November 22, 1996 Mr. Joseph R. Hardiman President National Association of Securities Dealers 1735 K Street, NW Washington, DC 20006 Re: Interpretive Guidance on the Order Execution Rules Dear Mr. Hardiman: On August 28, 1996, the Commission adopted new Rule 11Ac1-4 ("Limit Order Display Rule") and amendments to Rule 11Ac1-1 ("Quote Rule") under the Securities Exchange Act of 1934 ("Exchange Act").-[1]- In the Adopting Release, the Commission identified many issues for industry participants to consider in implementing the Limit Order Display Rule and amendments to the Quote Rule (collectively, "Order Execution Rules"). For example, self-regulatory organizations ("SROs") were requested to consider issues such as autoquoting, minimum quotation sizes, and the creation of linkages with electronic communications networks ("ECNs"). Broker-dealers also needed to evaluate whether any system changes were necessary to comply with the new rules.-[2]- Since publication of the amendments to the Quote Rule and the Limit Order Display Rule, the Division of Market Regulation ("Division") has received a number of inquiries from market participants regarding the implementation and operation of the rules, some of which indicate that interpretive guidance is needed. To aid your members in complying with the rules, which become effective on January 10, 1997, the Division is issuing this letter to address a number of these questions. I. Limit Order Display Rule ---------FOOTNOTES---------- -[1]- See Securities Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 (September 12, 1996) ("Adopting Release"). -[2]- See Securities Exchange Act Release No. 36310 (September 29, 1996), 60 FR 52792 (October 10, 1996) ("Proposing Release") at 31. ==========================================START OF PAGE 2====== Mr. Hardiman November 22, 1996 Page 2 The Limit Order Display Rule requires exchange specialists and OTC market makers to immediately display in their bid or offer both the price and the full size of each customer limit order that would improve their quoted price in a particular security. In addition, exchange specialists and OTC market makers who have a bid or offer that is equal to the national best bid or offer are obligated to reflect in their quote the size of a customer limit order that is priced equal to that bid or offer and represents more than a de minimis change in their quotation size. The Limit Order Display Rule provides for certain exceptions to the display requirement. For example, a customer may expressly request that its order not be displayed. This request may take place on an order-by-order basis, or, under certain circumstances, may be agreed to prospectively, as discussed below. Further, orders of block size need not be displayed unless a customer requests. Other exceptions include customer limit orders that are "odd-lot" orders, "all-or-none" orders, orders executed upon receipt, and orders delivered to another exchange member or OTC market maker that complies with the display requirement. The rule also permits an exchange specialist or OTC market maker to deliver a customer limit order to an exchange or association sponsored system or an ECN, rather than display the order in its own quote. To use this exception, however, a customer limit order at the best quote must be displayed and as accessible and transparent as if the limit order had been displayed in the exchange specialist's or OTC market maker's own quote. A. Immediate Display of Limit Orders As stated in the Adopting Release, the requirement that a limit order be displayed "immediately" means that the limit order must be displayed as soon as practicable, but no later than 30 seconds after receipt under normal market conditions.-[3]- The Division believes that this 30-second time period begins when the order is received by the specialist or trader that will display the order (or the firm's automated display system), rather than when the order is first received from the customer by another person at the firm such as a registered representative or institutional sales person. Of course, the order should be transmitted promptly to the specialist or trader. Some industry participants have inquired about the Limit Order Display Rule's application during market openings. The ---------FOOTNOTES---------- -[3]- See Adopting Release at 72. ==========================================START OF PAGE 3====== Mr. Hardiman November 22, 1996 Page 3 Division believes that, because of the special circumstances involved in setting an opening price in the OTC market and the volume of orders that may accumulate at the opening, OTC market openings should not currently be viewed as "normal market conditions" for purposes of the Limit Order Display Rule. Therefore, OTC market makers will not be required to include limit orders in the opening quote or to display limit orders within 30 seconds of receipt during the period shortly following the opening.-[4]- Nonetheless, the Division believes that limit orders held at the opening must be displayed as soon as practicable under the circumstances. Given that the development of systems that facilitate an efficient OTC market opening that include limit orders could result in more normal market conditions at the opening, the Division intends to review its position on limit order display at the opening as such systems develop. Questions have been raised regarding the display of limit orders that would lock or cross the market. In the Division's view, the Limit Order Display Rule does not require an exchange specialist or OTC market maker to immediately display a customer limit order that would lock or cross the market. In an exchange market, depending on the circumstances, if a limit order is marketable and display would result in an immediate execution against an existing quote in that market, a specialist may represent the limit order in a manner similar to a market order in order to get a better price for the customer. In the OTC market, depending on the circumstances, if a market maker receives a customer limit order that is marketable against its own quote, it may execute the order or attempt to get a better price for the order. If the limit order is marketable against another firm's quote, the market maker may attempt to execute the order against that quote prior to displaying the order.-[5]- For example, in such a situation, a Nasdaq market maker may send a SelectNet message to the market maker or ECN displaying the existing quote. The limit order should be displayed if it cannot be executed against the existing quote after reasonable efforts to do so, even if it locks the market. Although attempting to execute against the quote may result in the display of the customer limit order more than 30 seconds after receipt, the Division believes such action would not violate the Limit Order ---------FOOTNOTES---------- -[4]- Market participants should be reminded, however, that their best execution obligations, and limit order protection obligations under NASD rules, would continue to apply. -[5]- See, e.g., NASD Rule 4613(e)(2). ==========================================START OF PAGE 4====== Mr. Hardiman November 22, 1996 Page 4 Display Rule's immediacy requirement. B. Method of Display of Limit Orders As noted above, the Limit Order Display Rule requires an exchange specialist or OTC market maker to display the price and size of a customer limit order that improves its quote. The Division has received a number of requests for further clarification of a market maker's display obligation when it receives a customer limit order that improves its own quote but does not improve the national best bid or offer ("NBBO"). In this circumstance, the market maker must change its own quote to reflect the customer limit order (unless an exception applies). If, for example, the NBBO is 10 - 10 1/4 (1,000 x 1,000), and a market maker is quoting 9 5/8 - 10 1/4 (1,000 x 1,000), upon receipt of a customer limit order to buy 2,000 shares at 9 3/4, the market maker will be required to change its quote to 9 3/4 - 10 1/4 (2,000 x 1,000). In a situation where a market maker receives a customer limit order at a price equal to its quote, the market maker must change the size associated with its quote only when such quote equals the NBBO, and the customer limit order is for greater than a de minimis size in relation to the market maker's quote.-[6]- Therefore, if the market maker has changed its bid to reflect a customer limit order so that it is quoting 9 3/4 - 10 1/4 (2,000 x 1,000) and it then receives another customer limit order to buy 2,000 shares at 9 3/4, the market maker need not change its quote size. If the NBBO shifts to a 9 3/4 bid, so the market maker's quote now equals the NBBO, the market maker must display the additional 2,000-share order in its bid. Assuming the NBBO shifts back to a 10 bid, the market maker must continue to display the full size of the customer limit orders, and quote a bid of 9 3/4 for 4,000 shares. Subsequent customer limit orders received by the market maker at 9 3/4, however, will not need to be displayed as long as that price remains outside the NBBO. In addition, the Commission recognized in the Adopting Release that a number of broker-dealers operate automatic execution systems that are programmed to automatically execute customer orders at the NBBO and, in some cases, provide such orders with an opportunity for price improvement. Each broker-dealer makes its own determination as to the maximum size ---------FOOTNOTES---------- -[6]- See Adopting Release at 70 (interpreting a limit order to be de minimis when its size is less than or equal to 10% of the displayed size associated with a specialist's or OTC market maker's bid or offer). ==========================================START OF PAGE 5====== Mr. Hardiman November 22, 1996 Page 5 of orders that will be automatically executed. The Commission stated in the Adopting Release that it is not inconsistent with best execution principles for specialists and market makers using such systems to take into account the size of a limit order represented in the public quote in determining the price at which an order, or portion thereof, should be automatically executed.-[7]- A few industry participants have asked whether a specialist or market maker may also take into account the size of the public quote when it represents a specialist's or market maker's proprietary quote, in addition to a customer limit order. The Division believes that the Commission did not intend to draw a distinction based on whether the public quote size represents customer or proprietary interest, particularly because once customer limit orders are fully integrated into public quotes, it will be difficult to distinguish between customer orders and proprietary bids and offers. Questions also have been raised regarding the manner in which successive orders must be executed in light of the Commission's statement. The Division believes the following example should clarify a specialist's or market maker's execution responsibility. Assume market maker "A" generally provides automatic executions to all market orders up to 3,000 shares. Assume further that only market maker "B" is quoting at the NBBO, 10 - 10 1/4 (1,000 x 1,000), when market maker A receives a market order for a customer to buy 2,000 shares. The Division believes that, to provide best execution for that customer, market maker A would be expected to execute at least 1,000 shares of the order at 10 1/4 or better, unless market maker A, using "reasonable and efficient means,"-[8]- attempted but was unable to trade with market maker B at 10 1/4. If 1,000 shares were executed at 10 1/4, the Division believes it would not be inconsistent with best execution principles to execute the remaining 1,000 shares at the next best offer. The Division believes that, if market maker A then receives another order to buy 2,000 shares at the market, market maker A again must execute at least 1,000 shares at 10 1/4, unless market maker A had ---------FOOTNOTES---------- -[7]- See Adopting Release at 59-61. -[8]- The Division believes that market maker A has used reasonable and efficient means to execute at the NBBO if it has used an electronic order-routing system, such as SOES or SelectNet in the OTC market, or ITS in the listed market, to attempt to reach market maker B. ==========================================START OF PAGE 6====== Mr. Hardiman November 22, 1996 Page 6 recently attempted, but was unable, to execute against market maker B's offer through a "reasonable and efficient means." If market maker A was unable to execute against market maker B's offer through such means, market maker A could fill the market order at the next best offer.-[9]- The display requirement also has raised an issue regarding the Order Execution Rules' effect on passive market makers. Rule 10b-6A permits broker-dealers to engage in passive market making without being in violation of Rule 10b-6 under the Exchange Act. Due to the trading restrictions under Rule 10b-6A, a passive market maker could be in technical violation of Rule 10b-6A if it complies with the requirements of the Order Execution Obligations Rules. However, the Division will not recommend enforcement action if a passive market maker, in accordance with the Order Execution Rules, displays bids on behalf of customers, and executes customer orders in compliance with the rules even if the transactions otherwise would violate Rule 10b-6A.-[10]- In addition, the Division suggests that interested parties review a related interpretation from the Division regarding the obligations of passive market makers with respect to the handling ---------FOOTNOTES---------- -[9]- If more than one market maker is quoting at the NBBO, the market maker receiving the market order must look to the aggregate number of shares bid for or offered at the NBBO in determining the price at which an automatic execution must be provided. For example, if market maker B continues to quote at the NBBO for 1,000 shares, and market maker C begins to quote at the NBBO for 500 shares, then market maker A would have to automatically execute the 2,000 share order at 10 1/4 or better, for at least 1,500 shares, with the remainder of the order to be executed at the next best offer. The maximum number of shares that would be required to be executed automatically would depend on the size of orders to which market maker A generally provides automatic executions (3,000 shares in the present example). -[10]- This interpretation is consistent with Rule 103 as proposed in Regulation M. See Securities Exchange Act Release No. 37094 (April 11, 1996), 61 FR 17108. ==========================================START OF PAGE 7====== Mr. Hardiman November 22, 1996 Page 7 of customer limit orders.-[11]- C. Exceptions to the Limit Order Display Requirement As discussed above, the Limit Order Display Rule provides a number of exceptions to the display requirement. One such exception is where a customer expressly requests that its order not be displayed.-[12]- This request may be made prospectively by contract, or on an order-by-order basis. A customer and a broker-dealer may enter into an individual agreement giving the broker-dealer discretion to make the display decision. This agreement may be entered into at the time the account is opened or subsequently. Of course, as noted in the Adopting Release, this agreement cannot be in the form of standardized disclaimers or contractual language required of customers, but rather must be individually negotiated between the customer and the broker-dealer.-[13]- The Division believes an exchange specialist or an OTC market maker receiving a limit order from a broker may rely on a representation by a broker concerning a customer's request not to display its limit order, but a broker should communicate its customer's request on an order-by-order basis. Another exception to the display requirement allows an exchange specialist or OTC market maker to send a customer limit order to another exchange member or market maker that complies with the rule.-[14]- Some industry participants have inquired whether an exchange specialist or OTC market maker may fulfill its display obligations by routing an order for its own account, rather than the customer's order, to another market or market maker. The Division believes that an exchange specialist or OTC market maker may route its own order, rather than a customer order, to another market if the specialist's or OTC market maker's own order fully reflects the terms of the customer limit order, the order is displayed (or executed) by the other market, consistent with the Limit Order Display Rule, and any execution, in whole or in part, is passed on to the customer ---------FOOTNOTES---------- -[11]- See letter from Larry E. Bergmann, Associate Director, Division, SEC, to Eugene Lopez, Assistant General Counsel, NASD, dated July 19, 1995. -[12]- Rule 11Ac1-4(c)(2). -[13]- See Adopting Release at 75. -[14]- Rule 11Ac1-4(c)(6). ==========================================START OF PAGE 8====== Mr. Hardiman November 22, 1996 Page 8 limit order. An exchange specialist or OTC market maker order for less than the full size of the customer limit order would not be deemed to reflect the terms of the customer limit order; sending such an order to another market or market maker for display would not satisfy the Limit Order Display Rule. The use of a smaller "marker" order would be permitted, however, if the customer had authorized the exchange specialist or OTC market maker to use discretion in determining whether to display the order, or had requested that only the number of shares represented by the "marker" order be displayed, consistent with the exception contained in the Limit Order Display Rule for customer consent. In a related issue, some have asked whether an exchange specialist or OTC market maker can send a portion of an order to another market center that complies with the Limit Order Display Rule, and display the remainder in its own quote. The Limit Order Display Rule requires that a customer limit order be displayed in full.-[15]- In the Adopting Release, the Commission stated that the display of full size not only improves transparency, but also is a factor in attracting order flow and increases the likelihood that a limit order will be executed.-[16]- Therefore, an exchange specialist or OTC market maker should either display the full size of the order in its own quote or send it to a market center where the order will be fully displayed. Some have questioned whether a firm could avoid the limit order display requirement by only accepting "all-or-none" limit orders, which are not required to be displayed. The rule does not require an exchange specialist or OTC market maker to accept customer limit orders, or for that matter, any particular type of limit order; therefore, a specialist or market maker could choose to accept only "all-or-none" limit orders. However, the specialist or market maker could not use a standard customer agreement that would deem all customer limit orders to be "all or none" limit orders. This standard agreement would be inconsistent with the Limit Order Display Rule's requirement that customer agreements allowing non-display be individually negotiated. In addition, the Division believes that an exchange specialist or OTC market maker must have a reasonable basis for believing that the customer will benefit from designating the limit order as an "all-or-none" order before recommending that the customer accept such conditions on the limit order. ---------FOOTNOTES---------- -[15]- Rule 11Ac1-4(b). -[16]- Adopting Release at 67-68. ==========================================START OF PAGE 9====== Mr. Hardiman November 22, 1996 Page 9 D. Non-Regular Way Limit Orders Some industry participants have asked whether limit orders with special settlement instructions (e.g., cash or same-day settlement) are subject to the display requirement. Although there is no specific exception for such "non-regular way" limit orders, the Division believes that the display of such orders in the public quote is not consistent with the Limit Order Display Rule's objectives in requiring limit order display. Generally, quotes reflect an intention of regular way settlement, and the markets that currently display limit orders do not display "non- regular way" limit orders. Accordingly, the Division believes that non-regular way orders need not be displayed in the public quote. E. Effective Date of Limit Order Display Rule The Limit Order Display Rule, as adopted, contained a phase- in period for the rule's application to Nasdaq securities. However, because the Commission has recognized that the display of customer limit orders is a significant change for the OTC market, the Commission has determined that a more gradual phase- in of the Limit Order Display Rule for Nasdaq securities is necessary.-[17]- Therefore, while all exchange-listed securities will be subject to the rule on January 10, 1997, only 50 Nasdaq securities will be subject to the rule on that date.-[18]- An additional 100 securities will be phased in on January 31, 1997, and the remaining 850 of the 1,000 most liquid Nasdaq securities will be phased in on February 21, 1997. An additional 1,500 and 2,000 Nasdaq securities will be covered on March 28, 1997 and June 30, 1997, respectively. All remaining Nasdaq securities will be covered on the first anniversary of the rule's adoption, August 28, 1997. Although the Division believes the gradual phase-in will assist OTC market makers in becoming accustomed to the requirements of the Limit Order Display Rule in a limited number of stocks, experience during this phase-in may demonstrate the need for an extended phase-in period. Therefore, the Securities Industry Association and the Securities Traders Association have ---------FOOTNOTES---------- -[17]- See Securities Exchange Act Release No. 37972 (November 22, 1996)(revising the compliance date of the Limit Order Display Rule for 950 Nasdaq securities). -[18]- The 50 Nasdaq securities to be phased in January 10 will be identified by Nasdaq. ==========================================START OF PAGE 10====== Mr. Hardiman November 22, 1996 Page 10 agreed to form a committee including integrated, wholesale, and regional firms, to observe the operation of the Limit Order Display Rule during the phase-in period, and provide their views regarding whether the current schedule may need further modification. II. ECN Amendments to the Quote Rule The Quote Rule was amended to require exchange specialists and OTC market makers to change their public quotes to reflect any priced orders they enter into ECNs that would improve their published bid or offer ("ECN amendment"). The Commission also included an alternative provision in the ECN Amendment that permits exchange specialists and OTC market makers to comply with the ECN Amendment indirectly by using an ECN that furnishes the price and size of certain orders entered therein to the public quotation system ("ECN display alternative"). For an ECN to qualify under this alternative, it must meet two criteria. First, it must provide the best exchange specialist and OTC market maker prices, and the sizes associated with such prices, for a security in the ECN for inclusion in the public quotation system. Second, it must provide other brokers and dealers with a means of access to those orders that is equivalent to the access that would have been available if the prices had been published in the exchange specialist's or OTC market maker's own quote. A. Dissemination of Prices in ECNs To satisfy the definition of an ECN, a system must "widely disseminate" to third parties orders entered therein by a specialist or market maker, and permit such orders to be executed in whole or in part.-[19]- The Division believes that a system that executes orders internally but does not display order prices to any subscribers would not be an ECN because these prices are not "widely disseminated." The Division believes that to "widely disseminate" an order, the ECN must internally display that order to the ECN's subscribers. The Division believes that the "widely disseminated" requirement would not be satisfied merely by including the order prices in the public quotation system; these prices must be displayed within the ECN and be executable within the ECN. Similarly, the Division believes that an order entered into an ECN would not be "widely disseminated" and thus need not be displayed publicly if it was not shown to more than one other subscriber. In addition, if an ECN allows a subscriber to place ---------FOOTNOTES---------- -[19]- Section 11Ac1-1(a)(8). ==========================================START OF PAGE 11====== Mr. Hardiman November 22, 1996 Page 11 an order with an instruction to display to ECN subscribers only a specified number of shares, with additional shares of the order to be undisclosed, the additional shares must be displayed in the public quote unless they would have a lower priority for execution than all other orders displayed in the ECN at the same price. Some market participants have asked whether a specialist or market maker may designate, on a per order basis, which orders entered into an ECN the specialist or OTC market maker will display itself and which orders will be displayed under the ECN display alternative. To operate under the display alternative, the Division believes an ECN must display the best specialist and market maker priced orders entered therein. The Division believes this requirement would not be satisfied if certain specialist or market maker priced orders were entered, but not included in the quote furnished by the ECN. B. Equivalent Access to an ECN To make clear which ECNs are in compliance with the ECN display alternative, the Division plans to issue public no-action letters to those ECNs that it believes are in compliance with the ECN display alternative. The Division is also willing to respond to requests for guidance on whether a particular system is an ECN. In order to comply with the ECN display alternative, an ECN is required to (1) provide to an SRO for inclusion in the public quotation system the best prices and sizes that specialists and market makers have entered into the ECN;-[20]- and (2) provide non-subscriber brokers and dealers with access to those prices entered in the ECN equivalent to the access to the prices in the specialists' and market makers' own quotes.-[21]- Various SROs have asked whether they must accept ECN prices and on what terms. In the Adopting Release, the Commission asked the SROs to indicate whether they would be willing to accept ECN ---------FOOTNOTES---------- -[20]- The Division also believes that in order to comply with the Display Alternative, an ECN operating before the opening of the market should make its prices available to the receiving market at the time they begin displaying other market maker and specialist quotes. -[21]- Section 240.11Ac1-1(c)(5)(ii). ==========================================START OF PAGE 12====== Mr. Hardiman November 22, 1996 Page 12 prices for inclusion in the public quote.-[22]- The ECN display alternative, however, does not require any particular SRO to accept ECN priced orders for inclusion in the SRO's quote. Rather, the Division believes the Quote Rule should be interpreted as providing for ECN access to the National Market System ("NMS"), but only through an agreement with an SRO or SROs. The Division believes the Quote Rule amendments contemplated that, at least initially, the decision whether to accept ECN priced orders, and on what terms, would be left to each particular SRO. The Division believes that the terms of ECN access to an SRO should be resolved by negotiated agreements reached between ECNs and individual SROs providing access. Accordingly, in negotiating with ECNs, the Division believes that an SRO may set reasonable conditions on whether an ECN should be allowed access to the SRO's market. The Division expects that ECNs, at a minimum, will be broker-dealers-[23]- and, therefore, an SRO may choose to require ECNs to obtain membership in the SRO as a prerequisite to any linkage.-[24]- In addition, an SRO may require that the prices displayed in its market by an ECN not include fees or other charges if the SRO believes this is necessary to make these prices consistent with other quotes in its market. The Commission staff is monitoring closely discussions between SROs and ECNs and the conditions for access under consideration. If ultimately no SRO were willing to accept ECN priced orders on reasonable conditions, the Commission has reserved the right to use its authority under Section 11A of the Exchange Act to require the SROs to act jointly to reach the objectives outlined in the ECN amendment.-[25]- ---------FOOTNOTES---------- -[22]- See Adopting Release at 126. -[23]- The Division believes that any ECN that is not operated by a registered broker-dealer, or pursuant to a contractual relationship with a registered broker-dealer, must be operated by either a registered national securities exchange or a registered national securities association. -[24]- In addition, some ECNs disseminate orders from non-market makers which are not subject to the ECN amendment. As part of its agreement with an ECN, an SRO may agree to display the priced orders of non-market makers, such as institutions, along with specialist and market maker orders. The SRO may establish conditions regarding display of these prices as part of this agreement. -[25]- See Adopting Release at 127. ==========================================START OF PAGE 13====== Mr. Hardiman November 22, 1996 Page 13 The Division recognizes that an agreement between an SRO and an ECN may require systems changes and rule amendments to comply with the ECN display alternative. Agreements involving listed stocks also may require amendments to the national market system plans, including the Intermarket Trading System ("ITS") Plan. An ECN that supplies priced orders in listed securities to the public quotation system also must provide access to those market maker and specialist prices in the ECN that is equivalent to the access to the market maker's or specialist's own published quote. In the Adopting Release, the Commission stated that an ECN may impose certain fees for non-subscriber access to its system.-[26]- The Commission analogized these fees to market communications and systems charges, which typically are nominal. The Commission further stated that, in order to be consistent with the "equivalent access" requirement, such fees must be structured in a way that does not discourage access to ECN prices by non-subscriber broker-dealers. Although ECNs may charge fees to non-subscribers who send orders to execute against an ECN order, the Division believes that it would be inconsistent with the ECN amendment for an ECN to charge a fee if it reaches out to execute an order with a market maker at its public quote. C. Rounding In the Adopting Release, the Commission stated that where a priced order is entered into an ECN at a non-standard trading increment, the quote representing such order may be rounded to the nearest increment that can be accepted by the market disseminating the quote, with an indicator that the price has been rounded. This rounding provision was intended to accommodate an ECN's prices to a market with a larger trading increment. In order to calculate an NBBO including rounded prices, the Division anticipates that the SRO, or processor for the SRO, which is responsible for calculating the NBBO should receive the actual price from the ECN in order to prioritize the various bids and offers, including the quotes provided by ECNs. However, because some systems currently may not be able to receive the actual price from an ECN, the ECN will have to round its quote to the lowest increment at which the SRO, or its processor, can accept such quotation information until the requisite system changes have been made. - --------FOOTNOTES---------- -[26]- See Adopting Release at n. 272. ==========================================START OF PAGE 14====== Mr. Hardiman November 22, 1996 Page 14 An exchange specialist or OTC market maker that displays a rounded quote in its market to reflect a better priced order entered in an ECN will be responsible for executing orders it receives in its market at the actual, non-rounded price. If an ECN displays a rounded price pursuant to the ECN display alternative, the ECN should execute an order it receives at the better non-rounded price. The potential display of a rounding identifier has contributed to uncertainty with regard to application of the ITS Plan's trade-through policy, and broker-dealer best execution obligations, with respect to rounded prices. In the Adopting Release, the Commission noted that in situations where a specialist, OTC market maker, or other broker-dealer cannot determine, in an efficient manner, the actual price of the better priced ECN order, the specialists and market makers may execute orders at the rounded price without necessarily violating their duty of best execution.-[27]- The Division believes this interpretation applies particularly to situations where the order is executed on an automated basis, but also to orders handled manually where the rounded ECN price cannot be ascertained efficiently.-[28]- A number of exchanges have indicated that this interpretation should apply to a specialist or market maker in listed stocks where another market linked to the ITS is displaying a price that has been rounded to the NBBO and is tagged with a rounding indicator. The Division believes the interpretation would allow a specialist or market maker to trade with customers at the rounded price even when another market is displaying a price rounded to the NBBO with a rounding indicator because it may not be currently possible to efficiently ascertain the actual price of the order in the ECN. The Division does not believe that the resulting trade-throughs are inconsistent with the specialist's or market maker's obligations to customers under the circumstances. However, the ITS Plan Participants may need to submit to the Commission a proposed amendment or interpretation of the ITS Plan and SRO trade-through rules ---------FOOTNOTES---------- -[27]- See Adopting Release at 130. -[28]- The Division believes that an SRO may require a market maker or specialist that has placed a better priced order into an ECN to execute incoming orders in its market at the actual, non- rounded price of the order in the ECN, even if the public dissemination of the order has been rounded. ==========================================START OF PAGE 15====== Mr. Hardiman November 22, 1996 Page 15 clarifying the application of the trade-through rule in this situation. Questions have been asked regarding a broker-dealer's order routing and execution obligations with respect to rounded quotes. Under the interpretation expressed in the Adopting Release, a broker-dealer would not violate its best execution obligations to its customer if, under limited circumstances, it executed a trade for the customer at a rounded price despite the display of a rounding identifier.-[29]- In the Adopting Release and other contexts, however, the Commission has repeatedly stressed the duty of a broker-dealer to evaluate its order routing decisions on a periodic basis.-[30]- Such an evaluation must necessarily include a determination of which markets offer customer orders best execution, including the opportunity for price improvement. In order to satisfy this obligation, a broker-dealer should take into account those markets where trades actually occur at prices materially better than the displayed quote. To this end, broker-dealers should evaluate whether the display of rounded prices in a market has resulted in significant numbers of trades at materially improved prices in that market. D. Minimum Trading Increment Some industry participants have expressed concern that the Commission's requirement of display of a rounded quote with an identifier requires a change in the minimum trading increment in the public markets. The display of a rounding indicator for rounded ECN prices was intended to accommodate ECN prices in smaller increments without modifying existing market trading increments. While the Commission intended rounded ECN prices to be identified in the public quotation system, the Commission's adoption of the ECN amendment did not unilaterally alter the minimum increment used in the various public securities markets. The Commission did not require a market to accept quotes in finer price increments than those already accepted in that market, and the Division does not view allowing for a rounding indicator for ECN prices as the equivalent of mandating smaller quotation increments. The rules do not address whether an SRO may allow a specialist or OTC market maker to display a rounded quote in its market other than for an order entered by such specialist or OTC market maker into an ECN. The Division believes, however, that if the SRO decides to allow its specialists or market makers to quote in finer increments, it would be preferable for the SRO to ---------FOOTNOTES---------- -[29]- See Adopting Release at 130. -[30]- See Adopting Release at 162-169. ==========================================START OF PAGE 16====== Mr. Hardiman November 22, 1996 Page 16 change its minimum quotation increment to facilitate the display of the actual price of such orders, rather than for it to permit rounded prices with an indicator. The Division intends to continue the dialogue with the ITS Participants regarding the issues associated with rounded prices. E. Quote Size for ECN Orders Some have questioned what size must be displayed for orders entered into an ECN by a market maker or specialist for its own account and for customers. The size that must be displayed differs depending on whether the ECN display alternative applies and whether the ECN order represents a customer limit order. If the ECN display alternative applies, and a specialist or market maker enters an order in an ECN that is displayed as part of the ECN's quote, the full order size must be displayed by the ECN. If the order represents a customer limit order, the display of full size by the ECN will satisfy the limit order display rule's requirements. For example, if a market maker enters an 8,000- share order for a customer or its own account, and the ECN displays the order in its quote, the ECN must display a size of 8,000 shares. If the ECN display alternative does not apply, a specialist or market maker must display in its own quote the prices of ECN orders entered for its own account up to the minimum quote size required by its market. If the specialist or market maker enters a customer limit order in an ECN, the specialist or market maker must display in its quote the full size of the limit order as required by the limit order display rule, unless an exception from that rule applies. If the limit order is excepted from display under the limit order display rule, for example because it is of block size, the ECN amendment requires the specialist and market maker to display the limit order in its quote up to the minimum quote size required by its exchange or organization. For example, if a market maker enters an 8,000-share order for its own account in an ECN that is not displaying orders pursuant to the display alternative, and the ECN order is at a better price than the market maker's OTC quote, the market maker must display that price in its quote, but only for the size required by the NASD, for instance 1,000 shares. In contrast, if the 8,000-share ECN order is for a customer limit order that must be displayed pursuant to the limit order display rule, the market maker must display the full 8,000 shares in its quote. If, however, the 8,000 shares entered in the ECN is for a customer limit order that is excepted from the display rule, for example because the customer requested non-display, the market maker must ==========================================START OF PAGE 17====== Mr. Hardiman November 22, 1996 Page 17 display the size required by the NASD, for instance 1,000 shares. The market maker or specialist is generally only obligated to execute orders up to the size displayed in its market. Under the ECN display alternative, a specialist or market maker that entered an order into an ECN would not be required by the ECN amendment to display that size in its own quote, and would not be required to execute orders in its own market at that size (unless its market so required). If the ECN display alternative does not apply, the specialist or market maker is only required to trade at the quoted price reflecting an ECN order up to the size displayed in its quote (unless its market required otherwise). If the specialist or market maker executes an order at this size, yet continues to display an order in an ECN at that price, the specialist or market maker must continue to publicly display the minimum quote size. For example, where the ECN Display Alternative does not apply, if a market maker enters an order of 8,000 shares in an ECN and the minimum quote size in its market is 1,000 shares, the market maker must publicly display a 1,000- share quote at the ECN price. If the market maker executes a trade of 1,000 shares and reduces its ECN order to 7,000 shares, it must continue to display a public quote of 1,000 shares at that price. F. ECN Order Entry Although the Adopting Release discussed the duties of specialists and market makers upon entry of better priced orders into an ECN, some industry participants requested clarification as to when an order is considered to be "entered" for purposes of the ECN amendment. If a specialist or market maker has direct electronic access to an ECN, the order is entered when the order is placed directly into the ECN. Some ECNs may offer a "telephone brokerage desk" with discretion to "work" the orders at the request of subscribers. The Division believes that an order sent to such a brokerage desk is "entered" into the ECN at the time the representative places the order into the ECN, rather than when the specialist or market maker sends the order to the desk. Another issue has been raised with regard to the entry of priced orders into ECNs. At least one industry participant questioned whether a firm's block positioning desk is subject to the ECN amendment if it places into an ECN priced block orders for a security in which the firm also acts as a specialist or market maker from a different location. In such cases, the Division believes the specialist or market maker will be responsible for ensuring that either its public quote reflects any better priced order entered into an ECN by the block ==========================================START OF PAGE 18====== Mr. Hardiman November 22, 1996 Page 18 positioning desk, or that the ECN itself complies with the ECN display alternative. III. Counterparty Credit The Division has been asked whether specialists and market makers quoting large size to reflect customer limit orders, and ECNs displaying large orders pursuant to the display alternative, must trade with all parties at their quote regardless of their creditworthiness. The Quote Rule generally requires market makers and specialists to trade with broker-dealers, and others with whom they customarily deal, for up to their displayed size. The Division recognizes the potential credit risk posed by this requirement if displayed quote sizes increase. The Division believes the Quote Rule should be interpreted as providing an exception from the general requirement that a market maker or specialist, or an ECN publishing a quote, be firm for its quoted size if the market maker, specialist, or ECN has a substantial basis for believing that the counterparty to the transaction will not be able to honor the trade. Examples would include a situation where the counterparty has failed to settle on a trade the previous day; the counterparty's clearing firm has indicated it is no longer willing to clear for the counterparty; or the NASD's Automatic Confirmation Transaction ("ACT") service has publicized that the counterparty has exceeded its SuperCap and its clearing firm is not willing to honor the trade.-[31]- The Division intends to continue to work with the markets, clearing agencies, and other industry participants to reduce the potential credit exposure arising from large quote sizes, while preserving firm quote standards. The Division encourages the industry to explore alternatives that could address some of their concerns, such as higher SRO capital standards, earlier reporting of "locked-in" trades, and earlier clearing agency guarantees. IV. Autoquoting ---------FOOTNOTES---------- -[31]- ACT is the mechanism by which Nasdaq transactions are matched for clearance and settlement. Clearing firms that use ACT may set threshold amounts, called SuperCaps, that alert both the clearing firm and counterparties to a trade that a correspondent firm initiating the trade has reachedits credit limit with the clearing firm. ==========================================START OF PAGE 19====== Mr. Hardiman November 22, 1996 Page 19 In addition to the ECN amendment, the Commission amended the Quote Rule to require any exchange specialist or OTC market maker responsible for more than 1% of the volume in an exchange-listed security to publish two-sided quotations in that security. In addition, the Quote Rule was extended to include Nasdaq SmallCap securities within its scope. The Commission also amended the definition of "OTC market maker" within the rule to include broker-dealers that hold themselves out to customers or otherwise as willing to buy and sell on a regular or continuous basis. Questions have been raised concerning the Commission's request that the NASD and the ITS Participants review their limitations on computer generated quotes, and develop revised standards that would permit the use of computer generated quotes that contribute value to the market. The Division continues to expect the NASD and the ITS Participants to resolve this issue before the effective date of the rule. The Division notes, however, that the Commission's reference to computer generated quotes that contribute value was not meant to suggest that the use of autoquote tracking systems to generate 100-share quotes was inappropriate. Rather, the Division believes that the Commission intended to encourage the SROs to lift existing restrictions on computer generated quotes that could contribute value to the market. V. Conclusion The Division appreciates your efforts in responding to these Order Execution Obligations Rules with the necessary systems and regulatory changes. The Division hopes that this interpretive guidance will assist you and your members as they prepare for the implementation of the Order Execution Rules. If you have additional questions, please do not hesitate to contact me. Sincerely, Richard R. Lindsey Director