ex, respectively, for the execution of small public customer option orders. The Phlx has developed an automated order routing system for small customer options orders called Autom. In the OTC market, the National Association of Securities Dealers ("NASD") has developed a system called the Small Order Execution System ("SOES") that permits the automatic execution of small customer orders. For a more complete description of these systems, see Market Break Study, supra note 4, ch. 8 at 8-10 and ch. 9 at 12-13 and Appendix to Annenberg Forum Paper, supra, at 14-17 and 20-22.
Finally, the Cincinnati Stock Exchange ("CSE") has established a fully automated electronic trading system, National Securities Trading System ("NSTS"), that permits CSE members, without having to maintain a physical presence on the CSE floor, to enter agency or principal orders into the system through remote terminals. Once entered, orders are stored, queued, and executed by the system according to price and time priorities. Public agency orders, however, are granted priority over other orders at the same price, regardless of time of entry. The screens for each security traded in the system are updated instantaneously to reflect the entry, revision, cancellation and execution of orders.
|8||Through a coordinated and cooperative effort, SROs developed the Consolidated Transaction Reporting System and the Consolidated Quotation Reporting System in 1974 and 1978, respectively. These systems provide for the electronic collection and dissemination of real-time trade and quotation information (i.e., immediately or soon after the event, rather than at the end of the trading day) in NYSE and Amex listed securities, as well as certain regional securities. Under these plans, quotation and trade reports are submitted by participating markets electronically to a central processor, the Securities Information Automation Corporation ("SIAC"). SIAC, in turn, processes this information and broadcasts it to financial information vendors for dissemination to investors. For options, transaction and quotation information is collected and disseminated pursuant to a plan administered by the Options Price Reporting Authority ("OPRA"). As with equity securities, each options exchange electronically collects and transmits to OPRA last sale information and bids and offers for the options that it trades. OPRA, in turn, processes this information and disseminates it to vendors. In the OTC market, NASDAQ, Inc., a subsidiary of the NASD, operates a system that collects quotations that are electronically submitted by market makers from computer terminals in their offices and then disseminates them to vendors and other market makers. For the largest and most actively traded NASDAQ companies, which are known as NASDAQ/NMS securities, the NASD provides real-time last sale reports.|
|9||Trade comparison, the matching of the buy and sell sides of a securities transaction, is the process after a trade has been executed by which broker-dealers confirm with each other the trade's terms (e.g., security, number of units, and price) and the existence of a contract. Comparison is the first of three basic steps in processing a securities transaction, the other two being clearance and settlement. For a more complete discussion of trade comparison, see Market Break Study, supra note 4., ch. 10 at 1-5.
The NASD has developed a system, called Automated Confirmation Transaction ("ACT"), that facilitates the automated clearing of pre-negotiated trades. See Securities Exchange Act Release No. 26991 (June 29, 1989), 54 FR 28531. Act is a facility for same-day comparison of inter-dealer, over-the-counter equity trades. Participants must enter trade reports within specific time frames, which are then compared and submitted to clearing as matched, "locked-in" trades. The NASD also has introduced a system called the Order Confirmation Transaction ("OCT") System. See Securities Exchange Act Release No. 25263 (January 11, 1988), 53 FR 1430. OCT permits negotiation through screen terminals of trades of all sizes between market makers, and brokers and the automated, locked-in comparison of those trades once agreed upon. The system in effect replaces telephone negotiation with negotiation through computer links and screen. If an order is accepted, the system generates locked-in comparison reports, as well as publicly-disseminated trade reports.
The NYSE and the National Securities Clearing Corporation ("NSCC") recently have developed an automated comparison system called the Overnight Comparison System ("OCS"). This system, which is being implemented in stages, consists of two subsystems, called the Correction System and the Comparison Redesign System. The Correction System computerizes the NYSE's processing of uncompared trades. The Exchange's Correction System began operation on April 27, 1989, and July 18, 1989, all uncompared or "Questioned Trades" were being resolved through the System. See Securities Exchange Act Release No. 27096 (August 3, 1989), 54 FR 33299. The Comparison Redesign System permits all transactions to be compared or closed out by the close of the business day following trade date, T+1, as required by new NYSE Rule 130.
|10||In some cases, the queuing problems adversely affected the priority of orders placed in the system. For instance, in one system, once an order file was full, incoming orders would replace, or "wrap-over," orders previously placed in the system.|
|11||While some of the markets, such as the MSE, were able to make certain adjustments in their systems to continue operations, two markets, the PSE and the Phlx, asked members to refrain from using their automated systems for several periods of time during the week of October 19, 1987, because the systems were over loaded. See Market Break Study, supra note 4, ch. 7 at 15-41.|
|12||The OTC and options markets' automated execution systems, however, did not experience operational strains during the market break, in part because order flow was diverted from these systems for reasons unrelated to the operation of the computer facilities themselves. For a more thorough discussion of the problems encountered by these markets, see Market Break Study, supra note 4. at chs. 7-9. With regard to trade comparison systems, the number of uncompared trades on all securities markets increased substantially, thereby placing great stress on the clearance and settlement process. This was not, however, a system capacity problem, except for the NYSE's odd-lot system, the Automated Pricing and Reporting Service ("APARS"). APARS reports were delayed significantly on October 20 and 21, 1987, and the system as a whole experienced problems on October 20 when no member odd-lot trades were reported to NSCC (however, those trades were reported the next day and were entered into NSCC's clearance systems without further effect on timely settlements). APARS also experienced capacity overload problems on October 20, which caused a computer failure and, in switching over to a backup computer, loss of approximately 8,000 to 9,000 orders. The lost trades were re-established through the NYSE's trade correction process. See id. ch. 10 at 5-12. In December 1987, the Commission approved a NYSE rule change that modified pricing procedures for standard odd-lot market orders. The APARS system was eliminated, and standard odd-lots now are routed through the Exchange Limit Order File ("LMT"). See Securities Exchange Act Release No. 25177 (December 7, 1987), 54 FR 47472. Finally, there were delays at several of the regional exchanges in transmitting trade information to the Securities Industry Automation Corporation ("SIAC"). See id. ch. 7 at 3-7.|
|13||Not surprisingly, those exchanges that had conducted prior testing of their automated systems seemed to fare better than those that had not.|
|14||apparently, the computer receiving quote updates was so fast that the computer could not read and send the quotes to the computer which processes executions. Therefore, the computer or the link was shut off for approximately 20 minutes for 9:38 to 10:04 am.|
|15||The equities floor in San Francisco remained open on a limited basis with orders being routed to and executed in Los Angeles, while some workers at the PSE's main floor in San Francisco executed orders by flashlight. W.S.J. Oct. 19, 1989 at C14.|
|16||The Commission believes that the Policy Statement is consistent with and in furtherance of Sections 2 and 11A (a) (1) (B) and (C) of the Securities Exchange Act of 1934. Specifically, Section 2 states in pertinent part that "transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest which makes is necessary to provide for regulation and control of such transactions and of practices and matters related thereto, . . . to require appropriate reports, to remove impediments to and perfect the mechanisms of a national market system for securities and a national system for the clearance and settlement of securities transactions and the safeguarding of securities and funds related thereto, and to impose requirements necessary to make such regulation and control reasonably complete and effective, . . . " In Section 11A (a) (1), Congress found that: (1) "securities markets are an important national asset which must be preserved and strengthened"; (2) "new data processing and communications techniques create the opportunity for more efficient and effective market operations"; and (3) "it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure . . . [the] economically efficient execution of securities transactions."|
|17||The Commission notes that compliance with this policy statement by the SROs is voluntary. The Commission's examination program, however, will review carefully the preparedness of SRO systems to handle substantial volume spikes. If the Commission becomes concerned over the level of voluntary compliance with this Policy Statement, it may propose a rule that would place an affirmative obligation on the SROs to obtain a periodic review of their automated systems.
While this Policy Statement does not directly discuss the obligations broker dealers, proprietary trading systems, service bureaus, and vendors, the Commission believes all should engage in systems testing, and this Policy Statement should be used as a guideline. The Commission staff will review these entities' systems preparedness in the coming months and , if appropriate, the Commission may consider the issuance of a second Policy Statement thereafter.
|18||We note that, in fact, the SROs already have begun a testing program. For example, on Saturday, April 30, 1988, the NYSE and SIAC tested the key computer systems that experienced difficulties in October 1987. During the test the participants replayed actual data from October 19, 1987, compressed into five hours (8:00 a.m. to 1:00 p.m.) to achieve the peak volumes required to stress the systems. Beginning at 8:00 a.m., incoming market orders were accepted into the Opening Automatic Reporting System ("OARS") and limit orders were sent to display books and card printers. At 9:30 a.m., specialist personnel opened the "market" and simulated normal (but intense) trading activity by reporting executions and entering additional orders from the floor.
The NYSE reported that the test showed that the improvements made since October 19 (for example, expanding the trading floor, adding input/output devices, greatly increasing the use of display books, and upgrading hardware and software) have resulted in higher capacity, increased flexibility and better performance. The NYSE's systems processed a traffic flow comparable to that of October 19, 1987, in much less time and at much higher message rates. See Report from NYSE and SIAC, 600-Million-Share-Day Volume and Stress Test on April 30, 1988 (May 23, 1988).
On Saturday, November 12, 1988, the NYSE and SIAC, in conjunction with the member-firm community and the financial-service vendors, tested the Exchange's switching and order-processing systems. The test, according to the report of the NYSE and SIAC, met its five objectives. Specifically, it:
1. proved that the Common Message Switch (CMS) interface to member firms can accommodate message rates up to those expected on a 600-million-share day;
2. demonstrated that member firms can deliver orders to and receive reports from the NYSE at 600-million-share-day message rates;
3. identified potential weak lines when many systems were stressed at rates in excess of 600-million-share-day levels; collected extensive information about systems' behavior under heavy loads;
4. used the market-data systems to distribute trade and quote data to financial-service vendors in preparation for the 1989 test; and
5. helped NYSE/SIAC identify requirements for system tools and procedures to conduct similar tests routinely.
Report from NYSE and SIAC, 600-Million-Share-Day Member-Firm Interface Test on November 12, 1988 (December 16, 1988).
The 1989 tests focused on the National Market System ("NMS"), and consisted of three phases. On Saturday, May 13, 1989, NYSE and SIAC, with the cooperation of other market centers, conducted a vendor test. The NYSE and SIAC reported that the May test successfully transmitted test market data, previously recorded, from all market-center sources to the financial-service vendors and that the test met its two objectives by:
1. distributing trade and quote data to the vendor community at 600-million-share-day rates to test vendors' ability to receive and process at these rates; and
2. identifying the SIAC and vendor tools needed to conduct similar tests routinely.
Report from NYSE and SIAC, 600-Million-Share-Day Financial Service Vendor Test on May 13, 1989 (June 9, 1989).
On June 24, 1989, a stress test was conducted to examine the Consolidated Trading and Consolidated Quote Systems. According to the report issued by the NYSE and SIAC on August 4, 1989, the test met its two objectives by:
1. demonstrating that the Consolidated Trading System and the Consolidated Quote System can handle 600-million-share-day message rates when all participants are active: and
2. identifying the SIAC and participant tools needed to conduct similar tests routinely.
At 600-million-share-day rates, all SIAC operations ran smoothly, with minimal queuing. Report for NYSE and SIAC, 600-Million-Share-Day Consolidated Trade and Quote Systems Test on June 24, 1989 (August 4, 1989).
A third stress test conducted in September 1989, tested ITS. Reports of this third test are not yet available, although preliminary results indicated that the systems accommodated simulated volume levels that exceed those of the October 1987 Market Break.
|19||These objectives are discussed in greater detail in Section III, infra.|
|20||Senate Comm. on Banking, Housing & Urban Affairs, Report to Accompany S. 249, S. Rep. No. 94-75, 94th Cong., 1st Sess. 7, reprinted in 1975 U.S. Code Cong. & Ad. News 179. See also § 11A(a) (1) (B) and (C), 15 U.S.C. 78f (1982).|
|21||The term "automated systems" or "automated trading systems", as used in this release, refers collectively to computer systems for listed and OTC equities, as well as options, that electronically route orders to applicable market makers and systems that electronically route and execute orders, including the data networks that feed the systems. The term "automated systems" also encompasses systems that disseminate transaction and quotation information and conduct trade comparisons prior to settlement, including the associated communication networks. Moreover, because lack of adequate communications capacity can be as damaging to the overall performance of an exchange during peak periods as poorly designed order processing, capacity tests of the data networks that feed the computer systems also should be conducted.|
|22||See Letter from David S. Ruder, Chairman, SEC, to the Honorable William Proxmire, Chairman, Committee on Banking, Housing, and Urban Affairs dated March 4, 1988 (discussing contingency planning and coordination and operational capacity enhancements).|
|23||Future capacity estimates also should take into consideration increased message traffic resulting from planned modifications to existing systems or the introduction of new systems. For example, if the NYSE were to expand the instances where DOT automatically would execute orders or if the CBOE were to increase the order eligibility size for RAES, then they would have to incorporate the anticipated increase in order flow into their capacity estimates.|
|24||A contingency protocol is a plan to deal with extreme market conditions which potentially could overburden automated order routing and execution systems.|
|25||The Commission understands that many of the SROs already have produced similar capacity estimates, planning statements, and protocols that they will be able to use them to comply with this Policy.|
|26||In the future, the Commission may suggest expansion of this Policy to other SRO computer-driven support systems for, among other things, clearance and settlement, and market surveillance, if the Commission finds it necessary to ensure the maintenance of fair and orderly markets.|
|27||In view of the voluntary nature of this Policy, the Commission has not mandated specific requirements for determining whether a reviewer is independent. The Commission, however, requests comments on whether it should mandate such standards in the future, and if so, what those standards should be.|
|28||In addition, the Commission requests that each SRO include a general discussion of its automation review in its Exchange Act Form 1-A submitted annually to the Commission.|
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