April 30, 2004
Ms. Mai S. Shiver
Dear Ms. Shiver:
Based on the facts and representations set forth in your letter dated April 27, 2004, we find that it is appropriate in the public interest and consistent with the protection of investors to grant, and hereby grant, to Exchange Trading Permit Holders ("ETP Holders") of the Pacific Exchange ("PCX") that execute trades for their customers on the Archipelago Exchange ("ArcaEx") a limited exemption pursuant to Rule 10b-10(f) under the Securities Exchange Act of 1934 ("Exchange Act") from the requirement in Rule 10b-10(a)(2)(i)(A) to disclose to their customers the name of the person from whom a security was purchased, or to whom it was sold, or the fact that such information will be provided upon a customer's written request. The exemptive relief is limited to trades that ETP Holders execute on ArcaEx with other ETP Holders using the post-trade anonymity feature described in a proposed rule change filed by PCX (SR-PCX-2004-40).
In granting the relief, we note in particular that ETP Holders cannot direct or "preference" orders to any ETP Holders and that ArcaEx does not have an internalization exception to its execution algorithm. In addition, we note that there will be an exception to the post-trade anonymity feature that will inform members when they have executed an order by matching against other trading interest they have submitted to ArcaEx. As a result, all ETP Holders who execute trades in ArcaEx using the post-trade anonymity feature will have available to them the information necessary to comply with the remaining applicable requirements of Rule 10b-10.
The Office of Financial Responsibility has instructed us to inform you that the Commission staff will not recommend enforcement action to the Commission if, in lieu of making and preserving a separate record, the ETP Holder relies on ArcaEx's retention of the identities of ETP Holders that execute anonymous trades through ArcaEx, for the period specified in Rule 17a-4(a), to satisfy the requirements of Rules 17a-3(a)(1) and 17a-4(a) under the Exchange Act. The staff notes, however, that an ETP Holder has the responsibility to make, keep current, and preserve records of all purchases and sales of securities in accordance with Exchange Act Rules 17a-3 and 17a-4 for trades through ArcaEx if the ETP Holder knows the identity of the contra-party, including those instances in which ArcaEx discloses the contra-party to a trade (e.g., when the ETP Holder submits an order that has executed against an order submitted by that same ETP Holder).
This exemption from Rule 10b-10 and the staff position under Rules 17a-3 and 17a-4 are based solely upon the representations you have made and are limited strictly to the facts and conditions described in your letter. Any different facts or circumstances, including any change to the operation of ArcaEx or the post-trade anonymity feature, may require a different response. We express no view with respect to other questions the proposed activities of PCX or any ETP Holder relying on this relief may raise, including the applicability of any other federal or state laws or the applicability of self-regulatory organization rules concerning customer account statements or confirmations.
For the Commission,
Brian A. Bussey
VIA OVERNIGHT DELIVERY
April 22, 2004
Ms. Catherine McGuire
Re: Request For a Limited Exemption from Paragraph (a)(2)(i)(A) of Rule 10b-10 Under the Securities Exchange Act of 1934.
Dear Ms. McGuire:
The Pacific Exchange, Inc. ("PCX" or "Exchange"), through its wholly owned subsidiary PCX Equities, Inc. ("PCXE"), respectfully requests a limited exemption from paragraph (a)(2)(i)(A) of Rule 10b-10 under the Securities Exchange Act of 1934 ("Act") on behalf of Exchange Trading Permit Holders ("ETP Holders") that execute trades on the Archipelago Exchange ("ArcaEx") for their customers.1 The exemption request is limited to those trades that ETP Holders execute on ArcaEx with other ETP Holders using the post-trade anonymity process.2 The Exchange submits this letter in conjunction with a proposed rule change filed by the Exchange under Section 19 of the Act, and Rule 19b-4 thereunder, to modify certain PCXE rules to extend trade anonymity through post settlement for certain trades executed through ArcaEx.3 A copy of the proposed rule change is included with this exemption request.
A. Background - ArcaEx Described
As a trading facility of the PCX for equity securities, ArcaEx is the first open, electronic market in the United States. ArcaEx maintains an electronic file of orders, called the ArcaEx Book. The ArcaEx book is divided into three components: the Display Order Process, Working Order Process, and Tracking Order Process.4 ArcaEx ranks and maintains limit orders in each of the processes based on order type. In the Display Order and Working Order Processes, ArcaEx ranks and maintains orders in the ArcaEx Book according to price-time priority and affords priority to displayed orders and prices over undisplayed orders, sizes, and prices. In the Tracking Order Process, ArcaEx matches orders that are not filled through the first two processes in accordance with an order's stated instructions. The Tracking Order Process as set forth in PCXE Rule 7.37 is the last order execution process before an order may be routed outside of ArcaEx. In the Tracking Order Process, Users submit an instruction for the parameters of a Tracking Order that are ranked in the Arca Book on a price/time basis. Incoming market or limit orders are executed against Tracking Orders on a price/time rotating basis pursuant to PCXE Rule 7.31 only after first attempting to execute in the Display and Working Order Processes. At the ETP Holder's option, ArcaEx may route orders that are not matched on the ArcaEx Book to a different market center for execution.5
Pursuant to PCXE Rules 7.36 and 7.37, ETP Holders may currently display and execute orders on an anonymous basis or display trading interest on an attributed basis under a five-letter market participant identifier ("ETPID").6 At the end of each trading day, the Exchange reveals the contra-party's identity on a trade-by-trade basis to ETP Holders for their respective trades through web-based reports and clearing reports produced by the NSCC . Consequently, for those orders entered on an anonymous basis, the Exchange maintains anonymity through execution, but not through the end-of-day settlement process.
Finally, ArcaEx's trading algorithm permits orders originated by an ETP Holder to execute against other orders from that same ETP Holder on the same basis as orders from other ETP Holders. In instances where an ETP Holder has received an execution against itself, the ETP Holder is informed of these trades at the end of the day.7
B. Proposed New Rule to Adopt Total Anonymity through Settlement
Together with this request for a limited exemption from paragraph (a)(2)(i)(A) of Rule 10b-10, the Exchange has proposed to modify PCXE Rule 7.41 in order to extend post trade anonymity so that, except for specific instances discussed below, the Exchange will not reveal the contra-party to the trade. ETP Holders often seek to trade anonymously to prevent market impact and the consequences that arise when the market has knowledge that a large order must be executed. In these instances, for example, a seller does not want the buyer to know its identity because it may reveal the existence of a large order to be filled. The Exchange believes that post-trade anonymity benefits investors because preserving anonymity through settlement limits the potential market impact that disclosing the ETP Holder's identity may have. Specifically, when the contra-party's identity is revealed, ETP Holders can detect trading patterns and make assumptions about the potential direction of the market based on the user's presumed client-base. For example, if the ETP Holder handles large institutional orders and becomes an active buyer in the security, others could anticipate such demand and adjust their trading strategy accordingly. This could result in increased transaction costs for the ETP Holder representing the institutional orders.
The Exchange therefore believes that due to interest expressed by ETP Holders and the Commission's recent approval of NASDAQ's proposal to implement post-trade anonymity,8 it is essential for ArcaEx to offer ETP Holders anonymity through the settlement process. To facilitate ArcaEx's proposal, ArcaEx has worked with NSCC to accommodate anonymity on a post-trade basis. NSCC has assigned post-trade anonymous trades with a unique clearing number. ArcaEx will submit clearing records to NSCC, which, pursuant to its rules,9 will report trades executed on ArcaEx back to its clearing firms utilizing this unique clearing number.10
To address risk management concerns, ArcaEx will provide ETP Holders with concentration reports throughout the trading day that reflect, on an aggregate basis, the share volume and dollar amount executed by each contra-party.
Under specified circumstances, it might be necessary for ArcaEx to provide the identity of a contra-party to an ETP. As proposed, ArcaEx will reveal the contra-party only in those instances where: (i) the ETP has executed orders against itself;11 (ii) when required for legal or regulatory purposes; (iii) if the NSCC ceases to act for an ETP Holder or the ETP Holder's clearing firm, and (iv) if the NSCC determines not to guarantee the settlement of the ETP Holder's trade.
C. Rule 10b-10 - Identifying Contra-Party
Rule 10b-10, among other things, requires a broker-dealer to disclose to its customers the identity of the party the broker-dealer sold to or bought from to fill the customer's order. Specifically, under paragraph (i)(A) of Rule 10b-10(a)(2), when a broker-dealer is acting as agent for a customer, some other person, or for both the customer and some other person, the broker dealer must disclose "the name of the person from whom the security was purchased, or to whom it was sold, for such customer or the fact that the information will be furnished upon written request of such customer" (the "Contra-Party Identity Requirement"). A broker-dealer can provide this information on the confirmation, or it has the option to provide the information to a customer at a later time after receiving a written request from the customer. A broker-dealer has this option as long as it discloses on the confirmation that the contra-party information is available upon written request.
With the introduction of total anonymity at ArcaEx, the Exchange will not routinely reveal the identity of the actual contra-party when the order is executed against another ETP Holder.12 Therefore, ETP Holders will not know the identity of the party to whom they sold securities or from whom they purchased securities. Without this information, ETP Holders cannot comply with the Contra-Party Identification Requirement. To permit ArcaEx ETP Holders to utilize ArcaEx without violating Rule 10b-10, the Exchange is seeking an exemption, on behalf of such ETP Holders, from the Contra-Party Identification Requirement when ETP Holders execute transactions using the post-trade anonymity process on ArcaEx against other ETP Holders.
The Contra-Party Identification Requirement, in conjunction with the other requirements of paragraph (a)(2) of Rule 10b-10, is designed to provide customers with information that could alert them to potential conflicts of interest their broker-dealer may have had when handling their orders.13 The Exchange believes an exemption from the Contra-Party Identification Requirement when an ETP Holder trades with another ETP Holder through ArcaEx using the post-trade anonymity feature would not diminish the public policy and investor protection objectives of the Contra-Party Identification Requirement of Rule 10b-10. The Exchange believes the potential for a conflict of interest is less likely in those circumstances when an ETP Holder trades with another ETP Holder through ArcaEx because the trades are executed at the best price available on ArcaEx and the contra party is determined randomly based upon multiple factors not controlled by either ETP Holder. In such situations, ETP Holders on ArcaEx are not permitted the discretion in executing the order that would normally give rise to the opportunity for a conflict of interest.
There will be an exception to the post-trade anonymity process under which ArcaEx will inform ETP Holders when they have executed an order by matching against other trading interest they have submitted to ArcaEx. As a result, all ETP Holders who execute trades on ArcaEx will have available to them the information necessary to comply with the remaining applicable requirements of Rule 10b-10.
D. Books and Record Retention
The Exchange asks that the Commission staff not recommend enforcement action to the Commission if, in lieu of making and preserving a separate record, a broker-dealer relies on the Exchange's retention of the identities of ETP Holders that execute anonymous trades through ArcaEx to satisfy requirements of Rules 17a-3(a)(1) and 17(a)-4(a) under the Act. A broker-dealer would retain the responsibility to make, keep current and preserve records of all purchase and sales of securities in accordance with Exchange Act Rules 17a-3 and 17a-4 for trades through ArcaEx if the broker-dealer knows the identity of the contra-party, including those instances where ArcaEx discloses the contra-party to a trade.
In view of the foregoing, the Exchange respectfully requests that the Commission issue an exemption from the paragraph (a)(2)(i)(A) of Rule 10b-10 for ArcaEx ETP Holders that execute anonymous trades in ArcaEx for their customers with other ETP Holders. The PCX does not request that the exemption apply to those ETP Holders that know the identity of the contra party.
If you have any questions or concerns, please do not hesitate to call me at (415) 393-4266.
Mai S. Shiver
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