==========================================START OF PAGE 1======
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-37619A ; File No. S7-30-95]
RIN 3235-AG66
Order Execution Obligations
AGENCY: Securities and Exchange Commission
ACTION: Final Rules
SUMMARY: The Securities and Exchange Commission ("Commission")
is adopting a new rule requiring the display of customer limit
orders and amending a current rule governing publication of
quotations to enhance the quality of published quotations for
securities and to enhance competition and pricing efficiency in
our markets. These rules have been designed to address growing
concerns about the handling of customer orders for securities.
Specifically, the Commission is adopting new Rule 11Ac1-4
("Display Rule") under the Securities Exchange Act of 1934
("Exchange Act") to require the display of customer limit orders
priced better than a specialist's or over-the-counter ("OTC")
market maker's quote or that add to the size associated with such
quote. The Commission also is adopting amendments to Rule 11Ac1-1
("Quote Rule") under the Exchange Act to require a market maker
to publish quotations for any listed security when it is
responsible for more than 1% of the aggregate trading volume for
that security and to make publicly available any superior prices
that a market maker privately quotes through certain electronic
communications networks ("ECNs") ("ECN amendment"). Finally, the
==========================================START OF PAGE 2======
Commission is deferring action on proposed Rule 11Ac1-5 ("Price
Improvement Rule").
Effective Date: [insert date 120 days from the date of
publication in the Federal Register]. For specific phase-in
dates for the Display Rule, see section III.A.3.d of this
Release.
FOR FURTHER INFORMATION CONTACT: Elizabeth Prout Lefler or Gail
A. Marshall regarding amendments to the Quote Rule and David
Oestreicher regarding the Display Rule at (202) 942-0158,
Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street, N.W., Mail Stop 5-1, Washington,
D.C. 20549.
==========================================START OF PAGE 3======
SUPPLEMENTARY INFORMATION:
I. Introduction and Summary
On September 29, 1995, the Commission issued a
release-[1]- proposing for comment new Rules 11Ac1-4 and
11Ac1-5 and amendments to Rule 11Ac1-1-[2]- under the
Exchange Act.-[3]- As proposed, new Rule 11Ac1-4 would
require the display of customer limit orders that improve certain
OTC market makers' and specialists' quotes or add to the size
associated with such quotes. The proposed amendments to the
Quote Rule would require OTC market makers and specialists who
place priced orders with ECNs to reflect those orders in their
published quotes. The proposed Quote Rule amendments also would
require OTC market makers and specialists that account for more
than 1% of the volume in any listed security to publish their
quotations for that security ("Mandatory Quote Rule"). The Price
Improvement Rule would have required OTC market makers and
specialists to provide their customer market orders an
opportunity for price improvement; it also would have included a
non-exclusive safe harbor to satisfy the price improvement
obligation.
The Commission received 152 comment letters (from 145
---------FOOTNOTES----------
-[1]- Securities Exchange Act Release No. 36310
(September 29, 1995), 60 FR 52792 (October 10,
1995) ("Proposing Release").
-[2]- 17 CFR 240.11Ac1-1.
-[3]- 15 U.S.C. 78a to 78ll (1988).
==========================================START OF PAGE 4======
commenters) in response to the Proposing Release.-[4]-
Commenters generally supported the Display Rule and the Mandatory
Quote Rule, with some commenters suggesting specific
modifications or alternatives to the proposed rules. Commenters
also supported the objectives of the ECN amendment, but many
expressed concerns that diminishing the anonymity of such systems
would threaten their viability. Most commenters believed the
Price Improvement Rule would be costly to implement and would not
be necessary if the other proposals were adopted.
After considering the comments and relevant economic
research, and based on the Commission's experience with the
development of the national market system ("NMS") and its
knowledge of current market practices, the Commission is adopting
the Display Rule and the proposed amendments to the Quote Rule,
with certain modifications. The Commission believes that these
modifications are consistent with the proposals and responsive to
many of the concerns voiced by the commenters.
---------FOOTNOTES----------
-[4]- The comment letters and a summary of comments have
been placed in Public File No. S7-30-95, which is
available for inspection in the Commission's
Public Reference Room. The Commission received
comments on the proposals from 77 individual
investors, ten industry associations, seven
exchanges and the National Association of
Securities Dealers ("NASD"), eight academics, 41
market participants and the United States
Department of Justice. In addition, the
Commission met with representatives of broker-
dealers, self-regulatory organizations ("SROs"),
industry associations, and the U.S. Department of
Justice to discuss the proposals. The Commission
has conducted its own economic analysis of the
likely economic effects of the various proposals.
==========================================START OF PAGE 5======
The Display Rule adopted today requires OTC market makers
and specialists to display the price and full size of customer
limit orders when these orders represent buying and selling
interest that is at a better price than a specialist's or OTC
market maker's public quote. OTC market makers and specialists
also must increase the size of the quote for a particular
security to reflect a limit order of greater than de minimis size
when the limit order is priced equal to the specialist's or OTC
market maker's disseminated quote and that quote is equal to the
national best bid or offer.
The Commission has modified the proposed Display Rule in
some respects in response to comments. The proposal included an
exception to permit a specialist or OTC market maker to deliver a
limit order to an exchange or registered national securities
association ("association") sponsored system that complies with
the Display Rule. This exception has been expanded to permit
delivery to ECNs that display and provide access to these orders.
Additionally, with regard to implementation of the rule, the
Commission has provided for a phase-in over a one year period for
non-exchange-traded securities covered by the Display Rule.
Today, the Commission also is adopting two significant
amendments to the Quote Rule. These amendments are designed to
ensure that more comprehensive quotation information is made
available to the public. The first amendment requires a
specialist or OTC market maker to make publicly available the
price of any order it places in an ECN if the ECN price is better
==========================================START OF PAGE 6======
than the specialist's or OTC market maker's public quotation.
The Commission has adopted this amendment as proposed, with an
alternative ("ECN display alternative") that deems OTC market
makers and specialists in compliance with the Quote Rule if
prices these OTC market makers and specialists enter into an ECN
are publicly disseminated and the ECN provides access to other
broker-dealers to trade at those prices.-[5]- Thus, OTC
market makers and specialists may comply directly with the ECN
amendment by changing their public quote to reflect their ECN
order, or by using an ECN that facilitates their compliance with
the rule as described above.
Implementation of the ECN display alternative requires the
cooperation of the SROs in order to include the ECN prices in the
public quotation system and to provide equivalent access to these
quotations. The Commission expects the SROs to work
expeditiously with ECNs that wish to avail themselves of this
alternative to develop rules or understandings of general
applicability. The Commission is prepared to act if necessary to
ensure implementation of the ECN display alternative prior to the
effective date of the Quote Rule.
The second amendment to the Quote Rule expands the
categories of securities covered by the Mandatory Quote Rule. As
amended, the Quote Rule will require that OTC market makers and
specialists publish quotes in any listed security if their volume
---------FOOTNOTES----------
-[5]- This alternative means of compliance with the ECN
amendment is referred to hereinafter as the "ECN
display alternative".
==========================================START OF PAGE 7======
in that security exceeds 1% of the aggregate volume during the
most recent calendar quarter. Previously, these requirements
applied only to certain listed securities.-[6]-
The Commission is deferring final action on the Price
Improvement Rule at this time. The Commission will consider the
effect of the new Display Rule and the amendments to the Quote
Rule adopted today before determining the appropriate course of
action on that proposal.
In a parallel action, the Commission today is proposing for
comment an additional amendment to the Quote Rule. The proposed
amendment would require OTC market makers and specialists that
account for more than 1% of the volume in any Nasdaq security to
publish their quotations for that security.-[7]-
II. Basis and Purpose of the Display Rule and Quote Rule
Amendments
Twenty years ago, Congress directed the Commission -- having
due regard for the public interest, the protection of investors,
and the maintenance of fair and orderly markets -- to use the
Commission's authority granted under the Exchange Act to
facilitate the establishment of a national market system for
---------FOOTNOTES----------
-[6]- Additional amendments to the Quote Rule adopted
today provide that certain Quote Rule provisions
that previously applied to market makers that
elected to quote a Nasdaq National Market security
now also will apply to market makers electing to
quote a Nasdaq SmallCap security. See section
III.B.d.iii.
-[7]- See Securities Exchange Act Release No. 37620
(August 28, 1996) ("Companion Release").
==========================================START OF PAGE 8======
securities.-[8]- Congress further determined that the
public interest, investor protection and the maintenance of fair
and orderly markets required the NMS to feature:
(i) economically efficient executions;
(ii) fair competition among brokers and dealers, among
exchange markets, and between exchange markets and
markets other than exchange markets;
(iii) public availability of quotation and transaction
information;
(iv) an opportunity to obtain best execution; and
(v) an opportunity to obtain execution without dealer
intervention to the extent consistent with
economically efficient executions and the
opportunity to obtain best execution.-[9]-
The years since the 1975 Amendments have witnessed dramatic
developments in the U.S. securities markets. Last sale
reporting, which enables investors to determine the current
market for a security, has been extended to OTC-traded
securities. The Consolidated Quotation System ("CQS"), which
allows investors to view in a single source quotes disseminated
---------FOOTNOTES----------
-[8]- Pub. L. No. 94-29, 89 Stat. 97 (1975) ("1975
Amendments").
-[9]- Exchange Act Section 11A(a)(1), 15 U.S.C. 78k-
1(a)(1). This Section also recites the
Congressional findings that: the securities
markets are an important national asset which must
be preserved and strengthened; and new data
processing and communications techniques create
the opportunity for more efficient and effective
market operations.
==========================================START OF PAGE 9======
from dispersed market centers, did not exist in 1975. The
Intermarket Trading System ("ITS"), which permits investors'
orders in certain exchange-listed securities to be routed to the
market center displaying the best quotation, has greatly
facilitated quote competition. Moreover, technological
developments not envisioned twenty years ago have enabled market
centers to handle volume levels many times greater than those
that led to the "back office" crisis of the late 1960s and early
1970s. Taken together, these and other developments have made it
possible for investors' orders to be executed much more rapidly
and at far lower cost.
The Commission recognized that U.S. equity markets had
undergone significant changes since passage of the 1975
Amendments and were likely to undergo further changes of equal
magnitude.-[10]- Accordingly, the Commission announced in
July 1992 that its Division of Market Regulation ("Division")
would undertake a study of the structure of the U.S. equity
markets and of the regulatory environment in which those markets
operate.-[11]-
In January 1994, the Division published a
study,-[12]- which reviewed, among other things, market
---------FOOTNOTES----------
-[10]- See Securities Exchange Act Release No. 30920
(July 14, 1992), 57 FR 32587 (July 22, 1992)
("Market 2000 Concept Release").
-[11]- Id.
-[12]- Division of Market Regulation, Market 2000: An
Examination of Current Equity Market Developments
(January 1994) ("Market 2000 Study" or "Study").
==========================================START OF PAGE 10======
practices and structures that could affect the ability of
customers to obtain opportunities for better prices. The Market
2000 Study noted that U.S. equity markets had evolved since 1975
to provide a much wider array of trading venues to meet the
diverse needs of investors and made a series of recommendations
intended to facilitate the further development of a national
market system. As expected, U.S. equity markets have continued
to evolve since the Market 2000 Study was published.
This evolution of the markets is reflected in part by
comparing trading volumes and the venues in which orders are
executed. In 1976, the New York Stock Exchange ("NYSE") average
daily trading volume was approximately 21.2 million
shares.-[13]- By 1995, average daily trading volume
exceeded 346 million shares.-[14]- Third market trading,
i.e., OTC trading of listed securities, in NYSE-listed issues
accounted for 4.57% of consolidated volume in 1976.-[15]-
By 1995, third market trading increased to 7.94% of consolidated
volume.-[16]- In 1987, the NYSE handled almost 74% of
trades of NYSE-listed issues reported on the consolidated tape;
in 1995, it handled 70.22% of such trades.-[17]-
---------FOOTNOTES----------
-[13]- 1982 NYSE Fact Book.
-[14]- 1995 NYSE Annual Report.
-[15]- 1982 NYSE Fact Book.
-[16]- 1995 NYSE Fact Book.
-[17]- Regional exchanges, namely, the Boston Stock
Exchange ("BSE"), the Philadelphia Stock Exchange
(continued...)
==========================================START OF PAGE 11======
Comparable figures for The Nasdaq Stock Market ("Nasdaq")
are even more dramatic. In 1975, Nasdaq annual volume was
approximately 1.39 billion shares.-[18]- By 1995, Nasdaq
annual volume increased to 101.2 billion shares,-[19]-
which means that more shares traded hands on three average
trading days in 1995 than in all of 1975. In 1993, volume in all
proprietary trading systems combined represented 13% of the total
volume in Nasdaq/National Market securities;-[20]- by
January 1996, volume on Instinet alone represented approximately
15% of total Nasdaq volume and 20% of total volume for the 250
---------FOOTNOTES----------
-[17]-(...continued)
("Phlx"), the Cincinnati Stock Exchange ("CSE"),
the Chicago Stock Exchange ("CHX"), and the
Pacific Stock Exchange ("PSE"), have captured a
significant share of volume in NYSE-listed issues,
particularly with respect to smaller investor
orders. In 1995, the regional exchanges accounted
for 9.96% of consolidated volume in NYSE-listed
issues but accounted for 19.01% of trades of NYSE-
listed issues reported on the consolidated tape.
Id. They also accounted for approximately 35% of
share volume in trades of 100 to 2,099 shares.
Shapiro, U.S. Equity Markets: Recent Equity
Developments, in GLOBAL EQUITY MARKETS:
TECHNOLOGICAL, COMPETITIVE, AND REGULATORY
CHALLENGES 21 (R. Schwartz ed. 1995). In January
1996, trades of 100-499 shares represented between
65-72% of all trades in NYSE-listed issues on
regional exchanges; such trades represented only
37% of all trades on the NYSE. Ross, Shapiro and
Smith, Price Improvement of SuperDOT Market Orders
on the NYSE (NYSE Working Paper 96-01) (March 11,
1996 draft) (prepared for the NYSE Conference for
the Search for Best Price) ("Ross, Shapiro and
Smith").
-[18]- 1992 Nasdaq Fact Book.
-[19]- 1995 NASD Annual Report.
-[20]- Market 2000 Study at Appendix IV-2.
==========================================START OF PAGE 12======
Nasdaq stocks with the highest median dollar volume.-[21]-
The Study addressed the development of certain practices,
such as internalization,-[22]- payment for order
flow-[23]- and the non-disclosure of certain customer
trading interest to all market participants, that raise a variety
of market structure and customer order handling concerns. For
example, brokers today may quote one price publicly to retail
customers, while showing a better price privately to other
investors and dealers on an ECN. In addition, the quotes
displayed to public investors may not accurately reflect the best
price for a security because limit orders, which specify the
price at which customers will buy or sell a security, are not
---------FOOTNOTES----------
-[21]- The Introduction of NAqcess into the Nasdaq Stock
Market: Intent and Expectation, NASD Economic
Research Staff, June 6, 1996 ("NASD Study"),
Exhibit D to Securities Exchange Act Release No.
37302 (June 11, 1996), 61 FR 31574 (June 20, 1996)
(Notice of Filing of Amendment No. 2 to Proposed
Rule Change by National Association of Securities
Dealers Relating to the NAqcess System and
Accompanying Rules of Fair Practice)("NAqcess
Release 2").
-[22]- Internalized orders are customer orders routed by
a broker-dealer to an affiliated specialist or
executed by that broker-dealer as a market maker.
-[23]- The Commission now requires enhanced disclosure of
payment for order flow practices on customer
confirmations and account statements, as well as
upon opening new accounts. Securities Exchange
Act Release No. 34902 (October 27, 1994), 59 FR
55006 (November 2, 1994) (adopting rules requiring
enhanced disclosure of payment for order flow
practices on customer confirmations, and account
statements, as well as upon opening new accounts)
("Payment for Order Flow Release"). See also
Securities Exchange Act Release No. 35473 (March
10, 1995), 60 FR 14366 (March 17, 1995).
==========================================START OF PAGE 13======
uniformly required to be included in the quote.
The Study recommended that the exchanges and the NASD
consider taking action to respond appropriately to certain of
these developments. Since that time, Nasdaq market makers
holding customer limit orders have been prohibited from trading
ahead of those orders,-[24]- and some market makers have
begun to offer price improvement opportunities in OTC
transactions to their retail customers.-[25]- In addition,
the NYSE now requires almost all limit orders transmitted through
SuperDOT to be displayed to the market.-[26]- Further,
Commission rules require enhanced disclosure of payment for order
flow practices on customer confirmations and account statements,
as well as upon opening new accounts.-[27]-
Notwithstanding the progress achieved in this period, the
Commission believes that further regulatory initiatives are
warranted at this time. These changes, as indicated in the
Proposing Release, are intended to address current market
practices that inhibit opportunities for order interaction and
---------FOOTNOTES----------
-[24]- Securities Exchange Act Release No. 34279 (June
29, 1994), 59 FR 34883 (July 7, 1994) ("Manning
I"); Securities Exchange Act Release No. 35751
(May 22, 1995), 60 FR 27997 (May 26, 1995)
("Manning II").
-[25]- See, e.g., Louis, Schwab Debuts New Trading
System, San Francisco Chronicle, October 17, 1995,
at D1.
-[26]- Securities Exchange Act Release No. 36231
(September 14, 1995), 60 FR 48736 (September 20,
1995).
-[27]- See Payment for Order Flow Release supra note 23.
==========================================START OF PAGE 14======
that are inconsistent with Congress's vision of the national
market system. These changes also address certain problems in
Nasdaq. The Commission recently reported that, among other
things: (i) Nasdaq market makers widely followed a pricing
convention concerning the increments they used to adjust their
displayed quotes; (ii) adherence to the pricing convention was
not the result of natural economic forces, often impacted the
fairness and accuracy of public quotation information and
interfered with the economically efficient execution of customer
transactions; (iii) the pricing convention impaired the ability
of investors to ascertain the best market for their trades,
increased the costs of transactions, and resulted in unfair
discrimination among classes of market participants; (iv)
numerous market makers collaborated in ways that misled and
disadvantaged their customers and other market participants and
frequently failed to honor their price quotations; and (v) many
market makers have not consistently reported their trades on time
or appropriately designated them as late as required by NASD
rules.-[28]-
The Commission has taken specific regulatory and enforcement
actions to address these problems.-[29]- The Display Rule
and Quote Rule amendments adopted today should bring about other,
---------FOOTNOTES----------
-[28]- Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD, the
Nasdaq Market, and Nasdaq Market Makers,
Securities Exchange Act Release No. 37542 (August
8, 1996) ("21(a) Report").
-[29]- See id.
==========================================START OF PAGE 15======
significant changes in the operation of Nasdaq, by ensuring the
disclosure of customer and market maker buying and selling
interest that heretofore has been hidden from many market
participants. At the same time, the new rules will benefit
investors in the exchange markets by increasing transparency in
those markets and improving opportunities for the best execution
of customer orders.
The Commission firmly believes that the actions it is taking
today are consistent with the regulatory framework for a national
market system established by Congress in the 1975 Amendments.
Congress envisioned a national market system supported by
accurate and reliable public quotation and transaction
information, and fair competition among market centers. Congress
also believed that linking all markets for qualified securities
through communication and data processing facilities would foster
efficiency, enhance competition, increase information available
to market participants and contribute to the best execution of
customer orders.-[30]-
The Commission recognizes that investors will lose
confidence in the fairness of the markets unless market
structures and practices treat all investors fairly. The
regulatory initiatives adopted today address current market
practices that hinder competition among markets and affect the
prices at which customer orders are executed. The Display Rule
---------FOOTNOTES----------
-[30]- See Exchange Act Section 11A(a)(1)(D), 15 U.S.C.
78k-1(a)(1)(D).
==========================================START OF PAGE 16======
and Quote Rule amendments enhance transparency and facilitate
best execution of customer orders in a manner that preserves
maximum flexibility for the markets to design and implement
trading and communication systems that are consistent with the
objectives of the national market system. These rules contribute
to the achievement of the full potential of the national market
system as envisioned by Congress. They represent one more step
to facilitate the development of an efficient, competitive and
transparent national market system in which all market
participants can achieve best execution of their orders.
III. Discussion
A. Display of Customer Limit Orders
1. Introduction
As discussed above, the 1975 Amendments contain an explicit
statutory mandate for the establishment of a national market
system. Congress considered mandating certain minimum components
of the national market system, but instead created a statutory
scheme granting the Commission broad authority to oversee the
implementation, operation and regulation of the national market
system.-[31]- At the same time, Congress charged the
Commission with the responsibility to assure that the national
market system develop and operate in accordance with specific
---------FOOTNOTES----------
-[31]- S. Rep. No. 75, 94th Cong., 1st Sess. 8-9 (1975)
("Senate Report").
==========================================START OF PAGE 17======
goals and objectives.-[32]- The Commission believes that
the adoption of a limit order display rule furthers these goals
and objectives determined by Congress.
Specifically, the display of customer limit orders advances
the national market system goal of the public availability of
quotation information, as well as fair competition, market
efficiency, best execution and disintermediation. The enhanced
transparency of such orders increases the likelihood that limit
orders will be executed because contra-side market participants
will have a more accurate picture of trading interest in a given
security. Further, this increased visibility will enable market
participants to interact directly with limit orders, rather than
rely on the participation of a dealer for execution.
Moreover, as noted in the Proposing Release, the display of
limit orders that are priced better than current quotes addresses
at least three regulatory concerns. First, displaying customer
limit orders in the quotation can increase quote competition. If
the quotes from a market or market maker represent only market
maker buying and selling interest in a given security, the market
or market maker faces less price competition than if customer
---------FOOTNOTES----------
-[32]- Id. at 9. Among other things, Congress found it
in the public interest and appropriate for the
protection of investors and the maintenance of
fair and orderly markets to assure an opportunity
for investors' orders, in both dealer and auction
markets, to be executed without the participation
of a dealer, to the extent that this was
consistent with economically efficient executions
of such orders in the best market. Exchange Act
Section 11A(a)(1(c), 15 U.S.C. 78k-1(a)(1)(C).
==========================================START OF PAGE 18======
buying and selling interest is made public. As a result, the
price discovery process may be constrained. Second, the display
of limit orders can narrow quotation spreads. Third, because
many markets and market makers offer automatic executions of
small orders at the best displayed quotes, the display of limit
orders that improve the best displayed quotes can result in
improved executions for these orders.
Limit orders currently are handled differently in the
various auction and dealer markets. Generally, the rules of most
exchanges require that a limit order be displayed in the
quotation for a security when it improves the best bid or offer.
NYSE specialists, for example, must reflect a customer limit
order in their quotations at the limit price when requested to do
so.-[33]- In addition, the NYSE's order handling
procedures assume that all limit orders routed to a specialist
through SuperDOT contain a display request.-[34]-
Therefore, except in the unusual and infrequent circumstance
where a specialist believes market conditions suggest the
likelihood of imminent price improvement, a limit order received
---------FOOTNOTES----------
-[33]- See NYSE Rule 79A.10 (when a limit order is
presented to the specialist by a floor broker, the
floor broker must affirmatively request that the
specialist display the limit order; failure to so
request leaves the decision whether to display the
limit order to the discretion of the specialist);
see also NYSE Rule 60 (requiring specialists to
promptly report, inter alia, the best bid and
offer in the trading crowd in each reported
security in which the specialist is registered).
-[34]- NYSE Information Memo 93-12 (Mar. 30, 1993).
==========================================START OF PAGE 19======
by a specialist through SuperDOT should be reflected in the
specialist's quote as soon as practicable following receipt of
the order.-[35]- According to the NYSE, 93% of all
SuperDOT limit orders that improve the best bid or offer
displayed are reflected in the specialist's quote within two
minutes of receipt, while 98% of such limit orders are reflected
within five minutes of receipt.-[36]-
A recent NYSE policy statement requires specialists to
display the full size of all orders received through SuperDOT as
well as orders received by specialists manually that are
subsequently entered into the electronic book.-[37]- When
a member requests that less than the full size of the order be
shown, the specialist is obligated to show the size requested.
Specialists must display as soon as practicable any order that,
---------FOOTNOTES----------
-[35]- Id.
-[36]- Telephone Conference between Edward A. Kwalwasser,
Executive Vice President, NYSE, and Holly H.
Smith, Associate Director, Division of Market
Regulation, SEC, January 9, 1995.
Other exchanges also have rules regarding dissemination of
bids and offers. However, no uniform standard has been
adopted among the exchanges. Generally, the rules either
cite, in whole or in part, language from the Quote Rule, or
are drafted in such a manner as to allow for broad
interpretation with respect to the display of limit orders.
See, e.g., BSE Guide, Rules of the Board of Governors,
Chapter II, Sec. 7, (CCH) 2020; PSE Guide, Rules of the
Board of Governors, Rule 5.6(f), (CCH) 3979; American
Stock Exchange Guide, General and Floor Rules, Rule 115,
(CCH) 9265; CHX Guide, Article XX, Rule 7, (CCH) 1688;
Phlx Guide, Rules 105 and 229 (CCH) 2105 and 2229;
Cincinnati Stock Exchange Rules, Rule 11.9.
-[37]- See supra note 26.
==========================================START OF PAGE 20======
in relation to current market conditions in a particular
security, represents a material change in the supply or demand
for that security. This requirement includes increasing the size
of a quotation for orders at the same price as the current bid or
offer. If the quotation already reflects significant supply or
demand, and the specialist receives an order that is de minimis
in relation to such supply or demand, the specialist may take a
reasonable time (generally not more than two minutes) before
updating the size of the quotation.-[38]-
Currently in the OTC market, the quote for any security
typically represents a dealer's own bid and offer. The rules of
the NASD do not require market makers to display customer limit
orders, whether or not they better the best bid or offer for the
security.-[39]- Generally, customer limit orders in OTC
securities either will be routed to a broker-dealer's market
making desk or to another market maker for execution if the
customer's firm does not make a market in the security. In the
past, market makers typically did not execute limit orders until
the best bid (for sell orders) or offer (for buy orders)
---------FOOTNOTES----------
-[38]- The NYSE provides the following example of when a
specialist may take a reasonable time to update
the size of the quotation: If the market in XYZ
security is 20 (5,000) - 20 1/4 (50,000), and the
specialist receives an order to sell 200 shares at
20 1/4, such order would be considered de minimis
and the specialist would be permitted to wait a
reasonable period of time (but not more than two
minutes) before changing the size of the offer to
50,200.
-[39]- See NASD Manual, Rule 4613.
==========================================START OF PAGE 21======
displayed on Nasdaq reached the limit price. This practice has
changed, however, in recent years. In June 1994, the Commission
approved a rule change filed by the NASD that prohibits broker-
dealers from trading ahead of their customers' limit
orders.-[40]- This rule was expanded in May 1995, to
prohibit broker-dealers from trading ahead of customer limit
orders they accept from other brokers.-[41]- The NASD also
has filed a proposed rule change that would require, in certain
circumstances, the display of customer limit orders for exchange-
listed securities traded OTC.-[42]-
The exchanges and the NASD use automated trading systems to
route and, in some instances, execute orders up to a
predetermined size. Some of these systems accept limit orders.
---------FOOTNOTES----------
-[40]- See Manning I, supra note 24.
-[41]- See Manning II, supra note 24.
-[42]- See Securities Exchange Act Release No. 35471
(March 10, 1995), 60 FR 14310 (March 16, 1995).
The NASD proposal, applicable to exchange-listed
securities traded OTC, generally would require a
market maker either to execute immediately a limit
order of less than the minimum quotation size
priced better than the market maker's quotation,
or display the order in its quotation for an
amount equal to the minimum quotation size.
Market makers would have to display a limit order
greater than the minimum quotation size for that
security but would not have to display the full
size of the order. Any portion of the order not
displayed, however, would have to be executed at a
price at least as favorable as the displayed price
if the displayed portion is executed in its
entirety. At the NASD's request, the Commission
has postponed final action on the NASD's proposal
in order to permit the NASD to evaluate its
proposal in light of the Commission's actions on
the proposals it is adopting today.
==========================================START OF PAGE 22======
Each system, however, may differ in its handling of limit orders
that are not executed immediately upon receipt. For example, the
NYSE's SuperDOT system routes limit orders to the specialists'
posts where they are handled in accordance with NYSE rules
governing specialist representation of such orders. The American
Stock Exchange's ("Amex") PER system routes limit orders in the
same manner as SuperDOT and the orders are handled in accordance
with Amex rules. The NASD's Small Order Execution System
("SOES") treats limit orders priced at the current inside market
as market orders that are immediately executed.-[43]- All
other limit orders reside in a limit order file that can be
viewed only by market makers.-[44]- SOES does not provide
an opportunity for limit orders to interact with incoming market
orders. The Commission has published for comment an NASD
proposal to replace SOES with "NAqcess," a system that would
include a limit order file designed to display certain customer
---------FOOTNOTES----------
-[43]- Preferenced orders (i.e., orders routed to a
specific market maker pursuant to a pre-existing
agreement) are executed immediately at the inside
quote. Unpreferenced orders are executed against
market makers in a security in rotation. SOES,
however, does not execute an unpreferenced order
against a single market maker more than once every
15 seconds.
-[44]- The current SOES rules have been extended, with
certain changes that do not affect the handling of
limit orders, through January 31, 1997.
Securities Exchange Act Release No. 37502 (July
30, 1996), 61 FR 40869 (August 6, 1996).
==========================================START OF PAGE 23======
limit orders.-[45]-
The disparate treatment of limit orders across markets was
raised as an issue in the Market 2000 Study. The Commission
received numerous comments concerning whether the optimal degree
of pre-trade disclosure of limit orders was being achieved within
the U.S. equity markets. Some commentators alleged that
specialists and third market dealers sometimes fail to display
limit orders priced better than the displayed
quotation.-[46]- Questions also were raised about the lack
---------FOOTNOTES----------
-[45]- See Securities Exchange Act Release No. 36548
(December 1, 1995), 60 FR 60392 (December 8, 1995)
("NAqcess Release 1"); NAqcess Release 2, supra
note 21. As proposed, NAqcess would act as an
order delivery system with a limited public limit
order file.
Limit orders up to 9,900 shares would be permitted in
NAqcess for the top 250 Nasdaq National Market securities,
defined by median daily dollar volume, and for 1,000 shares
for all other Nasdaq securities. Market makers would be
allowed to query the entire limit order file. All other
market participants would be limited to viewing the top of
the NAqcess limit order file (i.e., the best priced buy and
sell limit orders, and the size associated with those orders
- the NAqcess inside market). This inside market would be
factored into the calculation for the inside quote for each
Nasdaq security. Although use of NAqcess would be
voluntary, limit orders not entered in NAqcess would be
provided with market-wide price protection under the
proposal.
-[46]- See generally Thomas H. McInish & Robert A. Wood,
Hidden Limit Orders on the NYSE, 21 J. Portfolio
Mgmt. 19 (No. 3, Spring 1995) ("McInish & Wood
Study"). The authors asserted that NYSE
specialists only display about 50% of limit orders
that better existing quotes. In their opinion,
this practice represents a serious policy issue
because it places both public investors and
regional exchanges at a disadvantage. They
asserted that hiding limit orders impedes
(continued...)
==========================================START OF PAGE 24======
of limit order exposure on Nasdaq. After considering these
comments, the Division recommended in the Study that the
securities exchanges consider whether to encourage the display of
all limit orders in listed stocks priced better than the best
intermarket quotes, unless the ultimate customer requests that
the order not be displayed. The Market 2000 Study also
recommended the display of limit orders in Nasdaq stocks when the
orders are at prices better than the best Nasdaq quotes, unless
the customer requests that the order not be
displayed.-[47]-
2. Discussion
---------FOOTNOTES----------
-[46]-(...continued)
strategic decisions on order placement; results in
publicly submitted market orders receiving
inferior prices; hampers the monitoring of order
executions; reduces the probability of a limit
order being executed; results in a delay in
reporting limit order executions; interferes with
the ability of the regional exchanges to execute
public orders; and artificially improves NYSE
performance relative to the regional exchanges
using a common benchmark. The authors also
claimed that NYSE Rule 60 is ambiguous in that the
specialists may have some leeway in choosing what
to disclose in their quotes.
In its comment letter to the Market 2000 Study, however, the
NYSE asserted that its publicly disseminated best bid or
offer includes all firm trading interest announced on the
floor as required by the exchange's rules. See Letter from
William H. Donaldson, Chairman and Chief Executive Officer,
NYSE, to Jonathan G. Katz, Secretary, SEC at 25-26 (November
24, 1992). In addition, the NYSE issued a policy statement
that reiterates that specialists have an obligation to
reflect in their quotes certain limit orders received
manually or via SuperDOT that are not executed on receipt.
See supra note 26.
-[47]- Market 2000 Study, at IV-6.
==========================================START OF PAGE 25======
a. Basis For Adoption of the Rule
After carefully considering all of the comments as well as
economic research regarding the Display Rule, and based on the
Commission's experience and knowledge of current market practices
and conditions, the Commission believes that adoption of the
Display Rule will promote transparency and enhance execution
opportunities for customer orders, and encourage
liquidity.-[48]- The Commission stresses, however, that
---------FOOTNOTES----------
-[48]- See, e.g., Letter from Thomas F. Ryan, Jr.,
President and Chief Operating Officer, Amex, to
Jonathan G. Katz, Secretary, SEC, dated February
1, 1996 ("Amex Letter"); Letter from David E.
Shaw, Ph.D., Chairman, D.E. Shaw & Co., to
Jonathan G. Katz, Secretary, SEC, dated January 9,
1996 ("D.E. Shaw Letter") (rule will promote
transparency); Letter from Paul A. Merolla, Vice
President, Associate General Counsel, Goldman,
Sachs & Co., to Jonathan G. Katz, Secretary, SEC,
dated January 26, 1996 ("Goldman Sachs Letter")
(rule would benefit marketplace); Letter from
Craig S. Tyle, Vice President and Senior Counsel,
Securities and Financial Regulation, Investment
Company Institute, to Jonathan G. Katz, Secretary,
SEC, dated January 16, 1996 ("ICI Letter")
(increased transparency of customer limit orders
in all markets could produce benefits to the
markets and investors); Letter from Donald L.
Crooks, Managing Director, Lehman Brothers, Inc.,
to Jonathan G. Katz, Secretary, SEC, dated
February 26, 1996 ("Lehman Letter") (rule promotes
transparency and results in improved opportunities
for execution of customer orders); Letter from
Bernard L. Madoff and Peter B. Madoff, Bernard L.
Madoff Investment Securities, to Jonathan G. Katz,
Secretary, SEC, dated January 12, 1996 ("Madoff
Letter") (rule will help achieve true price
discovery and fairness to investors); Letter from
Andrew E. Feldman, Director and Associate General
Counsel, Smith Barney Inc., to Jonathan G. Katz,
Secretary, SEC, dated January 29, 1996 ("Smith
Barney Letter") (rule will promote transparency
and assist in achieving best execution of orders).
(continued...)
==========================================START OF PAGE 26======
the rule is not meant to displace any SRO rules that provide
additional order handling protections to customer limit orders.
Instead, the Commission rule represents only a minimum display
standard.
The Commission believes that limit orders are a valuable
component of price discovery. The uniform display of such orders
will encourage tighter, deeper, and more efficient markets.
Limit orders convey buying and selling interest at a given price.
The display of limit orders can be expected to narrow the bid-ask
spread when this buying and selling interest is priced better
than publicly disclosed prices.-[49]- Both large and small
orders stand to benefit from the Display Rule's effect on price
discovery.-[50]- In fact, the importance of limit orders
---------FOOTNOTES----------
-[48]-(...continued)
But see Letter from Charles R. Hood, Senior Vice
President and General Counsel, Instinet, to
Jonathan G. Katz, Secretary, SEC, dated January
16, 1996 ("Instinet Letter") (exceptions to rule
eliminate potential positive impact on
transparency).
-[49]- For example, limit order trading allows investors
the opportunity to trade at prices superior to
those represented by the prevailing inside bid and
offer. See NASD Study, supra note 21.
-[50]- According to SuperDOT trade data analyzed by the
Commission's Office of Economic Analysis ("OEA"),
customer limit orders account for 50% of all NYSE
customer trades originating from orders routed
through SuperDOT ("customer trades") of 100-500
shares; 66% of all customer trades of 600-1,000
shares; 71% of all customer trades of 1,100-3,000
shares; and 74% of all customer trades of 3,100-
9,900 shares. The Commission believes that these
high percentages are based, at least in part, on
the fact that limit orders routed through SuperDOT
(continued...)
==========================================START OF PAGE 27======
in the trading process was documented in recent
studies.-[51]- The author quantified the impact of
exposing limit orders on quoted spreads and effective transaction
costs. Using NYSE data, he determined that the quote spreads
resulting from participation of the limit order book were
approximately 4 to 6 cents smaller than the spreads not set by
the limit order book. Further, trading costs on the NYSE were
approximately 3-4 cents less per share on a "round trip"
transaction when both the purchase and the sale were executed
against the limit order book.-[52]-
---------FOOTNOTES----------
-[50]-(...continued)
are required to be displayed in the specialist's
quote. The Commission believes that these
percentages help demonstrate the benefits
associated with limit order display for both large
and small order sizes. In addition, OEA data
shows that NYSE customer limit orders routed
through SuperDOT narrow the NYSE quote 22% of the
time and match the quote 39% of the time for
customer limit orders of 100-1,000 shares; narrow
the quote 17% of the time and match the quote 43%
of the time for customer limit orders of 1,100-
3,000 shares; and narrow the quote 14% of the time
and match the quote 46% of the time for customer
limit orders of 3,100-9,900. OEA data also shows
that, when the NYSE bid-ask spread was 1/4 point
or more, customer limit orders routed through
SuperDOT narrow the NYSE spread between 41% and
50% of the time, depending on the size of the
customer order.
-[51]- See Jason T. Greene, The Impact of Limit Order
Executions on Trading Costs in NYSE Stocks (An
Empirical Examination), December 1995 ("Greene
Study"); see also Jason T. Greene, Limit Order
Executions and Trading Costs for NYSE Stocks, June
1996 ("Greene Study II").
-[52]- The Commission further believes that the display
requirement will improve price transparency in
(continued...)
==========================================START OF PAGE 28======
The uniform display of limit orders also will lead to
increased quote-based competition. Market makers will not only
be competing amongst themselves, but also against customer limit
orders represented in the quote. The Commission believes that
this result will reduce the possibility of certain trading
behavior on Nasdaq that was recently the subject of a Commission
---------FOOTNOTES----------
-[52]-(...continued)
securities with diverse trading characteristics.
Based on SuperDOT trade data, the Commission's OEA
has determined that for NYSE securities with an
average daily trading value ("ADTV") of under
$100,000, customer limit orders account for 57% of
all NYSE customer trades originating from orders
routed through SuperDOT ("customer trades") of
100-500 shares; 69% of all customer trades of 600-
1,000 shares; 76% of all customer trades of 1,100-
3,000 shares; and 83% of all customer trades of
3,100-9,900 shares. Limit orders also are
frequently used for securities with higher ADTVs.
For example, for NYSE securities with an ADTV of
over $5,000,000, customer limit orders account for
48% of all NYSE customer trades of 100-500 shares;
68% of all customer trades of 600-1,000 shares;
72% of all customer trades of 1,100-3,000 shares;
and 73% of all customer trades of 3,100-9,900
shares. Moreover, OEA data shows that for NYSE
securities with an ADTV of under $100,000,
customer limit orders routed through SuperDOT
narrow the NYSE quote 30% of the time and match
the quote 32% of the time. For less liquid
securities, therefore, the display of customer
limit orders narrows spreads, improves price
discovery, and increases market depth. For NYSE
securities with an ADTV of $5,000,000 or more,
customer limit orders routed through SuperDOT
narrow the NYSE quote 18% of the time and match
the quote 41% of the time.
The NASD has suggested that the greater the size of the
displayed spread, the greater the use of limit orders. See
NASD Study, supra note 21.
==========================================START OF PAGE 29======
investigation.-[53]- As reported in the 21(a) Report,
Nasdaq market makers widely adhered to a "pricing convention,"
whereby Nasdaq market makers maintained artificially inflexible
quotations and as a result often traded with the public at prices
unduly favorable to such market makers.-[54]- In addition,
the Commission determined that Nasdaq market makers adhered to a
"size convention" that deterred Nasdaq market makers from
narrowing their quotes to create a new inside market unless the
market makers were willing to trade at least 2,000 to 5,000
shares at that price, rather than the minimum quotation size as
determined by NASD rules.-[55]- This practice prevented
---------FOOTNOTES----------
-[53]- See 21(a) Report, supra note 28. The
investigation identified a number of practices in
the Nasdaq market that are similar to practices
identified in the 1963 Special Study. See SEC,
Report of Special Study of Securities Markets
(1963). For example, the 1963 Special Study
discussed cooperation and information sharing
between traders, as well as other non-competitive
practices. Id. at pt. 2, 576-577.; See also
Competitive Impact Statement of the U.S.
Department of Justice Antitrust Division, United
States v. Alex. Brown & Sons, et. al., (S.D.N.Y.
1996).
-[54]- As a result of this convention, most Nasdaq stocks
were quoted only in increments of 1/4. Under the
convention, stocks with a dealer spread of 3/4 or
more would only be quoted in even-eighths (i.e.,
1/4, 1/2, 3/4), thereby giving rise to a minimum
inside spread of 1/4. Stocks with dealer spreads
less than 3/4 would be quoted in both even and
odd-eighths, thereby allowing a minimum inside
spread of 1/8. The pricing convention
significantly limited the flexibility and
competitiveness of price quotations in the Nasdaq
market.
-[55]- See 21(a) Report, supra note 28.
==========================================START OF PAGE 30======
the dissemination of improved quotes when a trader sought to
trade stock only at a size equal to the minimum quotation size.
Thus, the true buying and selling interest in a given security
was not reflected in the published quotes.
In addition to the Commission's actions, and those of the
Department of Justice in connection with its investigation of the
Nasdaq market, the Commission believes the requirement to display
customer limit orders in market maker quotes would inhibit market
makers from engaging in the conduct described above. Moreover,
the display of limit orders reduces the potential for certain
other conduct described in the 21(a) Report, including market
maker collaboration and coordination of trade and quote
activities. Market makers will be less able to improperly
coordinate such behavior due to the display of competing customer
order flow and the resulting transparency of ultimate buying and
selling interest. The Commission believes that the display
requirement will both foster renewed quote-based competition
among market makers and introduce new competition from customer
limit orders.
The Commission also believes that overall market liquidity
should be enhanced due to the increased trading volume that is
expected to result from the display of limit orders.-[56]-
---------FOOTNOTES----------
-[56]- See Greene Study and Greene Study II, supra note
51 (limit orders affect the quoted spread, provide
liquidity to traders that demand immediacy of
execution, and may contribute to reduced trading
costs); NASD Study, supra note 21 (the liquidity
supplied by limit orders reduces trading costs of
(continued...)
==========================================START OF PAGE 31======
As noted previously, customer limit orders account for a
significant percentage of total customer orders on the NYSE,
where customer limit orders generally are required to be
displayed when they represent a better price.-[57]-
Moreover, previous Commission initiatives designed to enhance
transparency have resulted in increased competition and liquidity
for the markets.-[58]-
Customers also will be better able to monitor the quality of
their executions. Currently, the failure to display limit orders
often results in inferior or missed executions for these orders.
The Commission has received frequent complaints from customers
whose limit orders have not been filled while other executions
are reported at prices inferior to their limit order prices.
Requiring the display of customer limit orders in specialist and
market maker quotes, although not guaranteeing that such limit
orders will be executed, will help ensure that other orders are
not executed at inferior prices until better priced limit orders
are executed. Similarly, customers entering market orders will
be able to determine whether their orders are receiving the best
---------FOOTNOTES----------
-[56]-(...continued)
market participants); OEA Data, supra notes 50 and
52 (limit orders narrow spreads, improve price
discovery, and increase market depth).
-[57]- See OEA Data, supra notes 50 and 52.
-[58]- See Market 2000 Study at Study IV. See also
discussion at section III.A.b.iii., infra; Simon &
Colby The National Market System For Over-The-
Counter Stocks ("Simon and Colby"), 55 Geo. Wash.
L. Rev. 17 (1986).
==========================================START OF PAGE 32======
price available. Customers also will be in a better position to
compare the execution quality provided by different broker-
dealers.-[59]-
The absence of a uniform limit order display requirement
across all markets has contributed to the controversy among
market participants regarding the availability of true price
improvement opportunities. Many claim that "hidden" limit orders
in exchange markets contribute to distorted price improvement
figures for these markets.-[60]- This potential distortion
---------FOOTNOTES----------
-[59]- The Commission notes that if the Display Rule
leads some market makers to charge commissions for
handling limit orders, Commission rules require
disclosure of such charges. See 17 CFR 240.10b-
10.
-[60]- See James J. Angel, Who Gets Price Improvement on
the NYSE?, Working Paper, December 1994. In
studying the availability of price improvement on
the NYSE, the author noted that over 18% of the
market orders that were price improved were filled
by SuperDOT limit orders. Based on this
percentage, the author estimated the percentage of
orders price improved by "hidden" limit orders and
determined that if such limit orders were
represented in the specialist's quote rather than
"hidden," spreads would have been narrower and
NYSE price improvement statistics would have
declined. See also, McInish & Wood Study, supra
note 46; Mitchell A. Petersen & David Fialkowski,
Posted Versus Effective Spreads: Good Prices or
Bad Quotes, 35 J. Fin. Econ. 269 (1994) (the fact
that so many orders execute inside the posted
spreads indicates that quotes do not represent the
true supply and demand of a given security, and
may be based, in part, on the failure to display
public limit order interest in the quote). Cf.
Ross, Shapiro and Smith, supra note 17 (although
the authors did not examine limit orders in
detail, and discounted the effect of "hidden"
limit orders on their statistics, the authors
found that limit orders provide 27% of the price
(continued...)
==========================================START OF PAGE 33======
also hinders a customer's ability to monitor execution quality.
Pursuant to the Display Rule, the vast majority of limit orders
will be publicly disclosed, thus enabling a more accurate
comparison of price improvement opportunities, and enabling
customers and broker-dealers to make more informed order routing
decisions.-[61]-
Moreover, the Commission believes that the display of limit
orders will benefit orders routed to automated execution systems.
To the extent these systems execute orders at prices based on the
best displayed quotation for a particular security,-[62]-
customers whose orders are executed through these systems will
receive the benefit of prices that more accurately reflect buying
and selling interest in the market.
In sum, the Commission believes the adoption of the Display
Rule is an important step in furthering the goals expressed by
Congress in the 1975 Amendments. The Display Rule will provide
---------FOOTNOTES----------
-[60]-(...continued)
improvement afforded to SuperDOT market order
volume).
-[61]- See, e.g., Amex Letter (rule would help eliminate
hidden limit orders); Letter from Frederick Moss,
Chairman of the Board, CSE, to Jonathan G. Katz,
Secretary, SEC, dated January 16, 1996 ("CSE
Letter") (elimination of hidden limit orders will
eliminate illusion of superior price improvement);
Letter from Harold S. Bradley, Vice President and
Director of Trading, Investors Research
Corporation, to Jonathan G. Katz, Secretary, SEC,
dated January 13, 1996 ("Investors Research
Letter") (hidden limit orders are not justified).
-[62]- Compare discussion of best execution at section
III.C.2.
==========================================START OF PAGE 34======
enhanced opportunities for public orders to interact with other
public orders, consistent with congressional goals.-[63]-
In addition, the display requirement will, among other things,
narrow quotes, enhance market liquidity, and improve an
investor's ability to monitor the quality of its
executions.-[64]- This will create a better environment
for execution of both limit and market orders without the
participation of a dealer. The increased order interaction will
result in quicker and more frequent executions of customer limit
orders. The Display Rule, therefore, will increase the
---------FOOTNOTES----------
-[63]- See 15 U.S.C. 78k-1(a)(1)(C)(v).
-[64]- The Commission notes that a few commenters are
concerned about the potential effects of the
Commission's proposals on institutional customers.
See Goldman Sachs Letter; Letter from Howard J.
Schwartz, Chairman and Chief Executive Officer,
and James Hanrahan, Managing Director - Trading,
Lynch, Jones & Ryan, Inc., to Jonathan G. Katz,
Secretary, SEC, dated February 9, 1996 ("LJR
Letter"); Letter from A.B. Krongard, Chairman, SIA
Board of Directors, and Bernard L. Madoff and
Robert Murphy, Co-Chairmen, Order Execution
Committee, Securities Industry Association, to
Jonathan G. Katz, Secretary, SEC, dated February
26, 1996 ("SIA Letter"). The Commission believes
that the Display Rule will benefit both retail and
institutional customers, while preserving the
access to the markets that institutional customers
have today. For example, an institutional
customer's block size limit order would not be
subject to the rule unless such customer requests
that the order be displayed. Moreover, any
customer, whether individual or institutional, can
request that its non-block size limit order not be
displayed. The Commission also notes that
increased quote competition and enhanced
transparency should improve the prices at which
institutions and market makers begin their
negotiations for the execution of institutional
orders. See also 21(a) Report, supra note 28.
==========================================START OF PAGE 35======
likelihood that limit orders will be executed, a result that the
Commission believes is consistent with the duty of best
execution.
b. Response to Comments-[65]-
The Commission proposed Rule 11Ac1-4 to establish minimum
display requirements for customer limit orders that improve a
specialist's or OTC market maker's best bid or offer for a
particular security as well as the size of such orders. In
addition, the rule requires the display of the size of certain
limit orders priced at the national best bid or offer ("NBBO").
Although the rule generally would mandate the display of limit
orders, market makers and specialists still would retain some
flexibility in handling limit orders accepted for execution.
Specifically, the rule allows an OTC market maker or
specialist, immediately upon receipt of a limit order, to: (1)
change its quote and the size associated with its quote to
reflect the limit order; (2) execute the limit order; (3) deliver
the limit order in an exchange- or association-sponsored system
that complies with the requirements of the rule; or (4) send the
limit order to another market maker or specialist who complies
with the requirements of the rule. The rule would require a
specialist or OTC market maker to display a customer limit order
when the order was "held" by the specialist or OTC market maker.
If the specialist or OTC market maker immediately sends the order
---------FOOTNOTES----------
-[65]- For further discussion of the views of commenters,
see the Summary of Comments, supra note 4.
==========================================START OF PAGE 36======
to a system or to another specialist or OTC market maker that
complies with the rule, the specialist or OTC market maker that
routed the order would have satisfied its obligation to display
the order. These alternatives are intended to allow market
makers, specialists, and market centers an opportunity to
continue to provide their valuable services while offering
customers the best available execution opportunities.
The Display Rule as adopted maintains these alternatives as
proposed. Additionally, to better achieve its aims and to
respond to comments, the Commission has made some modifications
to the proposed rule. For example, the Commission has decided to
permit a specialist or OTC market maker to deliver a limit order
to certain ECNs as an alternative to representing the limit order
in its quote. This change is an extension of the proposed
exception that permits a specialist or OTC market maker to
deliver a limit order to an exchange- or association-sponsored
system that complies with the Display Rule. Moreover, with
regard to implementation of the rule, the Commission is providing
for a four-stage phase-in over a one year period for non-
exchange-traded securities.
Of the commenters who specifically addressed the proposed
Display Rule, an overwhelming majority strongly support the
inclusion of customer limit orders in the quote.-[66]- One
---------FOOTNOTES----------
-[66]- See, e.g., Amex Letter; Letter from Marshall E.
Blume, Director, Howard Butcher Professor of
Financial Management, The Wharton School of the
University of Pennsylvania, to Jonathan G. Katz,
(continued...)
==========================================START OF PAGE 37======
commenter notes that true price discovery and fairness for public
investors can only be achieved when limit orders are reflected in
the NBBO.-[67]- Other commenters, expressing strong
support for the proposed rule, believe that market-wide limit
order procedures will improve the markets by enhancing overall
---------FOOTNOTES----------
-[66]-(...continued)
Secretary, SEC, dated January 11, 1996 ("Blume
Letter"); Letter from George W. Mann, Jr., Senior
Vice President and General Counsel, BSE, to
Jonathan G. Katz, Secretary, SEC, dated January
26, 1996 ("BSE Letter"); Letter from Robert H.
Forney, CHX, to Jonathan G. Katz, Secretary, SEC,
dated January 23, 1996 ("CHX Letter"); D.E. Shaw
Letter; Letter from Antitrust Division, U.S.
Department of Justice, to SEC, dated January 26,
1996 ("DOJ Letter"); Letter from Preston Estep,
Estep Trading Partners L.P., to Jonathan Katz,
Secretary, SEC, dated December 21, 1995 ("Estep
Letter"); Goldman Sachs Letter; ICI Letter; Lehman
Letter; Madoff Letter; Letter from William A.
Lupien, Chairman and Chief Executive Officer,
Mitchum, Jones & Templeton, Inc., to Jonathan G.
Katz, Secretary, SEC, dated January 8, 1996 ("MJT
Letter"); Letter from Joseph R. Hardiman,
President, National Association of Securities
Dealers, Inc., to Jonathan G. Katz, Secretary,
SEC, dated January 26, 1996 ("NASD Letter");
Letter from James E. Buck, Senior Vice President
and Secretary, NYSE, Inc., to Jonathan G. Katz,
Secretary, SEC, dated January 15, 1996 ("NYSE
Letter"); Letter from David S. Pottruck, President
and Chief Operating Officer, The Charles Schwab
Corporation, to Jonathan G. Katz, Secretary, SEC,
dated May 7, 1996 ("Schwab Letter II"); SIA
Letter; Letter from William R. Rothe, Chairman,
and John L. Watson III, President, Security
Traders Association, to Jonathan G. Katz,
Secretary, SEC, dated January 15, 1996 ("STA
Letter"); Letter from John F. Luikart, President
and Chief Executive Officer, Sutro & Co., to
Jonathan Katz, Secretary, SEC, dated January 16,
1996 ("Sutro Letter").
-[67]- Madoff Letter.
==========================================START OF PAGE 38======
market transparency-[68]- and eliminating the advantages
derived by some markets from hidden limit orders.-[69]-
The Department of Justice states that the proposed rule
encourages quote competition, which is likely to reduce
spreads,-[70]- and allows customer orders to interact with
one another.-[71]- In this regard, several commenters
recognize that the proposed rule would assist in achieving best
execution of customer orders-[72]- by increasing the
opportunities for execution of limit orders, and improving the
prices for market orders.-[73]- Another commenter states
that the proposed rule is consistent with investor expectations
and will act to protect retail customer interests.-[74]-
Other commenters oppose the proposal. Several commenters in
this group have raised the following general concerns regarding
the proposed rule.
---------FOOTNOTES----------
-[68]- See, e.g., Amex Letter; CHX Letter; CSE Letter;
D.E. Shaw Letter; ICI Letter; Investors Research
Letter; Lehman Letter; Smith Barney Letter.
-[69]- See, e.g., Amex Letter (rule would help eliminate
hidden limit orders); CSE Letter (elimination of
hidden limit orders will eliminate illusion of
superior price improvement); Investors Research
Letter (hidden limit orders are not justified).
-[70]- DOJ Letter.
-[71]- Id; see also Amex Letter; Lehman Letter.
-[72]- See, e.g., Lehman Letter; Smith Barney Letter.
-[73]- Lehman Letter.
-[74]- D.E. Shaw Letter.
==========================================START OF PAGE 39======
i. Distinction Between Markets
Several commenters argue that the Display Rule does not take
into account distinctions between auction and dealer markets.
Some of these commenters, discussing the Proposing Release as a
whole, argue that the Commission's proposals would "auctionize"
the dealer market.-[75]- One commenter warns that, because
auction and dealer markets are fundamentally different, a single
set of rules for both auction and dealer markets would reduce
quote quality and damage overall market integrity in dealer
markets.-[76]- Although the SIA reports that the consensus
view of its Ad Hoc Committee on Order Execution is to require a
market maker to reflect customer limit orders in the quote, the
SIA argues that the adoption of the proposed rule, without
suggested modifications, could adversely affect the dealer market
---------FOOTNOTES----------
-[75]- See, e.g., Letter from R. Steven Wunsch,
President, AZX, Inc., to Jonathan G. Katz,
Secretary, SEC, dated January 15, 1996 ("AZX
Letter"); Goldman Sachs Letter; Letter from David
Rich, Vice President, Jefferies & Company, Inc.,
to Jonathan G. Katz, Secretary, SEC, dated January
25, 1996 ("Jefferies Letter"); Letter from Robert
W. Murphy, President, RPM Specialist Corporation,
to Jonathan G. Katz, Secretary, SEC, dated
February 26, 1996 ("RPM Letter"); Letter from
Robert A. Schwartz, Professor of Finance and
Economics, and Yamaichi Faculty Fellow, Leonard N.
Stern School of Business, New York University, and
Robert A. Wood, Distinguished Professor of
Finance, Fogelman College of Business and
Economics, University of Memphis, to Jonathan G.
Katz, Secretary, SEC, dated January 23, 1996
("Schwartz & Wood Letter"); SIA Letter.
-[76]- RPM Letter.
==========================================START OF PAGE 40======
so as to weaken competition between dealer and auction
markets.-[77]-
The Commission believes that the application of the
principles underlying the limit order display rule to the dealer
market is neither a new nor radical concept. In 1975, Congress
envisioned an NMS in which public limit orders in qualified
securities would have a central role.-[78]- Congress
anticipated that the NMS would make all specialists and market
makers aware of public customer limit orders held anywhere in the
system, and provide enhanced protection and priority for limit
orders in stocks qualified for trading in a national market
system.-[79]- The Commission has consistently recognized
since 1975 that, in order to satisfy this Congressional vision,
multiple-market display of limit orders was an important
---------FOOTNOTES----------
-[77]- SIA Letter. Cf. Letter from A.B. Krongard,
Chairman, SIA Board of Directors, and Bernard L.
Madoff, Chairman, Trading Committee, to Jonathan
G. Katz, Secretary, SEC, dated August 1, 1996
("SIA NAqcess Letter") (the SIA, in its letter to
the Commission regarding the NASD's NAqcess
proposal, states that the Commission's Order
Execution Obligations proposal would narrow
quotation spreads, improve transparency, and
provide customers with best execution of their
orders, consistent with the 1975 Amendments).
-[78]- Senate Report, supra note 31.
-[79]- Id. The Senate Report stressed the need to
establish a mechanism by which specialists and
market makers could be made aware of customer
orders within the NMS. The Senate Report was
"satisfied that [the legislation] grant[ed] the
Commission complete and effective authority to
implement a system for the satisfaction of public
limit orders." Id. at 18.
==========================================START OF PAGE 41======
component for qualified securities.-[80]- More recently,
the Market 2000 Study recommended that the SROs, including the
NASD, consider requiring the display of customer limit
orders,-[81]- and the NASD, in a proposed rule change filed
with the Commission, proposed that CQS market makers display in
their quotes certain customer limit orders for exchange-listed
securities traded OTC.-[82]- The NASD also has proposed a
mechanism for the display and protection of customer limit orders
in Nasdaq securities.-[83]-
Although some commenters claim that the Commission is
attempting to "auctionize" the dealer market, the display
requirement is based on transparency and agency concerns,
including a broker-dealer's obligation to provide its customers
with best execution.-[84]- The display of customer limit
orders will act to narrow spreads, improve price discovery, and
---------FOOTNOTES----------
-[80]- See Securities Exchange Act Release No. 15671
(March 22, 1979), 44 FR 20360 (April 4, 1979)
(Development of a National Market System Status
Report). See also Securities Exchange Act Release
No. 18738 (May 13, 1982), 47 FR 22376 (May 24,
1982) (proposing limit order display requirement
for Rule 19c-3 securities).
-[81]- Market 2000 Study, at IV-6.
-[82]- See supra note 42.
-[83]- See supra note 45.
-[84]- See NASD Study, supra note 21 (enhancements to
limit order handling, within the dealer market
structure, will create significant benefits for
investors). See also Manning II, supra note 24
(Commission's extension of limit order protection
to Nasdaq does not suggest an intention to
"auctionize" the dealer market).
==========================================START OF PAGE 42======
increase market depth. The enhanced transparency resulting from
the Display Rule will increase the likelihood that customer limit
orders will be executed, improve the execution prices of market
orders, and strengthen an investor's ability to monitor the
quality of executions.-[85]- These results further several
Congressional goals.
In keeping with Congressional intent, the Commission
believes the treatment of limit orders should reflect the very
real changes in market structure that have taken place since the
enactment of the 1975 Amendments. These changes include the
development of a robust, liquid OTC dealer market that attracts
significant investor trading interest, that trades at many
multiples of the volume extant in 1975, and that is characterized
by the inclusion of thousands of securities that meet the NMS
designation.-[86]- In addition, the Commission believes
that application of the Display Rule should also benefit
investors in those securities that do not yet meet the NMS
---------FOOTNOTES----------
-[85]- See Senate Report, supra note 31 at 16-18
(discussing desirability of incorporating certain
auction market principles, such as limit order
display and protection, for certain qualifying
securities in dealer markets).
-[86]- To date, approximately 4,000 Nasdaq securities
have qualified for the NMS designation. In order
to qualify as an NMS security, transaction reports
are required to be reported on a real-time basis
pursuant to an effective transaction reporting
plan approved by the Commission. See 17 CFR
240.11Aa2-1 and 11Aa3-1.
==========================================START OF PAGE 43======
designation.-[87]- As noted earlier, the Commission
believes that the increased use of limit orders in these
securities will lead to a narrowing of spreads and ameliorate
certain anti-competitive practices that have developed in the
Nasdaq market.-[88]- The Commission has determined that
certain practices on Nasdaq have contributed to artificially wide
spreads for OTC securities.-[89]- The display of customer
limit orders in all Nasdaq securities will promote accurate
pricing and convey the true buying and selling interest in such
securities.
A few commenters believe that the Display Rule was proposed
solely to address problems in the OTC market, and accordingly
there is no need for a uniform rule applicable to exchange
markets.-[90]- As noted previously, the Commission's
intention is to create a minimum standard for the handling of
limit orders across all markets, consistent with market
transparency, competition, and best execution principles.
---------FOOTNOTES----------
-[87]- As discussed below, the Display Rule will apply
only to "covered securities." At the present
time, the Commission does not believe the rule
should be extended to securities for which market
makers are not required to quote continuous firm
two-sided markets, such as OTC Bulletin Board
securities.
-[88]- See supra discussion at section III.A.2.a.
-[89]- 21(a) Report, supra note 28.
-[90]- See, e.g., BSE Letter; NYSE Letter; RPM Letter;
Letter from David E. Humphreville, Executive
Director, The Specialist Association, to Jonathan
G. Katz, Secretary, SEC, dated February 2, 1996
("Specialist Assoc. Letter").
==========================================START OF PAGE 44======
Currently, the national securities exchanges do not handle limit
orders uniformly, and in fact the non-display of retail-size
limit orders is permitted under certain circumstances. The rule
will ensure that investors benefit from the display of limit
orders, no matter where an order is sent for
execution.-[91]- A minimum standard also addresses
concerns regarding the prevalence of hidden limit
orders.-[92]- The Commission believes, therefore, that a
market-wide limit order display requirement is most consistent
with the duty of best execution and the expectations of
investors.
ii. Distinction between Quotes and Orders
---------FOOTNOTES----------
-[91]- See, e.g., Greene Study & Greene Study II, supra
note 51.
-[92]- See generally McInish & Wood Study, supra note 46
(hidden limit orders result in, among other
things, artificial price improvement statistics
and inferior order executions); Traders Accuse
Specialists of Holding Back Limit Orders,
Investment Dealers' Digest, 8, (February 14, 1994)
(some traders have continued to accuse NYSE
specialists of hiding limit orders even after the
NYSE issued an Information Memo reminding
specialists of their duties); Greene Study and
Greene Study II, supra note 51 (one explanation
for the significantly lower bid-ask spreads in the
1994-95 sample than in the 1990 sample, and the
increase in the percentage of transactions at the
quoted prices from the 1990 sample to the 1994-95
sample, may be that NYSE specialists were more
diligent in reflecting the limit order book in
their quotes as per Information Memo 93-12); Amex
Letter (rule would help eliminate hidden limit
orders); CSE Letter (elimination of hidden limit
orders will eliminate illusion of superior price
improvement); Investors Research Letter (hidden
limit orders are not justified).
==========================================START OF PAGE 45======
Some commenters maintain that the rule blurs the distinction
between quotations and orders.-[93]- One commenter states
that limit orders represent only a finite trading interest while
quotes represent the "actual" market for a security; thus,
displaying limit orders would not reflect the "true" state of the
market and impair the quality of quotation
information.-[94]- The commenter suggests that a separate
limit order file would be more appropriate in light of these
distinctions.-[95]- In this vein, several commenters
mention the NASD's proposed NAqcess system,-[96]-
suggesting that the Commission postpone implementation of the
Display Rule until the Commission has an opportunity to assess
---------FOOTNOTES----------
-[93]- See, e.g., Letter from Raymond L. Aronson, Senior
Managing Director, Bear, Stearns & Co. Inc., to
Jonathan G. Katz, Secretary, SEC, dated February
1, 1996 ("Bear Stearns Letter"); Instinet Letter;
Letter from Carol L. Cunniff, Executive Vice
President, Ruane, Cunniff & Co., Inc., to Jonathan
G. Katz, Secretary, SEC, dated February 23, 1996
("Ruane Letter"); Letter from Charles R. Schwab,
Chairman and Chief Executive Officer, The Charles
Schwab Corporation, to Jonathan G. Katz,
Secretary, SEC, dated January 25, 1996 ("Schwab
Letter"). But see Schwab II Letter (supporting
the Display Rule).
-[94]- Ruane Letter.
-[95]- Id. See also Bear Stearns Letter (discussion of
proposed central limit order file for The Nasdaq
Stock Market so as to preserve distinction between
dealer quotes and agency or proprietary orders).
-[96]- See supra note 45.
==========================================START OF PAGE 46======
the effects of NAqcess.-[97]- A few commenters suggest the
implementation of an industry-wide consolidated limit order book
as an alternative or a logical outgrowth of the Display
Rule.-[98]-
The Commission believes that the display of limit orders is
an essential component of accurate price discovery. A quote
provides market participants with information regarding a market
maker's or specialist's trading interest at a given price. A
market maker or specialist could be willing to purchase or sell
---------FOOTNOTES----------
-[97]- See, e.g., Letter from A.B. Krongard, Chief
Executive Officer, Alex. Brown & Sons, Inc., to
Jonathan G. Katz, Secretary, SEC, dated February
29, 1996 ("Alex. Brown Letter"); Letter from
Albert G. Lowenthal, Chairman of the Board,
Fahnestock & Co., Inc., to Jonathan G. Katz,
Secretary, SEC, dated January 15, 1996
("Fahnestock Letter"); Jefferies Letter; Letter
from Gerard S. Citera, Deputy General Counsel,
First Vice President, PaineWebber Incorporated, to
Jonathan G. Katz, Secretary, SEC, dated February
9, 1996 ("PaineWebber Letter"); Schwab Letter; STA
Letter; Letter from Charles Snow, Counsel,
Securities Traders Association of New York, to
Jonathan G. Katz, Secretary, SEC, dated January
30, 1996 ("STANY Letter"); see also Letter from C.
Robert Paul, III, Associate General Counsel, Dean
Witter Reynolds, Inc., to Jonathan G. Katz,
Secretary, SEC, dated January 31, 1996 ("Dean
Witter Letter"); Goldman Sachs Letter.
-[98]- See, e.g., DOJ Letter; MJT Letter; Schwab Letter;
Letter from Junius W. Peake, Monfort Distinguished
Professor of Finance, University of Northern
Colorado, to Jonathan G. Katz, Secretary, SEC,
dated January 15, 1996 ("Peake Letter"); Letter
from Jeffrey P. Ricker, CFA, to Jonathan G. Katz,
Secretary, SEC, dated January 15, 1996 ("Ricker
Letter"); Letter from Peter W. Jenkins, Chairman,
and Holly A. Stark, Vice Chairman, Institutional
Committee, Securities Traders Association, to
Jonathan G. Katz, Secretary, SEC, dated January
19, 1996 ("STAIC Letter").
==========================================START OF PAGE 47======
additional shares above its quoted size.-[99]- Entry of a
customer limit order that improves the quote serves a similar
purpose. A limit order accurately represents trading interest
for a specific volume of a security at the limit price. There
are few practical differences between customer limit orders and a
market maker's quotation that is firm only for its quoted size.
Nonetheless, the proposed rule was not intended to equate
customer limit orders with market maker quotes. Instead, the
proposed rule was designed to facilitate greater transparency of
customer trading interest, with the expectation that orders would
have an increased opportunity for best execution without the
interaction of a dealer. In the Commission's opinion, these
objectives are more difficult to achieve if customer trading
interest is not routinely represented in publicly displayed
quotes. The Commission notes that the Display Rule provides
other means by which a market maker or specialist may comply with
the requirements of the rule in the event a specialist or market
maker elects not to display customer trading interest in its
quote.-[100]-
Further, the Commission does not agree with the suggestion
---------FOOTNOTES----------
-[99]- Under Commission rules, the market maker's quote
is only required to be firm up to its published
size. See 17 CFR 240.11Ac1-1(c)(2).
-[100]- For example, a market maker or specialist may
deliver a customer limit order immediately upon
receipt to another market maker or specialist, or
to an ECN or an exchange or association sponsored
system pursuant to the rule. Section 240.11Ac1-
4(c)(5) & (6).
==========================================START OF PAGE 48======
that the Commission postpone the adoption of the Display Rule
until the Commission has had an opportunity to evaluate the
NASD's NAqcess proposal.-[101]- Although the NASD has
argued that limit orders entered into NAqcess, as proposed, would
result in greater display of OTC limit order prices, there is no
assurance that market makers will enter such orders into NAqcess
rather than hold the orders internally.-[102]- Therefore,
the Commission believes that the Display Rule is necessary to
ensure display of these orders in the OTC market.-[103]-
If approved, NAqcess can assist in compliance with the Display
Rule to the extent that the system incorporates customer limit
orders in the consolidated quote stream, thereby allowing market
makers to enter limit orders in NAqcess rather than displaying
limit orders in their quotes.-[104]- As noted earlier,
the Commission has identified important benefits associated with
limit order display. Accordingly, the Commission believes that
it is not necessary to observe the effects of NAqcess in order to
---------FOOTNOTES----------
-[101]- The Commission notes that the proposed NAqcess
system is a significant and controversial proposal
which has generated approximately 1,100 comment
letters. The Commission is in the process of
reviewing the comments and has yet to decide what
action to take on the proposal.
-[102]- See NAqcess Releases, supra note 45. As noted
above, limit orders not entered in NAqcess would
be provided with market-wide price protection.
-[103]- In any event, NAqcess will not address at all the
issues of disparate limit order handling practices
or hidden limit orders in the exchange markets.
-[104]- See Section 240.11Ac1-4(c)(5).
==========================================START OF PAGE 49======
determine the benefits of the limit order display requirement.
iii. Liquidity
Several commenters assert that application of the Display
Rule to Nasdaq securities could reduce liquidity in the Nasdaq
market.-[105]- These commenters believe that market maker
profits may decline due to narrowed spreads or increased
compliance costs, with the result that many firms will decide not
to make the necessary capital commitment to continue their market
making operations. The commenters conclude that as the number of
market makers in a security declines, liquidity will be adversely
affected, leading to wider spreads. Moreover, some commenters
believe that the decrease in liquidity will impair the capital
formation process, especially for securities that are not mature
enough for auction trading.-[106]-
At least one commenter states that the usefulness of limit
orders could be diminished by the refusal of some market makers
to accept such orders, or by the imposition of high commission
---------FOOTNOTES----------
-[105]- See, e.g., Alex. Brown Letter; Bear Stearns
Letter; Dean Witter Letter; Letter from Robert F.
Mercandino, Senior Vice President, Dillon, Read &
Co., Inc., to Jonathan G. Katz, Secretary, SEC,
dated March 15, 1996 ("Dillon Letter"); Jefferies
Letter; Lehman Letter; Letter from Robert J.
McCann, Managing Director, Co-Head, Global Equity
Markets, Merrill Lynch, Pierce, Fenner & Smith
Incorporated, to Jonathan G. Katz, Secretary, SEC,
dated January 26, 1996 ("Merrill Letter"); NASD
Letter; PaineWebber Letter; Letter from David P.
Semak, Vice President Regulation, PSE, to Jonathan
G. Katz, Secretary, SEC, dated January 15, 1996
("PSE Letter"); SIA Letter.
-[106]- See, e.g., NASD Letter; SIA Letter.
==========================================START OF PAGE 50======
costs charged to recoup lost profits on spreads.-[107]-
Other commenters believe, however, that it will be difficult for
market makers to increase their commissions for limit
orders.-[108]- They believe commission charges would not
compensate for lost trading profits or prevent the ebb of market
liquidity.-[109]-
Other commenters believe the proposed rule will not have a
negative impact on market liquidity. One commenter explicitly
states that the benefits of the proposed rule would outweigh any
potential adverse effects on liquidity.-[110]- Another
commenter says that the proposed rule would not result in any
significant reduction in market making activity.-[111]-
The CSE notes that it has not noticed any negative effects on
market liquidity as a result of the implementation of its own
limit order display rule.-[112]- Yet another commenter
---------FOOTNOTES----------
-[107]- Letter from David K. Whitcomb, Professor of
Finance and Economics, Rutgers University Graduate
School of Management, to Secretary, SEC, dated
January 12, 1996 ("Whitcomb Letter").
-[108]- See, e.g., Letter from Irving M. Pollack, Alan B.
Levenson, and Robert H. Rosenblum, Fulbright &
Jaworski L.L.P., on behalf of Herzog, Heine and
Geduld, Inc., to Jonathan Katz, Secretary, SEC,
dated January 16, 1996 ("HHG Letter"); STA Letter.
-[109]- Id.
-[110]- Lehman Letter.
-[111]- Letter from Daniel G. Weaver, Ph.D., Assistant
Professor of Finance, Marquette University, to
Jonathan G. Katz, Secretary, SEC, dated January
10, 1996 ("Weaver Letter").
-[112]- CSE Letter.
==========================================START OF PAGE 51======
states that although it currently does not trade OTC securities,
it expects that many market participants, including the
commenter, would begin trading such securities if the proposed
rule was adopted, thereby increasing market
liquidity.-[113]-
The display of limit orders is designed, among other
objectives, to publicize accurate market interest and increase
quote competition.-[114]- The Commission understands that
certain costs, including a diminution in market maker profits,
are associated with this increased market transparency. For
example, a market maker that holds a customer limit order has, in
effect, a private "option" to execute the order as principal.
The longer this "option" remains open, the more time the market
maker has to determine whether it can profit from executing the
order as principal.-[115]- This private market maker
"option," however, is potentially detrimental to the execution
opportunities for the limit order. The Display Rule will limit
this "option" and expose the order to market-wide trading
interest. Moreover, increased price competition from limit
---------FOOTNOTES----------
-[113]- The commenter noted further that it does not
currently trade OTC securities because it cannot
be sure that its order will be represented to the
whole market. Estep Letter.
-[114]- See Market 2000 Study, at Study IV.
-[115]- The Commission recognizes that there is also a
cost associated with holding that limit order,
because a market maker is required to execute that
limit order if it has engaged in a transaction for
its own account that would have satisfied the
limit order. See Manning I & II, supra note 24.
==========================================START OF PAGE 52======
orders may reduce market maker profits through the narrowing of
spreads.-[116]- As a result, the Display Rule may force
less efficient competitors to stop making markets in some of the
securities they now quote.
Although the rule could lead to a reevaluation by some
market makers of the services they wish to provide, after
considering the available evidence, and in light of its
experience, the Commission does not believe that there will be a
significant negative impact on the markets for covered
securities. The Commission is not convinced that the loss of
some market competitors in securities with many market makers
would impair liquidity in these securities.-[117]- The
Commission believes that customer orders are the ultimate source
of liquidity to the markets, and that adoption of a rule that
improves the handling of such orders will have the effect of
enhancing market liquidity.-[118]- The Commission
---------FOOTNOTES----------
-[116]- See supra notes 53 - 55 and accompanying text
(display of customer limit orders in market maker
quotes will act to eliminate certain trading
behavior on Nasdaq and foster quote competition).
-[117]- See, e.g., STAIC Letter (limit orders are critical
to market liquidity).
-[118]- The Commission does not thereby denigrate the
contribution OTC market makers provide in a dealer
market. The Commission notes, however, that most
market makers provide primarily intra-day
liquidity to customers, and generally seek to end
the trading day with a limited inventory position
in order to minimize inventory risk. Customer
limit orders represent buying or selling interest
at specified prices for their stated duration,
which may be longer than intra-day. Market makers
(continued...)
==========================================START OF PAGE 53======
believes that a limit order display requirement will encourage
new limit orders in securities to be entered, thus providing
additional liquidity to the market from customers.-[119]-
The potential of limit orders to narrow quotes also may encourage
the entry of additional market orders.-[120]- The
Commission believes that the additional liquidity due to narrower
spreads and increased customer orders will outweigh any potential
loss of liquidity provided by market makers.
As noted above, some commenters expressed concern regarding
the effect of the Display Rule on the availability of liquidity
to small issuers.-[121]- In response to these comments,
the Commission's OEA examined market maker participation in 4,839
---------FOOTNOTES----------
-[118]-(...continued)
holding customer limit orders rely in part on
these limit orders in quoting their own prices to
buy and sell securities.
-[119]- See Greene Study & Greene Study II, supra note 51
(limit orders affect the quoted spread and provide
liquidity); NASD Study, supra note 21 (limit
orders, like market maker quotes, supply liquidity
to the markets); OEA Data, supra notes 50 and 52.
-[120]- See NASD Study, supra note 21 (those investors
that demand immediate execution, e.g. those
entering market orders, will pay less for
executions due to the augmented liquidity supplied
by limit orders); Greene Study and Greene Study
II, supra note 51 (limit orders provide liquidity
to traders that demand immediacy of execution and
may contribute to reduced trading costs); OEA
Data, supra notes 50 and 52 (display of limit
orders narrows spreads, improves price discovery,
and increases market depth for a variety of
securities, including those NYSE securities that
are thinly traded).
-[121]- This concern also was raised in the context of the
ECN Amendment to the Quote Rule.
==========================================START OF PAGE 54======
Nasdaq issuers over a one month period in 1996. The findings
indicate that: (1) the median number of market makers in a
security is not appreciably lower for initial public offering
("IPO") issuers or for securities with the smallest market
capitalization; (2) broker-dealers that participated in IPO
underwriting syndicates were active participants in aftermarket
trading, but were not alone in providing significant market maker
liquidity; and (3) in Nasdaq securities with the smallest market
capitalization ($2 million or less), the single most active
market maker in an issue typically participated in one-third or
fewer trades. Thus, there is no convincing evidence that Nasdaq
issuers, including IPO issuers, are dependent for liquidity on
any one market maker. The pattern of market making activity
indicates that significant liquidity is provided by market makers
who are not the "most active" market makers in a security.
Because there does not appear to be high concentration in market
making, and because of the Commission's belief that customer
order flow is a critical source of market liquidity, the
Commission believes that the proposals adopted today will not
unduly impact liquidity for small or new issuers.
Furthermore, Commission experience has been that
enhancements to transparency result in improved
liquidity.-[122]- The Commission believes that these
---------FOOTNOTES----------
-[122]- In several instances in the past, commenters have
claimed that other Commission initiatives to
increase transparency would act to reduce
liquidity; others have warned that such
(continued...)
==========================================START OF PAGE 55======
improvements are attributable, at least in part, to the impact of
transparency on market integrity and investor confidence. In
addition, while market maker profits per trade may be reduced as
spreads are narrowed, increased volume over time may result in
stable profit levels.-[123]-
---------FOOTNOTES----------
-[122]-(...continued)
initiatives would decrease the competitiveness of
the U.S. markets in relation to foreign
counterparts. These claims, however, have not
been borne out. For example, many industry
participants argued that the NASD's adoption of
its "Manning" rules would severely impact market
liquidity. See Market 2000 Study. However, there
has been no evidence offered to the Commission of
adverse liquidity consequences caused by these
limit order protections, and the Commission is not
aware of any significant diminution in liquidity.
Further, as discussed in the Market 2000 Study,
other transparency initiatives, such as the
adoption of real-time transaction and quotation
reporting, have resulted in increases in the
competitiveness and liquidity of both listed and
OTC equity markets despite market maker
protestations to the contrary prior to adoption of
these initiatives. See Id. at Study IV. See also
Simon & Colby, supra note 58. Even the creation
of Nasdaq itself was met with much opposition.
The result of this major structural change was far
from the predicted "death knell" of the OTC
market. Rather, OTC market strength and liquidity
have flourished since Nasdaq's inception. Based
on the Commission's experience with other market
structure initiatives, therefore, the Commission
believes that improvements in order handling,
market transparency, and efficiency will likely
improve market liquidity.
-[123]- Although the display requirement may decrease a
market maker's per trade profit due to narrowed
spreads, the Commission believes that this
decrease will be made up for in part by expected
increases in trading volume attributable to
enhanced liquidity and pricing efficiency. See
supra note 24. The Commission believes this
potential impact on market maker profits is
(continued...)
==========================================START OF PAGE 56======
It also may become feasible for market makers to charge
customers commissions for handling limit orders, even if that is
not the current practice today. As noted earlier, some
commenters claim that the Display Rule will have a disparate
impact on wholesale Nasdaq market makers in that such market
makers would not be able to offset the increased costs associated
with limit order display through charges or
commissions.-[124]- The Commission believes, however,
that the systems costs associated with the Display Rule should
not be overly burdensome,-[125]- nor should systems costs
or any reduced market maker profitability from declining spreads
be more extensive for wholesale market makers than for integrated
market makers. Although exchange specialists and integrated
firms may find it easier than wholesale firms to charge
commissions initially, the Commission notes that wholesale firms
---------FOOTNOTES----------
-[123]-(...continued)
justified in light of the benefits that will
accrue to investors and the markets as a whole.
Moreover, even if market makers' profits from
trading do decline, market makers may be able to
obtain increased revenues from commissions or
other fees charged directly to customers. Because
these other revenue sources are more transparent
to customers than are revenues from market maker
trading with customers on a proprietary basis,
increased reliance on these other revenue sources
will enable customers to make more informed
trading decisions.
-[124]- See, e.g., HHG Letter.
-[125]- See Memorandum from Stephen L. Williams, S.L.
Williams Co. to Richard R. Lindsey, Director,
Division of Market Regulation, SEC (July 29, 1996)
("Williams Study").
==========================================START OF PAGE 57======
are not prohibited from attempting to compensate for handling
limit orders, either through negotiated fee arrangements, or
reducing any payment made for order flow for limit
orders.-[126]-
iv. Discretion
Several commenters are concerned that the Display Rule would
eliminate their discretion to determine the best way in which to
---------FOOTNOTES----------
-[126]- The level of these fees, of course, would be
determined by competitive forces in the
marketplace. Any fees passed on to non-broker-
dealer customers would have to be disclosed in a
clear fashion to the customer, and otherwise
comply with applicable law. For example, NASD
Rule 2440 states, in part, that if a member acts
as agent for a customer in a transaction, the
customer shall not be charged more than a fair
commission or service charge, taking into
consideration all relevant circumstances. See
also NASD Regulatory & Compliance Alert Vol. 7,
No. 4 (December 1993). At least one commenter
argued that because spreads are ascertainable from
public quotations and commissions are not, a rule
that encourages charging commissions does not
satisfy the goal of increased transparency. See
Letter from Bruce C. Hackett, Managing Director,
Salomon Brothers Inc., to Jonathan G. Katz,
Secretary, SEC, dated January 25, 1996 ("Salomon
Letter"). The Commission notes, however, that
Rule 10b-10 under the Exchange Act requires
customer confirmations to disclose commissions
and, for listed and Nasdaq securities, the
difference between the reported price and the
price to the customer. Based on this disclosure,
execution costs could actually become better known
to customers if explicit fees are charged.
Therefore, the Commission believes that the
Display Rule will allow a customer to more easily
monitor the execution quality of its limit orders,
even if subject to fees for limit order
executions. In addition, this situation should
foster competition with respect to the amount, if
any, firms will charge for the execution of a
customer limit order.
==========================================START OF PAGE 58======
execute a customer's order. The commenters also claim that
customers rely on the judgment of a market professional in
choosing whether to display a limit order.-[127]- For
example, the NYSE believes that its current procedures allow
broker-dealers to achieve the best prices for their
customers.-[128]- Other commenters suggest that if the
rule were amended to require the display of representative size,
a dealer would retain some discretion on how best to execute the
order.-[129]- To preserve discretion, at least one
commenter argues that the rule should apply only when the
customer requests that its order be displayed.-[130]-
The Commission believes that the rule appropriately
establishes a presumption that limit orders should be displayed,
unless such orders are of block size, the customer requests that
its order not be displayed, or one of the exceptions to the rule
---------FOOTNOTES----------
-[127]- See, e.g., NYSE Letter; RPM Letter; Specialist
Assoc. Letter.
-[128]- See, e.g., NYSE Letter; Specialist Assoc. Letter.
According to the NYSE, a customer can choose to
benefit from the display of its order or to
benefit from relying on the specialist's
discretion, depending on whether the order is sent
to the post via SuperDOT, or is manually
submitted. The NYSE also notes that enabling a
specialist to use discretion in the handling of
limit orders is important in light of the fact
that the NYSE defines a limit order as an order to
buy or sell at a specified price, or at a better
price, if obtainable after the order is
represented in the trading crowd. See NYSE Rule
13.
-[129]- See, e.g., Madoff Letter; NASD Letter; SIA Letter.
-[130]- Jefferies Letter.
==========================================START OF PAGE 59======
applies. The exception allowing a customer to request that its
limit order not be displayed gives the customer ultimate control
in determining whether to trust the display of the limit order to
the discretion of a market professional, or to display the order
either in full, or in part, to other potential market
interest.-[131]-
v. Systems Burdens
Based on their belief that compliance with the Display Rule
would result in a large increase in quotation traffic, a number
of commenters maintain that the rule would require major
overhauls of the order handling systems used by brokers, market
makers and markets. For example, one commenter believes that it
would be impossible to comply with the rule without additional
automated systems.-[132]- The commenter concludes that
the costs associated with new systems and additional staff
necessary to monitor a more volatile market would contribute to
---------FOOTNOTES----------
-[131]- See discussion of the exceptions to the Display
Rule at section III.A.3.c., infra. See also
Section 240.11Ac1-4(c)(2); Section 240.11Ac1-
4(c)(4) (permitting a customer with a block size
limit order to request that the order be displayed
pursuant to the Display Rule). The Commission
does not mean to imply that a specialist or OTC
market maker that is not displaying a limit order
pursuant to the request of its customer may not
change its quotation in that security based on the
specialist's or market maker's own trading
interest.
-[132]- PaineWebber Letter.
==========================================START OF PAGE 60======
wider spreads and higher commissions.-[133]- In addition,
one SRO claims that quotation traffic must be kept at manageable
levels in order to allow entities to continue to manually process
limit orders, thus eliminating the need for entities to bear the
costs associated with automation of such orders.-[134]-
Other commenters also note their concern over the potential
operational costs associated with the rule.-[135]- The
STA states that an in-depth review is needed to determine the
costs for new equipment and technology necessary to comply with
the rule.-[136]-
A few commenters are concerned that the increased quotation
traffic that may be associated with the rule could pose a threat
to the integrity of the central quotation system.-[137]-
---------FOOTNOTES----------
-[133]- Id.; see also Bear Stearns Letter (noting that the
display rule would increase the volatility of
quotes and, as a result, market makers would have
a difficult time keeping up with the rapid changes
in bids, offers, and quote sizes).
-[134]- PSE Letter.
-[135]- See, e.g., Alex. Brown Letter; Bear Stearns
Letter; Jefferies Letter.
-[136]- STA Letter.
-[137]- See, e.g., Letter from Thomas J. Jordan, Financial
Information Forum, to Jonathan G. Katz, Secretary,
SEC, dated January 12, 1996 ("FIF Letter");
PaineWebber Letter; PSE Letter. This concern was
expressed with respect to the proposal that the
Commission adopt both the Display Rule and Price
Improvement Rule. The fact that the Commission
has deferred action on the Price Improvement Rule,
as discussed below, should substantially diminish
any system capacity concerns. Moreover, the
Commission's decision not to require display of de
(continued...)
==========================================START OF PAGE 61======
One commenter suggests that the rule be suspended for the first
30 minutes of trading.-[138]- Another commenter argues
that modifying the rule to require only the display of
representative size could act to alleviate some of the traffic
concerns.-[139]-
The Commission recognizes that achieving greater
transparency for limit orders depends upon the existence of
systems that are capable of the smooth and efficient display of
trading interest. The Commission believes that the Display Rule
will not substantially increase the quotation burden for exchange
markets, where systems currently exist for the display of
quotes.-[140]- In the OTC market, the Display Rule will
result in additional quotation entries for market makers that
---------FOOTNOTES----------
-[137]-(...continued)
minimis orders also should minimize system
capacity concerns.
-[138]- FIF Letter. According to FIF, the heaviest
traffic volume usually occurs within the first 30
minutes of trading.
-[139]- PSE Letter. The PSE notes, however, that the
rule, even if modified, still may result in an
increase in staffing costs. Id.
-[140]- For example, SuperDOT data indicates that 57% of
all customer trades originating from orders routed
through SuperDOT are limit orders. Of these limit
orders, 20% narrowed the NYSE quote. See supra
note 52. According to the NYSE, 93% of such
orders are reflected in the NYSE quote within two
minutes of receipt. See supra note 36 and
accompanying text (teleconference). See also CSE
Letter (costs associated with implementing such a
system are minimal, especially in light of the
benefits to the public); Paperwork Reduction Act
discussion at section VII, infra.
==========================================START OF PAGE 62======
display customer limit orders in their quotes. The Commission
believes, however, that current systems can handle the additional
volume, or can be expanded at moderate cost to handle the
additional volume.-[141]- Further, the Commission notes
that the Display Rule contains an exception to the display
requirement for limit orders of de minimis size priced at the
NBBO when the market maker's or specialist's quote matches the
NBBO.-[142]- The Display Rule also allows a specialist or
OTC market maker several ways to comply with the rule by routing
the order elsewhere without displaying the limit order in its own
quote by transmitting a customer limit order to an exchange- or
association-sponsored system or to a qualifying ECN.
Additionally, a few commenters believe that the Commission
---------FOOTNOTES----------
-[141]- The Commission notes that many small to medium
broker-dealers utilize shared trading systems that
enable such broker-dealers to streamline their OTC
market making and back office responsibilities.
Subscribers to such systems benefit by sharing
costs associated with the application of improved
technologies, rather than creating and updating
systems of their own. Therefore, it is assumed
that any changes deemed necessary to these shared
systems to facilitate efficient compliance with
the Display Rule also would be shared by all
subscribers.
In addition, the Commission specifically evaluated the costs
associated with implementation of the Display Rule. Based
on this evaluation, the Commission concluded that most
market makers will not be required to invest substantial
amounts of money in systems development in order to comply
with the Display Rule as adopted. See Williams Study, supra
note 125. See also CSE Letter (costs of implementing a
system for display of limit orders are minimal).
-[142]- See, Section 240.11Ac1-4(b)(1)(ii). See also
Section 240.11Ac1-4(b)(2)(ii).
==========================================START OF PAGE 63======
should give more consideration to the Display Rule's impact on
automatic execution systems.-[143]- These commenters
express concern that a market maker could be exposed to multiple
transactions from its own customers in the firm's automatic
execution system, which executes orders at the NBBO, even if the
NBBO represents a customer limit order as opposed to the price at
which a market maker is willing to trade. They claim this result
is unfair, especially if the automatic system has a minimum share
requirement that exceeds the customer limit order.
The Commission acknowledges the concern of some commenters
regarding the rule's interaction with automated execution
systems. However, because customer limit orders reflect actual
trading interest, it has been the Commission's intention to
enhance customer order executions throughout the markets by
requiring the display of these customer limit
orders.-[144]- Where a limit order represents the best
---------FOOTNOTES----------
-[143]- See, e.g., Dillon Letter; HHG Letter; Merrill
Letter; PaineWebber Letter; Schwab Letter.
-[144]- The Commission recognizes that SROs may have rules
regarding the minimum quotation sizes associated
with a specialist's or market maker's quote. The
Commission believes that SROs should consider
amending such rules and modifying certain systems
to allow a specialist or market maker to quote in
sizes smaller than the minimum quotation size when
such quote represents a customer limit order.
With these changes, a specialist or market maker
that displays a customer limit order in its quote
pursuant to the Display Rule would not be
responsible for executing as principal any
additional shares at the limit price where the
size of the customer limit order is less than the
minimum quotation size set by the SRO.
==========================================START OF PAGE 64======
quote, a market maker can respond by sending its customer order
to the market maker displaying the limit order at the NBBO,
thereby attempting to execute the limit order setting that price
and removing it as the NBBO.-[145]- Moreover, where the
size of a limit order represented in the best quote is smaller
than the size eligible for execution in an automated execution
system, the Commission believes that it is not inconsistent with
best execution principles for market makers and specialists using
automated execution systems to take into account the size of the
limit order quote in determining the price at which an order, or
portions thereof, should be automatically executed. The
Commission believes, however, that in such a case the market
maker or specialist should provide the customer order an
execution at the displayed price at least up to the displayed
size of the limit order.-[146]- For example, if customer
limit orders compose the NBBO of 10 1/4 - 10 1/2 (100 x 300), and
---------FOOTNOTES----------
-[145]- The Commission notes that the NASD's NAqcess
system, as proposed, would permit market makers to
send orders, including proprietary orders, to
other market makers through the system. See supra
note 45. See also ITS Plan. Moreover, the
Commission believes that the NASD should consider
modifying its SOES system to allow OTC market
makers to route customer orders for execution
against limit orders displayed by another market
maker in the same security.
-[146]- If the market maker or specialist attempted but
was unable to execute the displayed limit order
through a reasonable and efficient means, such as
sending an order through an automated system for
an OTC security, the market maker or specialist
would not be expected to give that limit order
price to its customer.
==========================================START OF PAGE 65======
a market maker receives a market order to sell 1,000 shares via
an automatic execution system, the market maker may automatically
execute 100 shares of the order at 10 1/4, and the remaining
portion of the order at the next best bid.
3. The Operation of the Rule As Adopted-[147]-
The rule as adopted applies to: (i) every member of an
exchange that is registered by that exchange as a specialist or
has been authorized by an exchange to perform functions
substantially similar to that of a specialist ("specialist"); and
(ii) OTC market makers.-[148]- The rule as adopted
applies to specialists that trade on the floor of an
exchange;-[149]- third market makers;-[150]-
members of a national securities association that are OTC market
makers;-[151]- and specialists that trade an OTC security
pursuant to unlisted trading privileges ("UTP").-[152]-
These market makers are required to reflect immediately in their
bid or offer the price and the full size of each customer limit
order they hold at a price that would improve their bid or offer
---------FOOTNOTES----------
-[147]- SRO rules that impose more stringent standards
would continue to apply.
-[148]- Although the Commission consolidated certain
sections of the proposed rule for clarity, the
rule as adopted applies to the same entities
identified in the proposed rule.
-[149]- Section 240.11Ac1-4(b)(1).
-[150]- Section 240.11Ac1-4(b)(2).
-[151]- Section 240.11Ac1-4(b)(2).
-[152]- Section 240.11Ac1-4(b)(1).
==========================================START OF PAGE 66======
in the security.-[153]- In addition, all market makers
covered by the rule are obligated to reflect in their quotes the
full size of a customer limit order that: (1) is priced equal to
their bid or offer; (2) is priced equal to the national best bid
or offer for the security; and (3) represents more than a de
minimis change in relation to the size associated with their bid
or offer.-[154]-
a. "Covered Securities" and "Customer Limit
Orders"
Rule 11Ac1-4 applies to "customer limit orders" in "covered
securities." A covered security is defined as any reported
---------FOOTNOTES----------
-[153]- Section 240.11Ac1-4(b)(1)(i) and (b)(2)(i). The
Commission wants to clarify that references to a
specialist's or OTC market maker's bid or offer
include instances where the bid or offer is a
proprietary quote, as well as instances where the
bid or offer represents a customer limit order.
Further, if a market maker is not quoting publicly
(e.g., a market maker that does not meet the 1%
threshold of the Quote Rule), it still must
publish a quotation that displays the limit order,
or avail itself of one of the exceptions.
Moreover, the Commission notes that some commenters suggest
that the rule should require broker-dealers that are not
specialists or OTC market makers to immediately transmit
limit orders they receive to an entity or system that will
display the orders in a manner consistent with the rule.
See, e.g., CSE Letter; Madoff Letter; Whitcomb Letter.
Also, at least one commenter believes that institutional
firms trading in block size should be considered "OTC market
makers" for purposes of the rule and subject to the display
requirement. Amex Letter. See generally infra notes 191 -
193 and accompanying text. The fact that the Commission has
not adopted these suggestions as part of the Display Rule
does not relieve broker-dealers which receive such orders
from compliance with their obligation to obtain best
execution for those orders.
-[154]- Section 240.11Ac1-4(b)(1)(ii) and (b)(2)(ii).
==========================================START OF PAGE 67======
security and any other security for which transaction reports,
last sale data or quotation information is disseminated through
an automated quotation system that is sponsored by a registered
securities association. This definition is designed to encompass
all exchange-listed securities, Nasdaq National Market securities
and Nasdaq SmallCap securities.-[155]-
The Commission received several comments regarding the
application of the rule to Nasdaq securities. Some commenters
believe that the rule should not extend to all Nasdaq securities,
and that some measure of liquidity should be used to determine
which Nasdaq securities should be subject to the
rule.-[156]- For example, one commenter suggests limiting
the rule's application to the top 250 Nasdaq National Market
securities with the highest average daily trading volume over the
previous calendar quarter.-[157]- In contrast, another
commenter favors the inclusion of Nasdaq SmallCap securities
---------FOOTNOTES----------
-[155]- Securities listed on regional exchanges that do
not substantially meet NYSE or Amex original
listing criteria do not satisfy the definition of
"covered security." Such securities are not
"reported securities" as that term is defined, nor
do they meet the other elements of the definition
of covered security. OTC Bulletin Board ("OTCBB")
securities also do not satisfy the definition of
covered security. The Commission has determined
not to extend the display requirement to any of
those securities at the present time.
-[156]- See, e.g., Bear Stearns Letter; Lehman Letter;
Merrill Letter; NASD Letter; SIA Letter.
-[157]- SIA Letter.
==========================================START OF PAGE 68======
within the definition of "covered security."-[158]-
Further, at least one commenter suggests that the rule apply not
only to all Nasdaq securities, but also to OTCBB
securities.-[159]-
As noted above, the Commission believes that the Display
Rule should apply equally to exchange-traded as well as non-
exchange-traded securities. In addition, the Commission believes
it is appropriate to include all Nasdaq securities within the
definition of "covered security." The Commission believes that,
regardless of the current trading volume of a particular
security, the investors in any security can benefit from the
uniform display of customer buying and selling interest if all
quotations in that security are required to be firm. As noted
previously,-[160]- data analyzed by the Commission shows
that limit orders are used frequently for transactions in NYSE
securities with ADTVs under $100,000. On average, 63% of
customer orders in such securities are limit orders. Of those
limit orders, 30% narrowed the NYSE quote and 32% matched the
quote. This data indicates that the display requirement may lead
to increased customer trading interest in securities that are
currently thinly traded.-[161]-
---------FOOTNOTES----------
-[158]- PSE Letter.
-[159]- Ricker Letter.
-[160]- See supra notes 50 and 52.
-[161]- As stated previously, because dealers are not
required to register as OTC market makers in OTCBB
(continued...)
==========================================START OF PAGE 69======
The Commission reiterates that limit order display is not
solely an issue of improved transparency. The Display Rule will
improve the handling of customer orders across all markets and
increase the probability that a customer limit order will be
executed. Therefore, the Commission believes that a uniform
limit order display requirement is closely related to a broker-
dealer's ability to obtain best execution for limit orders.
The Commission recognizes, however, that the rule represents
a significant change for the OTC market. The Commission,
therefore, has determined to provide a phase-in period for
application of the rule to customer limit orders in Nasdaq
securities.-[162]- The Commission believes that the
phase-in period will allow the Commission to monitor the effects
of the rule on the most liquid Nasdaq securities first, while
ensuring that customer limit orders in all Nasdaq securities will
receive the benefits of the rule within one year of its adoption.
This schedule also will provide OTC market makers with time to
adjust their systems to comply with the rule's
requirements.-[163]-
Under the rule, a customer limit order includes any order to
---------FOOTNOTES----------
-[161]-(...continued)
securities and are not required to enter and
maintain continuous firm two-sided quotations in
OTCBB securities, the Commission does not believe
that the Display Rule should be extended to such
securities at this time.
-[162]- See description of the phase-in at section
III.A.3.d., infra.
-[163]- See, e.g., Amex Letter.
==========================================START OF PAGE 70======
buy or sell a covered security at a specified price not for the
account of a broker or dealer. Customer limit orders transmitted
from one broker-dealer to another for execution are included in
the definition. Although some commenters believe that the rule
should be extended to orders for the account of a broker or
dealer, the Commission does not believe such extension is
appropriate at this time. The Commission acknowledges that the
display of all limit orders, including those of a broker or
dealer, would further enhance transparency.-[164]-
Requiring the display of broker-dealer limit orders, however,
would be a significant extension of the rule that could change
its impact on market maker participation and increase its
operational burdens. Therefore, the Commission believes that the
effects of the rule should be observed, and additional comment
should be solicited, before the rule is expanded.-[165]-
b. Size
As noted above, some commenters expressed concern regarding
the requirement that specialists and OTC market makers display
---------FOOTNOTES----------
-[164]- The Commission also is sensitive to the fact that
providing suitable opportunities for broker-
dealers, including options market makers, to lay
off risk is an important component of overall
market liquidity and efficiency. See Manning II,
supra note 24.
-[165]- The Commission notes that other actions recently
taken by the Commission address certain anti-
competitive behavior in the Nasdaq market that
heretofore may have negatively impacted the
ability of some broker-dealers, including options
market makers, to efficiently perform their market
making function. See 21(a) Report, supra note 28.
==========================================START OF PAGE 71======
the full size of a customer limit order. These commenters
suggest that the rule only require the display of representative
size.-[166]- They argue that the use of representative
size would preserve the ability of a specialist or OTC market
maker to exercise some discretion in determining the best
execution of the order.-[167]-
Other commenters, however, believe that the full size of a
customer limit order should be required to be
displayed.-[168]- Such commenters argue that the display
of full size is an important element in the Commission's effort
to improve transparency and, therefore, no dealer discretion
should be permitted unless a customer expressly requests that its
order not be displayed, or expressly grants discretion, pursuant
to the Display Rule.-[169]-
The Commission continues to believe that the display of full
size is important to improved transparency. The display of full
size will provide the most accurate picture of the depth of the
---------FOOTNOTES----------
-[166]- See, e.g., BSE Letter; CSE Letter; Madoff Letter;
NASD Letter; NYSE Letter; PSE Letter; SIA Letter;
Specialists Assoc. Letter; see also LJR Letter
(questioning whether the display of size, at least
with respect to institutional orders, would be
consistent with best execution obligations).
-[167]- See, e.g., Madoff Letter; NASD Letter; NYSE
Letter; SIA Letter; Specialists Assoc. Letter.
-[168]- See, e.g., Amex Letter; CHX Letter; D.E. Shaw
Letter.
-[169]- See, e.g., Amex Letter; CHX Letter; D.E. Shaw
Letter; ICI Letter.
==========================================START OF PAGE 72======
market at a particular price.-[170]- The Commission
believes that size, as well as price, is a factor in attracting
order flow and that the display of full size increases the
likelihood that a limit order will be executed. The Commission,
however, understands that there may be instances where a customer
would not want its order displayed, or does not want the full
size of its order displayed. The Display Rule, therefore, still
contains an exception for a customer that decides to rely on the
discretion of a broker-dealer rather than to take advantage of
the display requirement for its limit order.-[171]- The
Display Rule also permits a customer to state explicitly what
---------FOOTNOTES----------
-[170]- A few commenters believe that all customer limit
orders should be displayed, including the size of
those orders that equal the specialist's or OTC
market maker's bid or offer, but are not equal to
the NBBO. See, e.g., CHX Letter; Letter from
Edward J. Johnsen, Vice President and Counsel,
Morgan Stanley & Co., to Jonathan G. Katz,
Secretary, SEC, dated January 16, 1996 ("Morgan
Stanley Letter"); Peake Letter; Weaver Letter.
The Commission believes, however, that the burden
associated with the commenters' suggestion would
outweigh the corresponding benefit to market
transparency. Of course, the rule represents a
floor, rather than a ceiling. An exchange,
association, or broker-dealer may determine to
adopt more stringent display requirements.
Requiring display of size when the limit order is away from
the NBBO and equals the market maker's or specialist's quote
would provide some additional market information but also
would require market makers not quoting at the NBBO to
change their quote size on an ongoing basis. Although some
market makers or specialists may choose to do so to be
prepared if their quotation becomes the NBBO, on the whole
the Commission believes the increased transparency that
would result from this updating would not outweigh the
burdens imposed by a display requirement.
-[171]- Section 240.11Ac1-4(c)(2).
==========================================START OF PAGE 73======
portion, if any, the customer wants displayed.-[172]-
Furthermore, the Display Rule contains other exceptions to the
display requirement that will ease any potential operational
burdens associated with the display of full size.-[173]-
The following example illustrates the application of the
Display Rule where a customer limit order improves the price of a
specialist's or market maker's quote. Assume that a market maker
covered by the rule is quoting 10 - 10 1/2 (2,000 x 2,000) when
it receives a customer limit order in a covered security to buy
4,000 shares at 10 1/4. Under the rule, the market maker must
change the price and size associated with its quote to 10 1/4 -
10 1/2 (4,000 x 2,000). If this new quote represents the NBBO,
the Display Rule would require the market maker to increase the
size associated with the quote upon the receipt of additional
customer limit orders. For example, if the market maker
subsequently accepts another customer limit order to buy 4,000
shares at 10 1/4, the market maker must change its quote to 10
1/4 - 10 1/2 (8,000 x 2,000).
---------FOOTNOTES----------
-[172]- Id.
-[173]- As noted above, a specialist or OTC market maker
has the ability to execute a customer limit order
upon receipt; transmit the order to another
exchange member or OTC market maker that will
display the limit order in accordance with the
rule; or transmit the order to an exchange or
association sponsored system pursuant to the rule.
Additionally, a specialist or OTC market maker may
transmit an order to an ECN that provides for
public display of limit orders and provides access
to these orders. Moreover, the rule contains an
exception to the display requirement for certain
orders of de minimis size.
==========================================START OF PAGE 74======
The rule as adopted contains a de minimis standard
applicable in situations where a customer limit order equals a
specialist's or market maker's displayed price and that price is
equal to the NBBO. One commenter states that the use of
representative size would eliminate the Commission's need to rely
on a de minimis standard.-[174]- Another commenter
believes that the rationale underlying the de minimis standard
demonstrates that the display of size does not benefit public
customers.-[175]- Some commenters also believe that the
de minimis standard should be clarified or even
eliminated.-[176]-
The Commission proposed the de minimis standard to strike a
balance between the benefits of increased transparency and
operational burdens that might arise under the display
requirement in displaying limit orders irrespective of size. The
de minimis standard was intended to reduce the burdens of
displaying the smallest of limit orders where the frequent
updating of the quote for smaller orders would not result in
significant improvements in quotation size. The Commission
believes that the size of a customer limit order should be
considered de minimis if it is less than or equal to 10% of the
displayed size associated with a specialist's or OTC market
---------FOOTNOTES----------
-[174]- CSE Letter.
-[175]- Dean Witter Letter.
-[176]- See, e.g., Amex Letter; CHX Letter; Schwab Letter.
==========================================START OF PAGE 75======
maker's bid or offer.-[177]-
The Commission believes that this de minimis standard will
ease potential operational burdens associated with the display of
additional size in a specialist's or OTC market maker's quote.
The following example illustrates the application of the de
minimis standard.
Assume a market maker's quote is 10 - 10 1/2 (1,000 x
1,000), and the NBBO is 10 - 10 1/4 when the market maker
receives a customer limit order to buy 2,000 shares at 10. Under
the rule, the market maker is obligated to change the size of its
quote immediately to 10 - 10 1/2 (3,000 x 1,000).-[178]-
In this case, the 2,000 share order size is more than de minimis
in relation to the size associated with the market maker's quote.
If the limit order was for 100 shares, however, the market maker
would not be required to change its quotation size because the
order is de minimis in relation to its quote.-[179]-
---------FOOTNOTES----------
-[177]- Any SRO may set more stringent display
requirements through its own rules.
-[178]- If the original 1,000 shares displayed represents
the market maker's proprietary quote and,
consistent with Rule 11Ac1-1, the market maker no
longer wishes to trade for its own account at 10,
the market maker may quote at 10 - 10 1/2 (2,000 x
1,000).
-[179]- The Commission stresses that all other orders
previously considered de minimis and not displayed
must be added to the order under consideration for
purposes of the de minimis calculation.
Therefore, in the case of a 100 share limit order
to buy at 10, where the market maker had a
previous 100 share limit order to buy at 10 that
was not displayed pursuant to the de minimis
(continued...)
==========================================START OF PAGE 76======
Alternatively, the market maker could voluntarily display the
additional 100 shares.
c. Exceptions
The rule requires the "immediate" display of certain
customer limit orders. To satisfy this requirement, a specialist
or OTC market maker must display the limit order immediately upon
receipt unless there exists an applicable exception to the
display requirement. Some commenters have asked for
clarification of the "immediate" display
requirement.-[180]- The Commission is mindful that some
measure of time is needed for specialists or market makers to
display limit orders in the quote. Assuming that a specialist or
OTC market maker does not rely on one of the exceptions to the
Display Rule, however, such specialist or OTC market maker must
display the order as soon as is practicable after receipt which,
---------FOOTNOTES----------
-[179]-(...continued)
standard, both orders must be considered together
for purposes of making the de minimis calculation.
Because 200 shares is more than 10% of the
displayed size of 1,000, the market maker must
include the 200 shares in its quote.
The Commission notes that if an OTC market maker chooses not
to display a de minimis limit order, the NASD's
interpretation regarding limit orders would prohibit the
market maker from trading ahead of the limit order. See
Manning I & II, supra note 24. In addition, the NASD has
indicated that market makers must establish and consistently
follow policies regarding the priority in which limit orders
received from customers, which would include de minimis
orders, will be executed. See Special NASD Notice to
Members 95-43 (June 5, 1995).
-[180]- See, e.g., Amex Letter; D.E. Shaw Letter; NYSE
Letter; PSE Letter.
==========================================START OF PAGE 77======
under normal market conditions, would require display no later
than 30 seconds after receipt.-[181]-
There are seven exceptions to the general requirements of
the rule. The first exception applies to any customer limit
order that is executed upon receipt of the order.-[182]-
If the order is executed upon receipt, then no duty arises under
the rule.
The second exception applies to any limit order that is
placed by a customer who expressly requests that the order not be
displayed.-[183]- This request may take place on an order
by order basis, or may be agreed to prospectively. Most
commenters that addressed the issue were in favor of the
exception.-[184]- The Commission included this exception
because there could be instances in which a customer prefers to
exclude its order from public display. For example, a customer
with a large limit order could wish to let its broker work the
---------FOOTNOTES----------
-[181]- The Commission stresses that specialists and OTC
market makers still are under an obligation to
protect the customer limit order even during the
time the limit order is not displayed. See, e.g.,
Manning I & II, supra note 24 (prohibiting trading
ahead of customer limit orders). It should also
be noted that this standard would supersede SRO
rules that are less stringent with regard to the
time in which limit orders are to be displayed.
Those rules that impose more stringent standards
may continue to apply.
-[182]- Section 240.11Ac1-4(c)(1).
-[183]- Section 240.11Ac1-4(c)(2).
-[184]- But see, e.g., Madoff Letter; Morgan Stanley
Letter.
==========================================START OF PAGE 78======
order rather than display the entire order. This exception gives
the customer the right to decide if the order should be displayed
in its entirety, in part, or not at all.-[185]- The
Commission notes that under this exception, a customer may leave
the decision to display an order to the discretion of a broker-
dealer. Therefore, rather than instructing a broker-dealer not
to display an order, a customer, consistent with this exception,
may instruct the broker-dealer to use its discretion in
determining whether to display the order. Although allowing some
orders to not be displayed or to be displayed partially in the
system reduces transparency, the Commission believes this
exception is appropriate to give investors flexibility in
deciding how their orders should be handled.
The exception to the rule requires a customer to expressly
request that an order not be displayed.-[186]- A customer
request that an order be placed in a particular non-public
trading system would not, by itself, be deemed to be a non-
---------FOOTNOTES----------
-[185]- Any portion of a customer limit order that is not
displayed pursuant to this exception shall not be
included in the calculation for determining
whether any other limit order is de minimis. See
supra note 179.
-[186]- At least one commenter believes that documentation
of such customer requests should be required. CHX
Letter. Although the Commission does not believe
it necessary to mandate a particular method of
record keeping, the Commission expects the
compliance departments of individual firms to
discharge their responsibilities in such a manner
as to allow adequate supervision of compliance
with the customer's request not to display or to
display pursuant to discretionary authority
provided by the customer.
==========================================START OF PAGE 79======
display request. The Commission expects that most retail
customers will want their limit orders displayed pursuant to the
rule. Thus, the Commission has written the rule to require
specialists and OTC market makers to assume that retail customers
wish to have their orders displayed unless the customer
specifically requests that the order not be displayed.
The exception also permits any customer to negotiate with
its broker-dealer an individual agreement regarding the display
of its limit orders either on an order-by-order basis or
prospectively. Standardized disclaimers or contractual language
in broker-dealer new account agreements, however, would not be
deemed to be an individual request by a customer that its order
or orders not be displayed.
The third exception applies to odd-lot orders.-[187]-
The rule does not require the display of an order for less than a
unit of trading as established by the rules of the exchange or
association. In the event that a round-lot limit order
represented in the quote is partially filled and, as a result,
the remainder of the order would then be deemed an odd-lot order,
the remainder of the order may be treated as an odd-lot for
purposes of this exception. For example, assume a market maker
is quoting at the NBBO (10 1/4 -10 3/8 (200 x 1000)) and is
representing a 200 share customer limit order to buy when a
market order to sell 150 shares is received. Upon execution of
150 shares of the 200 share customer limit order, the market
---------FOOTNOTES----------
-[187]- Section 240.11Ac1-4(c)(3).
==========================================START OF PAGE 80======
maker is not required to display the remaining 50 shares of the
order at 10 1/4.-[188]-
The fourth exception applies to block size
orders.-[189]- Orders of at least 10,000 shares or for a
quantity of stock having a market value of at least $200,000 need
not be displayed in accordance with the rule, unless the customer
so requests.-[190]- The Commission recognizes that the
display of block size orders would add to market transparency.
In practice, however, the handling of block size orders differs
from other orders. For example, in the OTC market, market makers
often negotiate terms and conditions with respect to the handling
of block size orders, and display of block size orders may impact
market maker quotations in a security more than would smaller
---------FOOTNOTES----------
-[188]- The market maker still will have best execution
obligations with respect to the remaining odd-lot
portion of the customer limit order.
-[189]- Section 240.11Ac1-4(c)(4).
-[190]- This block definition is consistent with the
current definition used in NYSE Rule 127.10. Some
commenters, however, suggest that the parameters
for such orders be increased or made flexible
depending on the liquidity of a particular
security. See, e.g., D.E. Shaw Letter; PSE
Letter; Schwab Letter. Still others believe that
there should be no exception for orders of block
size. Instead, these commenters want such orders
to be included within the scope of the rule so as
to add to market transparency. See, e.g., Amex
Letter; ICI Letter; Lehman Letter; Peake Letter;
Ricker Letter. One commenter suggests the use of
a "block indicator" to give a specialist or OTC
market maker the option of displaying the full
size of the order or using the indicator to
identify the quote as representing a block size
order. Lehman Letter.
==========================================START OF PAGE 81======
limit orders.-[191]- Further, one of the major objectives
in proposing the Display Rule was to improve the handling and
execution opportunities afforded to customers that lack the power
to negotiate better terms. Because most investors that trade in
block size have such power, the Commission has chosen not to
mandate the display of block size orders, unless the customer so
requests.-[192]- The Commission is satisfied that the
current definition strikes an appropriate regulatory balance by
requiring a presumption in favor of display for those orders
requiring enhanced protection, while not extending the
presumption to those orders less likely to need such protection.
Of course, the Commission may reevaluate its treatment of block
size orders at a later date.
As proposed, the fifth exception would have applied to a
limit order that is delivered immediately to an exchange or
association sponsored system that displays limit orders and
complies with the requirements of the rule with respect to that
order.-[193]- This exception did not relieve a specialist
---------FOOTNOTES----------
-[191]- See, e.g., Manning II, supra note 24.
-[192]- Customers placing block orders, however, may
request that the order be displayed in accordance
with the requirements of the rule; a specialist or
OTC market maker that accepts the order will be
obligated to honor such a request. Section
240.11Ac1-4(c)(4). The Commission expects that
adequate procedures will be developed to ensure
compliance with a customer request. See supra note
186.
-[193]- Section 240.11Ac1-4(c)(5). A facility would not
be deemed to comply with the requirements of the
(continued...)
==========================================START OF PAGE 82======
or OTC market maker from its display obligation for orders it
received through exchange or association facilities, unless the
facility itself displayed the order.-[194]-
In the Proposing Release, the Commission requested comment
on whether to extend this exception from display to instances
where customer limit orders are sent to ECNs or PTSs by a
specialist or OTC market maker.-[195]- As discussed below
in connection with the amendments to the Quote Rule, the
Commission is amending the Quote Rule to require specialists and
---------FOOTNOTES----------
-[193]-(...continued)
Display Rule if the highest priced buy orders and
lowest priced sell orders entered by a specialist
or OTC market maker in the facility for a
particular security were not included in
calculating the best bid and offer for the market
and incorporated in the consolidated quote.
-[194]- One commenter argues that the exception permits
specialists and OTC market makers to become "fair
weather dealers," effectively allowing them to
selectively withdraw from the national market
system, which creates a misleading picture of
liquidity. Madoff Letter. The Commission
believes, however, that the exception provides a
specialist or OTC market maker with an appropriate
amount of discretion in handling a customer limit
order while ensuring that orders at the best price
are displayed to the marketplace.
-[195]- See, e.g., Letter from James Lynch, General
Counsel, ITG, Inc., to Jonathan G. Katz,
Secretary, SEC, dated, January 15, 1996 ("POSIT
Letter") (not supporting the extension of the
exception); PSE Letter (extension of exception
should be contingent on access provided by ECNs);
Whitcomb Letter (doubtful that exception could be
extended in today's environment); see also Madoff
Letter (market makers and specialists should be
able to represent a portion of the size of a
customer limit order in other markets or ECNs, but
the best price and some size should be reflected
in their quote).
==========================================START OF PAGE 83======
OTC market makers to include priced orders they enter into ECNs
in the bids and offers they communicate to their exchange or
association for reflection in their published quotations, when
such orders improve their published quotations.-[196]- In
recognition of the concerns raised by commenters, the Commission
also has included an alternative to the amendment designed to
preserve the anonymity of specialists and OTC market makers that
is currently provided by certain ECNs, while still publicizing in
the public quotation stream better prices entered into ECNs. The
ECN display alternative in the Quote Rule is available only if
the ECN provides for public dissemination of the price and full
size of the orders entered by specialists and OTC market makers
to an exchange or association and provides access to other
broker-dealers to trade at those prices which is equivalent to
that provided in the market where the prices are
disseminated.-[197]-
The Commission believes that ECNs that provide their best
specialist and market maker prices to the public quotation system
and provide ready access to their prices can provide an effective
---------FOOTNOTES----------
-[196]- See Section 240.11Ac1-1(c)(5)(i)(A); see also
Amendments to the Quote Rule discussion at section
III.B.2.c.ii., infra.
-[197]- As discussed, the Commission expects the SROs to
work expeditiously with ECNs that wish to avail
themselves of this alternative, and is prepared to
act if necessary to ensure the effectiveness of
the ECN display alternative, prior to the
effective date of the Quote Rule amendments. See
Introduction and Summary, supra; see also Section
240.11Ac1-1(c)(5)(ii); Amendments to the Quote
Rule discussion at section III.B.2.c.iii., infra.
==========================================START OF PAGE 84======
means for specialists and OTC market makers to ensure that
customer limit orders are handled in a manner consistent with the
Display Rule. In view of the ECN display alternative in the
Quote Rule, the Commission believes it is appropriate to extend
the exception in the Display Rule to orders entered into ECNs
that comply with the Quote Rule alternative.-[198]-
Accordingly, a specialist or OTC market maker that delivers a
customer limit order to an ECN will be deemed to have satisfied
its display obligation with regard to that order if the ECN
complies with the requirements of the new alternative in the
Quote Rule.-[199]- The proposed exception for limit
orders entered into exchange or association sponsored systems
contemplated that such orders would be transparent and
accessible. Therefore, expanding the exception to include the
use of ECNs that provide for the requisite transparency and
accessibility is consistent with the rule as proposed.
The Commission notes that this exception to the Display Rule
maintains the benefits, including increased transparency,
---------FOOTNOTES----------
-[198]- See Amendments to the Quote Rule discussion at
section III.B.2.c.i., infra, for a description of
the ECN definition; see also Section 240.11Ac1-
1(a)(8); Section 240.11Ac1-4(a)(8).
-[199]- Section 240.11Ac1-4(c)(5). See also, Amendments
to the Quote Rule discussion on accessibility at
section III.B.2.c.iii., infra. Additionally, a
specialist or OTC market maker may be relieved of
its display obligation if it delivers the customer
limit order to an exchange or association
sponsored system that complies with the new
alternative in the Quote Rule. Section 240.11Ac1-
4(c)(5).
==========================================START OF PAGE 85======
provided to customer limit orders under the rule. The exception
ensures that customer limit orders will have equivalent public
disclosure whether they are sent to an ECN that complies with the
alternative or displayed directly in a specialist's or OTC market
maker's quote.-[200]-
The sixth exception applies to a limit order that is
delivered to another exchange member or OTC market maker that
complies with the display requirements of the rule with respect
to that order.-[201]- For example, a market maker that
receives a limit order subject to the display requirement under
the rule may immediately send the order to another market maker
in the security if the other market maker will display the order
in accordance with this rule.-[202]-
The seventh exception applies to "all-or-none limit orders."
An "all-or-none limit order" is an order accompanied by the
customer's instruction that the order is to be executed in its
---------FOOTNOTES----------
-[200]- An OTC market maker or specialist choosing to
enter customer limit orders for display through an
ECN must still evaluate whether the customer order
is likely to obtain best execution through display
in that ECN. See section III.C.2., infra.
-[201]- Section 240.11Ac1-4(c)(6).
-[202]- One commenter believes that the rule should
require a specialist or OTC market maker to obtain
assurances that a customer's limit order will be
displayed in accordance with the rule before such
an order is sent. MJT Letter. But see PSE
Letter; Salomon Letter. As noted earlier, the
Commission believes that it is best left to a
firm's compliance department to decide on the
necessary assurances that the order will be
displayed in conformance with the rule.
==========================================START OF PAGE 86======
entirety or not at all.-[203]- Although this exception
was not included in the proposed rule, the Commission believes
that exempting all-or-none limit orders is necessary to avoid
operational difficulties regarding partial executions at the
public quote.-[204]- In this regard, all-or-none limit
orders typically are not displayed in the exchange markets
today.-[205]- The Commission believes, therefore, that
this exception is consistent with the goals and objectives of the
Display Rule.
Finally, a new provision has been included that enables the
Commission to exempt, conditionally or unconditionally, any
transactions that it may determine are not encompassed within the
purposes of the Display Rule. The Commission believes that this
exemptive authority provides flexibility in applying the Display
Rule.-[206]-
d. Effective Date and Phase-In
The Display Rule will become effective on [insert date 120
days from the date of publication in the Federal Register]. As
of this date, the Display Rule will apply to exchange-traded
securities. Moreover, this date will mark the beginning of the
---------FOOTNOTES----------
-[203]- See, e.g., NYSE Rule 13.
-[204]- For example, if an all or none order to buy 1,000
shares at 10 1/4 were displayed in the quote and
represented the NBBO, a subsequent market order to
sell 500 shares could not be matched against the
all or none order.
-[205]- See, e.g., NYSE Rule 13.
-[206]- Section 240.11Ac1-4(d).
==========================================START OF PAGE 87======
first phase-in for Nasdaq securities. As of this date, the
Display Rule will apply to the 1,000 Nasdaq securities with the
highest average daily trading volume in the previous quarter.
The second phase-in date will be on March 28, 1997. From
this date forward, the Display Rule will apply to the next 1,500
Nasdaq securities with the highest average daily trading volume
over the previous quarter.-[207]-
The third phase-in date will be on June 30, 1997. From this
date forward, the Display Rule will apply to the next 2,000
Nasdaq securities with the highest average daily trading volume
over the previous quarter.
The final phase-in date will be on August 28, 1997. From
this date forward, the Display Rule will apply to all remaining
Nasdaq securities.
Although the Commission believes that the Display Rule
should apply equally to exchange-traded and non-exchange-traded
securities, the Commission understands that the Display Rule will
more significantly impact current order handling procedures for
Nasdaq securities in light of existing practices in that market.
The phase-in period will allow the Commission to monitor the
---------FOOTNOTES----------
-[207]- Any security already covered by the rule will not
be included as part of the calculation of the
securities to be included in any subsequent group.
Therefore, if a security is included as one of the
1,000 securities in the first group, such security
will not be counted as one of the next 1,500
securities in the second group (even if such
security's average daily trading volume over the
previous calendar quarter would otherwise place it
in the second group).
==========================================START OF PAGE 88======
effects of the Display Rule on successive groups of Nasdaq
securities while ensuring that all covered securities receive the
benefits of the display requirement within one year of the
Display Rule's adoption.
B. Amendments to the Quote Rule
1. Background
Public quotation reporting for equity securities is governed
by the Commission's Quote Rule,-[208]- as well as by
exchange and NASD rules. These rules require registered
exchanges and securities associations to file quotation reporting
plans with the Commission that provide for the collection and
transmission of quotation information on a real-time basis for
securities covered by the Quote Rule.-[209]- Market
makers and exchange specialists communicate their quotes to the
NASD or to an exchange pursuant to these plans and the NASD and
exchanges in turn make this information available to vendors for
dissemination to the public.-[210]-
The Quote Rule requires the collection and public
dissemination of the best bid, best offer, and size for each
---------FOOTNOTES----------
-[208]- 17 CFR 240.11Ac1-1. See also Securities Exchange
Act Release No. 14415 (January 26, 1978), 43 FR
4342 (February 1, 1978) ("Quote Rule Adopting
Release").
-[209]- Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1)
(dissemination requirements for exchanges and
associations).
-[210]- Rule 11Ac1-2, 17 CFR 240.11Ac1-2 ("Vendor Display
Rule") requires vendors of market information to
display quotation information in a non-
discriminatory manner.
==========================================START OF PAGE 89======
market quoting any security covered by the Quote Rule, as well as
the consolidation of those markets' quotations and public
dissemination of the national "consolidated" best bid and offer
("NBBO").-[211]- These quotations must be firm, and a
market maker or specialist generally is obligated to execute an
order at a price at least as favorable as its published bid or
---------FOOTNOTES----------
-[211]- Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1).
Pursuant to the Quote Rule and the Joint
Consolidated Quotation Plan ("CQS Plan"), the
inside quotations collected and calculated by the
exchanges and Nasdaq for exchange-listed
securities are consolidated and disseminated to
vendors by SIAC, the exclusive processor for
consolidated quotations in listed securities.
Similarly, Nasdaq is the exclusive processor for
quotations in Nasdaq National Market ("Nasdaq
NMS") securities. Nasdaq collects and
consolidates inside quotations furnished by OTC
market makers and by exchanges pursuant to a Joint
Self-Regulatory Organization Plan that provides
for exchange trading of Nasdaq securities. Nasdaq
then disseminates to vendors the inside bid and
offer in Nasdaq NMS securities, and disseminates
to various subscribers more specific information
concerning the individual market maker and
exchange quotes in each Nasdaq security. The
terms "consolidated quote" and "publicly available
quotation," when used with respect to information
disseminated by exchanges and Nasdaq via their
exclusive processors, refer to the quotes that
SIAC or Nasdaq furnishes to vendors for
dissemination to the public. The terms "public
quote" or "publicly available quote," when used
with respect to a specialist or market maker,
refer to the bid and offer that the specialist or
market maker has furnished to its exchange or
association for inclusion in the consolidated
quote. The term "public quotation system" refers
to this entire structure through which SROs
collect quotations from market participants, and
the exclusive processors collect, process, and
disseminate those quotations to vendors.
==========================================START OF PAGE 90======
offer up to the size of its published bid or offer.-[212]-
Broker-dealers covered by the Quote Rule, including dealers
trading listed securities in the OTC market (i.e., third market
makers), must supply quotations to their exchange or association
for dissemination to quotation vendors.
The 1975 Amendments identified the need for a prompt,
accurate and reliable central quotation reporting
system.-[213]- The Quote Rule, in particular, was
designed to facilitate the NMS by requiring specialists and
market makers publishing quotes to provide these quotes to a
central system so they could be made available to the public.
Congress considered the public availability of quotation
information to be critical to fair and competitive markets
because published quotations provide investors, their brokers,
and other market participants with essential information about
the condition of the market. This information assists investors
in making investment decisions and in finding the best market for
a security, while making it possible for investors to evaluate
the quality of their executions.
Since the 1975 Amendments and the adoption of the Quote
Rule, there have been dramatic changes in the markets and the
---------FOOTNOTES----------
-[212]- Rule 11Ac1-1(c)(1), 17 CFR 240.11Ac1-1(c)(1).
This is referred to as the broker-dealer's
"firmness" requirement.
-[213]- Senate Report, supra note 31. Cf. H.R.Rep. No.
229, 94th Cong., 1st Sess. 29 (1975)("Conference
Report")(noting that the conference committee
adopted the Senate's provisions on the NMS with
minor revisions).
==========================================START OF PAGE 91======
technologies used by market participants. To ensure that the
Quote Rule keeps pace with the evolution of the securities
markets and continues to ensure the public availability of
accurate, reliable, and comprehensive quotation information, the
Commission has determined that certain amendments to the Quote
Rule are necessary and appropriate in furtherance of the
objectives of the Exchange Act.
The Commission proposed an amendment to the Quote Rule to
require specialists and market makers to reflect in their public
quotes any better priced orders they place in certain systems
that are not currently integrated into the NMS. In particular,
the ECN amendment is intended to incorporate within the public
quotes any better priced orders broadly displayed by market
makers and specialists through ECNs. This amendment is being
adopted with modifications to address concerns raised by some
commenters. Specifically, in order to provide specialists and
market makers with an alternative method to meet the ECN display
requirement, the Commission is adopting an alternative suggested
in the proposing release that deems a specialist or market maker
in compliance with the ECN amendment if the ECN provides the best
prices entered into the ECN by market makers or specialists for
each covered security to an exchange or association for inclusion
in the public quotation system and provides access to those
prices equivalent to the access currently available to other
quotes published by the exchange or association. In addition,
the Commission is amending the Quote Rule to expand the
==========================================START OF PAGE 92======
categories of securities covered by certain existing Quote Rule
provisions. The quotation requirements that previously applied
to substantial specialists and market makers in only certain
exchange-listed securities now will apply to substantial
specialists and market makers in all exchange-listed securities.
Further, certain Quote Rule provisions that previously applied to
market makers electing to quote particular Nasdaq securities now
will apply to market makers electing to quote any Nasdaq
security. The Commission is adopting these amendments
substantially as proposed, along with minor technical amendments
to the Quote Rule that are discussed more fully below.
2. Public Dissemination of Market Maker and
Specialist Prices in ECNs
a. Basis for the ECN amendment
Over 20 years ago, the Commission noted that an essential
purpose for the establishment of the NMS was "to make information
on prices, volume, and quotes for securities in all markets
available to all investors, so that buyers and sellers of
securities, wherever located, can make informed investment
decisions and not pay more than the lowest price at which someone
is willing to sell, or not sell for less than the highest price a
buyer is prepared to offer."-[214]- At the time, the lack
---------FOOTNOTES----------
-[214]- Securities and Exchange Commission, Statement of
the Securities and Exchange Commission on the
Future Structure of the Securities Markets
(February 2, 1972) ("Future Structure Statement")
at 9-10, 37 FR 5286, 5287 (February 4,
1972)(emphasis added). See also Securities and
Exchange Commission, Policy Statement of the
(continued...)
==========================================START OF PAGE 93======
of consolidated quote information made it difficult to ascertain
the different prices that were often available in the various
markets for a particular security. This lack of transparency as
to the best prices among competing markets was widely recognized
as preventing investors and their brokers from ascertaining
accurate trading interest for a security and obtaining the best
prices for their orders.-[215]- To address these
concerns, Congress directed the Commission to facilitate the
creation of a national market system that would link the various
markets trading a security. The price and quotation transparency
resulting from the Commission's ensuing NMS initiatives has
produced extremely liquid, successful, and, in most cases,
competitive markets.
As discussed in the Proposing Release, the Commission for
many years has been concerned that the development of so-called
"hidden markets," in which a market maker or specialist publishes
quotations at prices superior to the quotation information it
disseminates on a general basis, impedes these NMS
objectives.-[216]- Over the course of the last decade,
certain trading systems that allow market makers and specialists
to widely disseminate significant trading interest to certain
---------FOOTNOTES----------
-[214]-(...continued)
Securities and Exchange Commission on the
Structure of a Central Market System (1973) at 25-
28.
-[215]- See Senate Report, supra note 31.
-[216]- See Proposing Release at 4.
==========================================START OF PAGE 94======
market participants without making this trading interest
available to the public market at large have become significant
markets in their own right. Although offering benefits to some
market participants, widespread participation in these hidden
markets has reduced the completeness and value of publicly
available quotations contrary to the purposes of the NMS.
Because these systems are not registered as exchanges or
associations, they are currently not required to integrate into
the public quote the prices at which their subscribers, including
subscribing market makers and specialists, are willing to
trade.-[217]- The use of these systems by market makers
and specialists to quote prices not incorporated into the NMS has
resulted in fragmented and incomplete dissemination of quotation
information.
Certain markets, in particular ECNs that allow
subscribers-[218]- to enter priced orders that are widely
---------FOOTNOTES----------
-[217]- Certain ECNs may be registered with the Commission
as broker-dealers and indeed perform various
brokerage functions. Nevertheless, the Commission
recognizes that in providing a mechanism by which
system subscribers can (1) broadcast prices to
other system subscribers and (2) trade with one
another at those prices, these systems also
function as securities markets.
-[218]- ECN subscribers may include institutional
investors, broker-dealers, and market makers.
ECNs provide their services to subscribers for a
fee or commission equivalent. Some ECNs (such as
SelectNet) have been available only to broker-
dealers and not to investors generally.
==========================================START OF PAGE 95======
disseminated to third parties-[219]- and permit such
orders to be executed in whole or in part through the system,
communicate orders that are closely analogous to quotations.
These ECNs, in effect, allow market makers and specialists to
display different prices to different market participants.
Although these ECNs can facilitate the execution of their
subscribers' orders and allow institutions to participate
directly in price discovery, the display of better prices
privately in ECNs reduces the reliability and completeness of
consolidated quotations, the accuracy of which continues to be an
essential element of the NMS. These private markets have
resulted in fragmented quotations and a reduction in the
reliability of public quotations as an accurate indicator of
market makers' and specialists' best prices, the identical
situation that prompted Congress to adopt the NMS amendments in
1975. The unavailability of full market maker and specialist
quotation information prevents investors and their brokers from
ascertaining the true trading interest for a security, and
obtaining the best price for market orders, and prevents
investors from monitoring the efforts of their brokerage firms to
obtain best execution for their orders.
The Commission's analysis of the trading activity in these
ECNs has produced clear evidence of the existence of a two-tiered
---------FOOTNOTES----------
-[219]- "Third parties" in this context refers to
subscribers or any other entities (such as
customers of subscribers) that receive information
from the ECN concerning any priced order entered
into the ECN by another subscriber.
==========================================START OF PAGE 96======
market in which market makers routinely trade at one price with
retail customers and at better prices with ECN
subscribers.-[220]- For example, analysis of trading
activity in the two most significant ECNs in the Nasdaq market,
Instinet and SelectNet, reveals that approximately 85% of the
bids and offers displayed by market makers in Instinet and 90% of
the bids and offers displayed on SelectNet were at better prices
than those posted publicly on Nasdaq.-[221]- Furthermore,
approximately 77% of the trades executed on Instinet and 60% of
the trades executed on SelectNet occurred at prices between the
Nasdaq best bid and offer. Market makers participated on at
least one side of approximately 90% of the trades in these ECNs.
The trading activity in Instinet, which comprised approximately
17% of trades and 15% of the volume in Nasdaq securities,
represents a significant portion of the overall market for Nasdaq
securities.-[222]-
---------FOOTNOTES----------
-[220]- For example, a market maker with a public offer
constituting the best public offer of 20 3/4 might
offer to sell shares in an ECN at 20 5/8. If the
market maker did not change its public offer to
reflect this improved selling price, public
customers buying from the market maker would pay
the higher price of 20 3/4 for the security
because they do not have access to the market
maker's price in the ECN.
-[221]- The Commission's analysis is based on Instinet and
SelectNet data for the months April through June
1994. See 21(a) Report at notes 48-52 and
accompanying text and Appendix at notes 18-28 and
accompanying text.
-[222]- More trading volume now occurs on Instinet than on
any of the organized U.S. stock markets other than
(continued...)
==========================================START OF PAGE 97======
The Commission's recent investigation into various trading
practices in Nasdaq stocks revealed that the existence of this
two-tiered market facilitated the maintenance of wide spreads on
Nasdaq. As discussed in the 21(a) Report, Nasdaq market makers
engaged in a widespread course of conduct that resulted in
artificially wide spreads in a large percentage of Nasdaq stocks.
The maintenance of wide spreads was made possible at least in
part by the fact that ECNs like Instinet and SelectNet did not
affect the prices at which market makers traded with the general
public, thus allowing market makers to attract trading interest
at prices inside the spread without adjusting their Nasdaq
quotes. Integrating the better prices market makers quote in
ECNs should significantly limit the types of uncompetitive
practices identified in the investigation without limiting the
usefulness of these systems as efficient alternative mechanisms
for negotiating transactions.
The Commission firmly believes that all investors should
have an opportunity to have their orders filled at the best
prices made available by market makers. Consistent with
Congress's goals for a NMS, these opportunities must be made
available to all customers, not just those customers who, due to
---------FOOTNOTES----------
-[222]-(...continued)
the NYSE and Nasdaq. In 1994, trading volume on
Instinet totalled approximately 10.8 billion
shares with an approximate dollar volume of $282
billion. In comparison, Nasdaq traded
approximately 74 billion shares, with an
approximate dollar volume of $1,449 billion. Id.
at note 50 and accompanying text.
==========================================START OF PAGE 98======
size or sophistication, may avail themselves of prices in ECNs
not currently linked with the public quotation system. The vast
majority of investors may not be aware of the better prices
widely disseminated by market makers or specialists through ECNs
and many do not have the ability to route their orders directly
or indirectly to such systems. As a result, many customers, both
institutional and retail, do not always obtain the benefit of the
better prices entered by a market maker or a specialist into an
ECN.
Brokers frequently use the consolidated quote as the
benchmark for automated execution of customer orders and for the
starting point in negotiating execution prices with institutional
investors.-[223]- Consolidated quotations in listed
---------FOOTNOTES----------
-[223]- Some commenters argue that the ECN amendment
focuses on expanding the availability of these
systems to small investors, and ignores the fact
that small investors already benefit from these
systems in that institutional subscribers in ECNs
primarily represent the collective interests of
small investors, e.g., through mutual funds and
401(k) plans. See, e.g., CALpers Letter; Dillon
Letter; Instinet Letter; LJR Letter; Northern
Trust Letter; SIA Letter; STAIC Letter. The
objectives of the ECN amendment, however, are not
limited to improving market transparency and
accessibility for small investors. Comprehensive
and transparent information about market
conditions is critical to efficient and
competitive markets for all investors, whether
retail or institutional. Indeed, while large
institutional investors often have access to ECNs,
the public quotes nevertheless frequently serve as
a benchmark for their negotiations with market
makers. In any event, while retail investors
directly account for a significantly smaller
percentage of trading volume than institutional
investors, they still account for half of the
(continued...)
==========================================START OF PAGE 99======
stocks are provided by CQS to vendors, who then provide this
information to the public. In approving the CQS as the mechanism
to serve this vital function, the Commission stressed that it
would expect broker-dealers to take into account pricing
information made available through the CQS in fulfilling their
best execution obligations.-[224]- Similarly, for OTC
securities, Nasdaq disseminates to market makers, vendors, and
investors multiple market maker quotations, and a "best" bid and
offer derived from these quotations. As broker-dealers and
markets have developed automated order-routing and order
execution systems, they have relied on these consolidated quotes
in pricing and executing customer orders routed through their
systems.-[225]- Including the prices entered into ECNs by market
makers and specialists in the consolidated quotation will help
broker-dealers using these automated systems to provide their
customers' orders with improved executions, and will improve
institutions' ability to ascertain true market prices.
---------FOOTNOTES----------
-[223]-(...continued)
direct equity investment in U.S. markets. NYSE
1995 Fact Book at 57. The Commission recognizes
that direct retail participation provides critical
liquidity and therefore limited access and
transparency to the best prices available
undermines the efficiency of our markets and
jeopardizes public confidence in their fairness.
-[224]- See Securities Exchange Act Release No. 15009
(July 28, 1978), 43 FR 34851 (declaring the CQS
Plan temporarily effective); Securities Exchange
Act Release No. 16518 (Jan. 22, 1980), 45 FR 6521
(permanently approving the CQS Plan).
-[225]- See discussion of best execution principles, infra
section III.C.2.
==========================================START OF PAGE 100======
In light of the stated fundamental purposes of the 1975
Amendments and clear evidence of a two-tiered market, the
Commission believes it is imperative to amend the Quote Rule to
ensure the public dissemination of accurate quotes that represent
the best prices that market makers and specialists widely
disseminate. Thus, the ECN amendment is intended to integrate
into the public quote the prices of market makers and specialists
that are now widely disseminated to ECN subscribers but are not
available to the rest of the market.-[226]-
Most commenters support the Commission's goal of improving
the quality of quotation information made available to the
public, although many raise questions, discussed below, about the
proposal. In particular, and as discussed below, some commenters
expressed concern about the potential impact of the rule on
benefits provided to the market as a whole by ECNs. Upon review
of the comments received, the Commission has determined that it
is appropriate to adopt the proposed ECN amendment. Furthermore,
in response to the concerns noted, and to facilitate compliance
with the ECN amendment, the Commission has included the ECN
display alternative that permits a market maker or specialist to
---------FOOTNOTES----------
-[226]- Several commenters characterize ECNs as
"wholesale" markets, and argue that the ECN rule
would require market makers to trade with retail
customers at wholesale prices. See, e.g., Davis
Letter; Instinet Letter; LJR Letter; Merrill
Letter. The Commission notes that market makers
are compensated by the spread between their bid
and offer prices, and nothing in the ECN rule
prevents market makers from buying at the bid from
one customer and selling at the offer to another.
==========================================START OF PAGE 101======
comply with the amendment through an ECN that meets two
conditions. First, the ECN into which the market maker or
specialist enters its order must ensure that the best prices
market makers and specialists have entered therein are
communicated to the public quotation system. Second, the ECN
must provide brokers and dealers access to orders entered by
market makers and specialists into the ECN, so brokers and
dealers that do not subscribe to the ECN can trade with those
orders. The ECN display alternative therefore allows a market
maker or specialist to comply with the ECN amendment directly by
changing its quote, or alternatively by using an ECN that meets
the above two conditions.
As discussed above, the Commission expects the SROs to work
expeditiously with ECNs that wish to avail themselves of the ECN
display alternative to develop rules or understandings of general
applicability. The Commission is prepared to act as necessary to
ensure implementation of the ECN display alternative prior to the
effective date of the Quote Rule.
b. Response to Comments-[227]-
The Commission solicited comment on whether the proposed
amendment achieves the goals of deterring fragmented markets and
promoting improved quotations. The Commission also invited
comment on whether there are any feasible alternatives to the
---------FOOTNOTES----------
-[227]- This section includes a discussion of the
principal arguments advanced by the commenters. A
more detailed discussion of the comments is
provided in the Summary of Comments.
==========================================START OF PAGE 102======
rule, and on possible business or economic justifications for
permitting market makers and specialists to publish prices in
ECNs that differ from their public quotations. The Commission
requested comment on the competitive effects of the proposal on
existing ECNs, subscribers, and users.-[228]- In
addition, the Commission solicited comment on alternatives to the
proposal that would minimize any negative effects, yet still
achieve the Commission's goals. The Commission specifically
asked whether ECNs should, as an alternative, furnish market
makers' and specialists' best prices to the applicable exchange
or association for further dissemination, and provide access to
those prices through some form of linkage.-[229]-
i. General Comments
The Commission received numerous comments on the ECN
proposal. Many commenters support the proposal as an important
initiative designed to further investor protection by improving
publicly available quotation information and assuring best
execution of customer orders.-[230]- Some commenters
---------FOOTNOTES----------
-[228]- The Commission also specifically solicited comment
on whether exceptions to the rule would be
appropriate, particularly if a customer requests
that the market maker refrain from publicly
disseminating its order. The Commission also
solicited comment on whether market makers should
be required to disseminate publicly the full size
of orders placed in ECNs. The Commission received
only minimal response to these questions, which is
discussed in the Summary of Comments.
-[229]- See Proposing Release at 28-29.
-[230]- See, e.g., DOJ Letter; Lehman Letter; Madoff
Letter; Amex Letter; NASD Letter.
==========================================START OF PAGE 103======
recognize that a number of brokers and dealers have adopted the
practice of placing superior priced orders in ECNs without
including these better prices in their public
quotes.-[231]- These commenters agree that the Commission
should be concerned that some retail investors may have neither
knowledge nor access to the best available prices under these
circumstances.-[232]- They voice general support for the
rule, and recommend one or more mechanisms-[233]- by which
the Commission could ensure that public quotes contain the best
prices otherwise widely disseminated by market makers and
specialists.
ii. Impact on ECNs, Market Makers and
Specialists, and Institutions
Some commenters express concern that the amendment could
negatively impact services provided by ECNs and caution the
Commission not to diminish the benefits provided by ECNs to the
market as a whole. Some commenters argue that, under the
proposal, market makers and specialists that use ECNs would lose
the anonymity that these commenters believe is crucial to
---------FOOTNOTES----------
-[231]- See, e.g., Amex Letter; DOJ Letter; Madoff Letter;
RPM Letter.
-[232]- See, e.g., Letter from Gerri Detweiler, Policy
Director, National Counsel of Individual
Investors, to Jonathan G. Katz, Secretary, SEC,
dated January 22, 1996 ("NCII Letter"); Goldman
Sachs Letter; PaineWebber Letter; SIA Letter;
Madoff Letter; Lehman Letter; DOJ Letter.
-[233]- See discussion of alternative approaches, infra at
section III.B.2.b.iv.
==========================================START OF PAGE 104======
successfully execute large trades for institutional
investors.-[234]- Some commenters anticipate the adoption
of the ECN amendment prompting a potential decline in the use of
certain ECNs.-[235]- In addition, some commenters contend
that this amendment, because of the impact on ECNs and their
subscribers, will lead to a loss of liquidity in both ECNs and
the public markets-[236]- and to a decline in the variety
of available trading options which could be detrimental to all
investors.-[237]- Other commenters argue that the
proposal would effectively double the risk of a specialist or
market maker that enters orders into an ECN because the
---------FOOTNOTES----------
-[234]- See AZX Letter; Instinet Letter; ICI Letter;
Investors Research Letter; NASD Letter; Ruane
Letter; STAIC Letter; Letter from Edward G.
Shufro, Partner, Shufro, Rose & Ehrman, to
Jonathan G. Katz, Secretary, SEC ("Shufro
Letter"); Sutro Letter.
-[235]- See Goldman Sachs Letter; STA Letter; AZX Letter;
Instinet Letter; Schwartz and Wood Letter; Ruane
Letter.
-[236]- See DOJ Letter; STA Letter; Alex. Brown Letter;
Letter from Jeffrey L. Davis, Economists
Incorporated, to Jonathan G. Katz, Secretary, SEC,
dated October 25, 1995 ("Davis Letter"); Dillon
Letter; Instinet Letter; Merrill Letter. (citing
the "deleterious effects concerning liquidating
inventory and replacing necessary capital" at pp.
7-8); Schwartz and Wood Letter; Letter from Mary
Kay Wright, Second Vice President and Senior
Equity Trader, The Northern Trust Company, to
Jonathan G. Katz, Secretary, SEC, dated February
28, 1996 ("Northern Trust Letter").
-[237]- See Letter from Anthony R. Gray, Chairman and CIO,
STI Capital Management, to Jonathan G. Katz,
Secretary, SEC, dated February 12, 1996 ("STI
Capital Letter"); Ruane Letter; DOJ Letter; and
LJR Letter.
==========================================START OF PAGE 105======
specialist or market maker could be simultaneously responsible
for multiple executions based on its disseminated quote as well
as its ECN order.-[238]- Moreover, at least one commenter
argues that quotes, bids, offers, and orders have historically
had different meanings and that the proposal's treatment of
priced orders as quotes confuses the essence of the terms,
thereby resulting in inadvertent anti-competitive
effects.-[239]- Some commenters also argue that the
better prices frequently available in ECNs reflect the lower
costs of doing business in those systems, and therefore, it would
be inappropriate to require market makers and specialists to
match their ECN prices in their public quotes.-[240]-
---------FOOTNOTES----------
-[238]- See, e.g., Merrill Letter.
-[239]- See Instinet Letter. Instinet also bases much of
its arguments on its regulatory identification as
a broker-dealer. Instinet argues that the
proposal targets its ECN operations for treatment
different from other broker-dealers. The
Commission notes that Instinet (and similar
systems) provides to its customers ECN services
that are significantly different from the services
provided by other broker-dealers to their
customers. Specifically, Instinet, without
discretion, publicizes subscriber orders and
enables other subscribers to trade with these
orders at their stated price.
-[240]- See, e.g., Dillon Letter; HHG Letter; LJR Letter;
Merrill Letter; STA Letter; Goldman Sachs Letter.
There appear to be counter arguments. For example, there is
no reason to suppose that adverse selection costs Ä that is,
the risks of trading with an informed trader Ä are any lower
in ECNs, whose subscribers typically can include market
makers, other broker-dealers, institutional money managers,
hedge funds, momentum traders, and options market makers.
(continued...)
==========================================START OF PAGE 106======
The Commission agrees with commenters that ECNs provide
certain valuable benefits to their subscribers. It also
recognizes the benefits competing systems bring to the market as
a whole, particularly systems that take advantage of new
technologies to offer improved trading opportunities. The
Commission, therefore, has adopted an alternative method of
compliance with the ECN requirement discussed in the proposing
release to reduce the amendment's potential impact on existing
ECNs and their subscribers, and to maintain incentives and
opportunities for new ECNs to enter the
marketplace.-[241]- The Commission continues to believe
---------FOOTNOTES----------
-[240]-(...continued)
Second, because traders can more easily mask their
identities and thus their trading motives in ECNs than in
the primary market, informed traders may prefer to trade in
ECNs. These higher information asymmetries would be
expected to lead to higher, rather than lower, trading
costs. Finally, ECNs often impose transactions charges that
may not otherwise be incurred by dealers trading in the
primary market.
Furthermore, it does not appear that the better prices
available in ECNs can be explained by differences in the
size of orders and transactions given that the average order
size and trade size in one ECN (Instinet) is substantially
similar to the average size of quotes and trades in the
primary market. In any event, the Commission generally
would not expect larger size orders to receive better prices
in view of the considerable literature suggesting that in
equities markets, larger orders tend to get worse prices
because of the risk of trading with an informed trader.
See, e.g., David Easley and Maureen O'Hara, 19 J. Fin. Econ.
69, (No. 1, September 1987).
-[241]- The Commission believes that although the ECN
amendment may marginally reduce the incentive of
some subscribers to participate in an ECN, on the
whole the effect on ECNs should not be so
significant as to affect their viability.
(continued...)
==========================================START OF PAGE 107======
it is important that the best prices of orders entered into these
markets by market makers and specialists are properly integrated
into the public market so that all market participants can
benefit from the price discovery taking place within these
markets.
In its comment letter, the NASD stated its view that the
proposal could discourage market makers' use of ECNs because a
market maker placing an order in an ECN at a better price would
have to simultaneously change its quote, thereby telegraphing its
interest. In proposing a solution to this situation, the NASD
specifically referred to the ECN alternative noting "...this
problem can be addressed without discouraging market maker use of
ECNs through the approach suggested by the Commission as a
possible alternative, i.e., by reflecting the better ECN prices
in the inside market display, rather than in individual
quotes."-[242]-
In response to the concerns raised by the NASD and other
---------FOOTNOTES----------
-[241]-(...continued)
Moreover, given the availability of the ECN
display alternative, which is designed to minimize
any potentially detrimental effects of the rule on
ECNs, the Commission believes that the benefits of
the amendment to investors of publicizing the
better prices entered by market makers and
specialists outweigh the limited likely costs to
ECNs. Many of the comments received that
addressed the ECN proposal raised concern about
the importance of preserving the anonymity offered
by these systems. See, e.g., Alex. Brown Letter;
AZX Letter; Dillon Letter; Estep Letter; ICI
Letter; Instinet Letter; NASD Letter.
-[242]- NASD Letter at 14.
==========================================START OF PAGE 108======
commenters, the ECN display alternative is designed to preserve
the benefits associated with the anonymity that some ECNs
currently offer to subscribing market makers and specialists and
their customers.-[243]- This alternative will ensure that
the best prices of market makers and specialists are publicly
disseminated and that non-ECN-subscribing brokers and dealers can
trade with the ECN orders represented by those prices. Under the
display alternative, the best prices and sizes of orders entered
into an ECN by specialists and market makers would be publicly
disseminated while the specialists and market makers themselves
would remain anonymous. This alternative not only preserves
anonymity, but also eliminates the risk that a market maker or
specialist could be exposed to multiple executions at the ECN
price.-[244]-
---------FOOTNOTES----------
-[243]- The Commission recognizes that in certain
securities, specific market makers or specialists
may be viewed as price leaders for those
securities. Therefore, if the market knows that
one of those firms has changed its quote, other
market makers or specialists are likely to follow
that price change and frustrate the first's firms
ability to obtain an execution at the improved
price. The ability to place an anonymous order in
an ECN allows the firm to change its price without
triggering corresponding price changes from other
market makers or specialists and thereby increases
its potential to obtain an execution at the
improved price.
-[244]- Certain commenters fear that, as originally
proposed, the amendment would have an adverse
impact on institutional investors which currently
subscribe to ECNs. These commenters appeared to
believe that the ECN amendment would seriously
harm ECNs, and thus harm institutional users. See,
(continued...)
==========================================START OF PAGE 109======
The ECN amendment, as proposed, sought to minimize the
potential impact on market makers, specialists, and ECNs by
requiring a market maker or specialist to display in its public
quote only the size required by its exchange or association,
rather than the actual size of any order the firm places into an
ECN. This part of the amendment is being adopted as proposed for
orders for the accounts of market makers and specialists.
However, for customers' orders entered into an ECN by a market
maker or specialist that are smaller than the quote size required
by the market maker's or specialist's exchange or association,
the Commission has amended the rule to allow market makers and
specialists to display only the customer's order
size.-[245]- The requirement to display no more than the
required size for market makers' and specialists' own orders
should reduce any disincentives to use ECNs that could otherwise
result from the ECN amendment, and responds to the concern that
---------FOOTNOTES----------
-[244]-(...continued)
e.g., ICI Letter; Ruane Letter. The Commission
does not believe that the amendments will
significantly interfere with the operations of
ECNs. Moreover, the Commission believes that as
adopted, particularly with the addition of the ECN
display alternative, ECNs will continue to be able
to provide services to institutional investors of
similar value to those they provide today. The
Commission also believes that the benefits of the
amendments, including increased market maker
competition and decreased fragmentation, will flow
to all investors, institutional as well as retail.
See 21(a) Report.
-[245]- As discussed supra in footnote 144, SROs may wish
to allow market makers or specialists to quote in
sizes smaller than the minimum quotation increment
when the quote represents a customer limit order.
==========================================START OF PAGE 110======
disclosure of the full size of the order in the market maker's or
specialist's quote could impede its ability to execute the
order.-[246]- Moreover, permitting the display of
customer orders of less then the minimum quote size should reduce
the potential burden on a specialist or market maker of having to
publish a public quote for more than the customer's order size
when the customer's order is for less than the minimum quotation
size required by the specialist's or market maker's exchange or
association.
Market makers and specialists who avail themselves of the
ECN display alternative will be required to furnish to the public
quotation system the full size of the best buy and sell orders
they enter into the ECN. The Commission believes that the
display of full size by the ECN will help inform the public
market of the true trading interest entered by specialists and
market makers, without impeding the execution of these orders by
disclosing the identity of the specialist or market maker placing
the order. Under the ECN display alternative, the market maker
or specialist will be able to continue to represent the order on
an anonymous basis both in the ECN and in the public quote,
substantially reducing any negative impact of the amendment on
---------FOOTNOTES----------
-[246]- The Commission received several comments that
support this aspect of the proposal. See, e.g.,
Lehman Letter; and Smith Barney Letter. These
commenters believe that display of full size in a
market maker's quote could impair the quality of
an execution obtained for a customer because the
display in the public quotation system is broader
than the display in the ECN.
==========================================START OF PAGE 111======
ECN users.
Where the order entered by the market maker or specialist is
on behalf of a customer, the display of full size under the ECN
display alternative is consistent with the requirement under the
Display Rule, which requires market makers and specialists to
display the full size of their customer limit orders. Therefore,
the full size of customer limit orders will be displayed whether
the specialist or market maker displays the order itself or
enters the order into an ECN complying with the ECN display
alternative.-[247]-
The Commission believes that the concerns expressed by some
commenters about a potential loss of liquidity resulting from the
---------FOOTNOTES----------
-[247]- The Commission notes that the exceptions under the
Display Rule for limit orders of block size and
for limit orders that a customer has asked not to
be displayed will not apply to customer limit
orders entered by a market maker or specialist
into an ECN. If entered into an ECN, these orders
must either be reflected in the market maker's or
specialist's own quote or displayed via the ECN
alternative. As discussed previously, the
Commission believes that a customer should have
discretion to permit a market maker or specialist
to handle its limit order without public display,
and large limit orders should not be required to
be displayed unless the customer makes a request.
However, the Commission does not believe these
orders should be withheld from public display if
they are being displayed in an ECN. The
Commission believes that if these orders, when
handled by market makers or specialists, are
displayed widely through an ECN to the ECN's
subscribers, then they should also be displayed to
the public generally. Moreover, limiting display
to only one market would be inconsistent with
Congress's goal for a NMS in which trading
interest in disparate markets would be
consolidated and publicly disseminated.
==========================================START OF PAGE 112======
proposal have been substantially addressed by the alternative
adopted today. Because this alternative preserves the anonymity
some ECNs afford to the users of their systems, the proposal
maintains incentives for subscribers to continue participating in
such systems. In fact, a market maker or specialist, who
presumably wants its orders executed at prices it is widely
displaying through the ECN, should benefit from attracting
greater trading interest by having the prices of its orders
displayed to the entire market.
Finally, under the proposal, priced orders of institutions
and other non-market makers entered directly into ECNs would not
be required to be reflected in the public quote. Some commenters
criticized the proposal because it did not require the inclusion
of all better priced orders in the public quote. This result,
however, is consistent with existing quotation principles.
Institutional bids, offers, and orders handled independent of a
market maker historically have been outside the scope of the
Quote Rule, and the Commission's proposal was not intended to
expand the scope of the Quote Rule in this respect.-[248]-
Furthermore, the Commission believes that, although institutional
investors' direct orders in ECNs provide valuable liquidity, the
amendments will substantially strengthen the public quotation
system by publishing orders entered by market makers and
---------FOOTNOTES----------
-[248]- The fact that ECNs will continue to contain
institutional investors' orders priced better than
the public quotes will provide another incentive
for market participants to continue to participate
in those systems.
==========================================START OF PAGE 113======
specialists without creating new requirements for orders not
controlled by market makers or specialists.-[249]-
Nevertheless, the Commission will continue to monitor closely
issues involving the display of prices published by institutions
in light of the Quote Rule and its objectives.
iii. Technology and Innovation
Some commenters predict that the proposal may have a
chilling effect on technological innovation, primarily because
the proposal applies only to ECNs and not to all available
communication technologies that may be used for disseminating
interest to buy and sell a particular number of shares at a
specified price.-[250]- Some commenters argue that the
proposal is anti-competitive and otherwise antithetical to the
purposes of the Exchange Act because it will deter future
technological advances in automated trading environments by
favoring less automated trading methods (e.g., telephone
transactions).-[251]-
The Commission is cognizant of the importance of the
continued development of innovative trading systems and services.
New technologies have expanded the ways in which investors'
---------FOOTNOTES----------
-[249]- The Commission notes that, as described in the
Commission's 21(a) Report, institutions trading
with dealers or others accounted for less than 20%
of trades in one ECN (Instinet). See Appendix to
the 21(a) Report at A-11.
-[250]- See DOJ Letter; SIA Letter; Instinet Letter;
Schwab Letter; STI Capital Letter; Sutro Letter.
-[251]- See, e.g., Instinet letter.
==========================================START OF PAGE 114======
buying and selling interest can be brought together and have
fostered additional competition in the securities markets. The
Commission believes that this competition should be encouraged.
Nonetheless, to promote competition, efficiency, and transparency
in the securities markets, and insure the integrity of publicly
available information, the Commission believes it is appropriate
to set minimum standards that apply to the entry of the
functional equivalent of quotations by market makers and
specialists in trading systems.-[252]- Indeed, consistent
with the Commission's experience with previous NMS
initiatives,-[253]- these minimum standards will permit
and foster the development of new technologies that improve the
public availability of trading information, while discouraging
practices that are inconsistent with the purposes of the 1975
Amendments. The Commission believes that the Quote Rule as
amended will not unduly diminish the beneficial services provided
by existing ECNs, nor will it stifle the development of new
---------FOOTNOTES----------
-[252]- The Commission notes that the focus of the
proposal is not on any particular system or
systems but, rather, on the types of orders that
are the fundamental equivalent of quotations, and
the fragmented market that results when the prices
of these orders are not integrated into publicly
available quotations.
-[253]- See Simon and Colby, supra note 58. The
Commission also notes the growth in technologies
over the past twenty years, including broker-
dealer and exchange automated execution systems,
that clearly rely on, and were facilitated by,
successful operation of NMS and joint industry
initiatives such as the Quote Rule, CTA, and the
ITS Plan.
==========================================START OF PAGE 115======
trading technologies or new ECNs.
iv. Alternative Approaches
In the Proposing Release, the Commission suggested
alternatives to the proposal, and solicited comment on these
alternatives. The Commission also invited commenters to suggest
possible alternatives. The Commission specifically asked whether
it should require ECNs to furnish prices to the applicable
exchange or association for public dissemination and to provide
some access, such as a linkage, to the prices in the
ECN.-[254]- A number of commenters supported this
approach.
The NASD recommended, as an alternative to the proposed
rule, that the better ECN price be reflected in the inside
market, rather than in individual quotes. Under the alternative
described by the NASD, an ECN would report its best market maker
or specialist inside prices to the SRO that is the primary market
in the security. The NASD also recognizes that more assured
access to orders in the ECNs would be necessary under this
option.-[255]- Similarly, one commenter agreed that the
inside market available to the public should reflect the best bid
and offer prices whether in a market maker's quote or in a market
maker's order on an ECN. The Commenter suggested that this could
be accomplished by requiring quotations in ECNs to be made part
of the public quotation and by separately identifying the ECN
---------FOOTNOTES----------
-[254]- See Proposing Release and e.g., NASD Letter.
-[255]- See NASD Letter.
==========================================START OF PAGE 116======
into which the order is entered rather than the market maker that
placed the order.-[256]- Finally, certain commenters
state that expanding ITS to include orders entered into ECNs
would be a better alternative to the proposal.-[257]-
The Commission believes that the ECN display alternative
adopted today is consistent with these suggested alternatives and
will minimize many of the asserted negative effects of the rule.
The adopted provision provides an alternative to an ECN that
disseminates specialists' and market makers' best prices to the
public quotation system. Thus, the amendment enables a market
maker or specialist to comply with the Quote Rule either directly
by sending to its exchange or association the prices of orders it
places into ECNs that improve the market maker's or specialist's
public quote, or indirectly by using an ECN that transmits the
best prices entered therein by market makers and specialists for
publication in the public quotation system.
The ECN display alternative is consistent with the
alternative recommended by the NASD because the adopted provision
enables the specialists' or market makers' best prices in ECNs to
be consolidated with the exchange's or association's best prices
for dissemination within the consolidated quotes. In addition,
the adopted amendment requires the ECNs to provide an equivalent
means of access to those best prices.
---------FOOTNOTES----------
-[256]- Morgan Stanley Letter. See also, PaineWebber
Letter (recommending that priced orders in ECNs be
included in the NBBO).
-[257]- See, e.g., STAIC Letter; ICI Letter.
==========================================START OF PAGE 117======
The Commission recognizes that this alternative may reduce
the content of information that is publicly available because
under the ECN display alternative, the identity of the market
maker or specialist that entered the better priced order in the
ECN will be withheld.-[258]- The Commission believes this
result is justified because the inside prices and full sizes of
orders entered by market makers and specialists will be in the
public quotation system to inform the entire market of these
prices and ECNs will provide equivalent access to those prices.
Moreover, the Commission believes the benefits of facilitating
the use of ECNs, by permitting the continued anonymity of market
makers and specialists, more than offset the reduced information
available on the identity of a particular market maker or
specialist.
As an alternative to the ECN amendment, certain commenters
suggested that enforcement of best execution principles would be
sufficient to protect public investors.-[259]- As
discussed in more detail in section III.C.2., the Commission does
---------FOOTNOTES----------
-[258]- The Commission also notes that under the
alternative, a specialist or market maker that
puts an order into an ECN that is priced better
than that specialist's or market maker's public
quote, but is not the best priced quote from any
specialist or market maker in the ECN, will not
have its better priced order reflected in the
public quote. The prices will be displayed,
however, if the better price in the ECN is
executed or withdrawn and the lower specialist's
or market maker's priced quote then becomes the
best priced quote.
-[259]- See, e.g., Instinet Letter.
==========================================START OF PAGE 118======
not believe this is a practical alternative because ECNs do not
provide broker-dealers with automated links and thus may not be
reasonably available for the handling of retail orders on an
automated basis. Furthermore, investors and their brokers cannot
efficiently ascertain if they have received the best prices for
their orders if publicly available prices do not reflect the best
prices at which specialists and market makers are willing to
trade. Under these circumstances, providing customers the best
executions available can be achieved most effectively by ensuring
that the consolidated quotes systematically include the better
prices that market makers and specialists have entered into an
ECN.
Finally, certain commenters argue that, as an alternative to
adopting the ECN proposal, the Commission should defer any action
until further study is completed on the use of ECNs because the
Proposing Release provides insufficient data regarding whether
customers currently get the best available price, or market maker
and specialist use of ECNs results in harm to
customers.-[260]- The Commission has determined to go
forward with the amendments now because of compelling concerns
presented by two-tiered markets. Many of the commenters to the
proposed rules also recognize these concerns. Furthermore, as
part of its recently concluded Nasdaq investigation, the
---------FOOTNOTES----------
-[260]- See, e.g., Instinet Letter, asserting that the
Commission should obtain and study data on this
matter and that, absent such data, adoption of the
proposed amendment is unwarranted.
==========================================START OF PAGE 119======
Commission has conducted an extensive analysis since the
proposals were published that supports the Commission's proposal
and clearly evidences the existence of a "two-tiered" market in
which customer orders are executed at publicly available prices
inferior to prices contemporaneously available in existing
ECNs.-[261]- Moreover, Commission data shows that the
pricing opportunities available in at least two ECNs (Instinet
and SelectNet) are not limited to block trades, but extend to
smaller orders executed in the system.-[262]- The
Commission believes, therefore, that further study is not
necessary to address a structural disparity in market information
that disadvantages investors who lack access to ECNs.
c. Operation of the Rule Amendment
i. Definition of the term "Electronic
Communications Network"
The proposed amendment did not specifically define the term
"electronic communications network." The Commission did state,
---------FOOTNOTES----------
-[261]- As discussed previously, the Commission believes
the data it has reviewed supports the need for
prompt adoption of the ECN amendment to the Quote
Rule. See supra notes 222 and 223, and
accompanying text. Given the strong evidence that
investors would benefit from public dissemination
of the hidden prices that are broadly disseminated
to subscribers in these systems, the Commission
believes that it is appropriate to adopt the
amendments to the Quote Rule.
-[262]- As noted above, the Appendix to the 21(a) Report
states that average trade size for Nasdaq NMS
securities on Instinet was approximately 1,600
shares for the period studied, while the average
trade size generally in the securities was
approximately 1,900 shares. See Appendix to the
21(a) Report at A-8.
==========================================START OF PAGE 120======
however, that priced orders that market makers and specialists
enter into certain ECNs are bids and offers for the purposes of
the Quote Rule.-[263]- The proposal applied to systems
that widely disseminate priced orders to third parties and permit
such orders to be executed against in whole or in part. The
Commission further explained that the term "electronic
communications network" was intended to include continuous
auction trading systems, but was not intended to include crossing
systems or broker-dealer internal order routing systems.
Several commenters suggested the need for a definition of
the term "electronic communications network."-[264]- The
Commission agrees that it is appropriate to define the term in
the Quote Rule and has decided to adopt a definition that
reflects the fundamental characteristics of an ECN as discussed
in the Proposing Release.
As discussed earlier, the objective of the ECN amendment is
to incorporate within the consolidated public quote firm prices
quoted by market makers and specialists in securities markets
---------FOOTNOTES----------
-[263]- As a result, relevant provisions of the Quote
Rule, such as the obligation on exchanges and
associations to disseminate quotes, and the
firmness requirement placed on a market maker or
specialist who furnishes the quotes, become
operative with respect to a security when a market
maker or specialist enters an order for that
security into an ECN. See section III.B.2.c.v.,
infra.
-[264]- See Goldman Sachs Letter; Instinet Letter; Schwab
Letter. In addition, one commenter argues that
ECNs should include SRO stock crossing systems and
all non-market-maker broker-dealers. NYSE Letter.
==========================================START OF PAGE 121======
that widely disseminate those prices but are not registered as
exchanges or associations and thus are not integrated into the
NMS. Therefore, the Commission has defined the term "ECN" as an
electronic system that widely disseminates to third
parties-[265]- orders entered therein by a market maker or
specialist, and permits such orders to be executed against in
whole or in part. The definition specifically excludes any
system that crosses multiple orders at one or more specified
times at a single price set by the system and that does not allow
orders to be crossed or executed against directly by participants
outside of such times. This exclusion is consistent with
statements made in the Proposing Release that it was not the
Commission's intention to cover crossing systems because these
systems do not communicate to multiple market participants the
prices at which system subscribers are willing to trade. Rather,
the excluded crossing systems themselves establish an internal
trading price for subscribers on an episodic basis.-[266]-
The ECN definition also excludes any system operated by, or
on behalf of, a market maker or specialist that executes customer
orders primarily for its own account as principal, other than as
---------FOOTNOTES----------
-[265]- The Commission intends the term "third parties" to
refer to subscribers to the ECN, other than the
ECN and the market maker or specialist that is
entering its priced order into the ECN. The ECN
also may disseminate to others, including non-
subscribers.
-[266]- The Commission notes that broker-dealers that
publish quotes through a vendor are already
covered by the rule.
==========================================START OF PAGE 122======
riskless principal. This exclusion is intended to ensure that,
as discussed in the Proposing Release, internal broker-dealer
order routing systems in which the market maker trades primarily
with customer orders on a principal basis are not ECNs within the
scope of the amendment. The exclusion would not except from the
ECN definition systems that involve multiple market makers or
specialists competing as principal in a security or that cross
multiple market maker and customer orders.
Furthermore, the Commission believes the definition should
be read broadly to include systems that match orders internally
and deliver the matched order to some other market for execution.
Thus, the term "permits such orders to be executed against"
should not be read to exclude systems where a narrow technical
reading of "executed" is the only reason that the system would
not fall within the ECN definition. For example, if a system
puts buy orders and sell orders together for execution, completes
all necessary elements of the trade, and then sends the matched
pair to an exchange or association merely to print the terms of
the trade on the Consolidated Tape, the system would be an ECN.
ii. "Priced orders" in ECNs
Under this definition, the Commission intends to include in
the public quotation system firm prices for securities entered by
market makers or specialists, whether such firm prices are
labeled as "quotes" or "orders." The Commission believes that
priced orders entered by market makers or specialists into ECNs
where the orders are widely disseminated and executable are the
==========================================START OF PAGE 123======
functional equivalent of market maker or specialist quotations,
and like quotations, play a key role in the price discovery
process. The Commission thus believes that these "quotation-
equivalents" should be made part of the public quote.
Although some commenters argue that priced orders entered
into ECNs are more closely parallel to prices communicated over
the telephone to other market makers than to market quotes, the
Commission recognizes a fundamental distinction between limited
communication of price in bilateral telephone negotiations and
broad exposure of firm prices to multiple participants in a
market.-[267]- Accordingly, prices communicated by
telephone are excluded because these prices generally are not
widely disseminated to other parties for execution. The rule
also would not cover indications of interest that do not
constitute firm prices.
In this connection, the Commission intended the term "priced
order," which is deemed under the ECN amendment to be a bid or
offer, to encompass commitments to buy or sell a security at a
particular price for a particular number of shares. The
---------FOOTNOTES----------
-[267]- The Commission recognizes that market makers and
specialists may be willing to trade with certain
customers at better, negotiated prices, such as
when market makers negotiate with customers over
the telephone. In contrast, however, the prices
quoted by market makers and specialists in ECNs
are widely disseminated to market participants.
In adopting the ECN amendment, the Commission is
reaffirming the NMS principle that prices
advertised in one market must be integrated into
the national market -- that is, the consolidated
public quote.
==========================================START OF PAGE 124======
Commission also does not intend the term "priced orders" to
include interest to buy or sell a security where price or the
number of shares is not specified to system subscribers, unless
the price or size is otherwise understood as part of the system's
operation.-[268]- The ECN amendment would, however,
include priced orders entered into an ECN by a market maker or
specialist that are visible only to some system subscribers if
these orders can be executed against in the ECN. The ECN
amendment is intended to require the public display of priced
orders entered into ECNs by market makers and specialists where
these priced orders are similar to quotations. Accordingly, the
Commission does not intend the ECN amendment to apply to a priced
order that is entered into an ECN by a market maker or specialist
merely in order to execute against an existing order visible in
the ECN, and not entered to elicit other buying or selling
interest. If, however, the order entered by the market maker or
specialist does not in fact execute immediately in full against
an existing order but rather is itself disseminated as an open
order in the ECN, the market maker or specialist must comply with
the requirements of the ECN amendment with respect to the order.
In order to ensure that customers consistently receive the
benefit of better prices entered into ECNs, a market maker or
---------FOOTNOTES----------
-[268]- The definition of an ECN specifically excludes any
system that crosses multiple orders at one or more
specified times at a single price set by the ECN
(by algorithm or by any derivative pricing
mechanism) and does not allow orders to be crossed
or executed against directly by subscribers
outside of such times. See 11Ac1-1(a)(8).
==========================================START OF PAGE 125======
specialist entering an all-or-none or minimum size order for its
own account into an ECN would be required to include this price
in its public quote, or disseminate the price via the ECN display
alternative, and thereby publicly display the order for the full
number of shares for execution in whole or in part. Although the
execution of an all-or-none order is typically conditioned on
execution of the entire size of the order, the Commission
believes that allowing market makers to avoid public display of
an unconditional quote when using this type of order could
seriously undermine the purposes of the rule.-[269]- The
rule will permit, however, a market maker or specialist to enter
an all-or-none customer order into an ECN without requiring
public display of the quote for that order where the customer
specifically requests that the order be executed on an all-or-
none basis. This latter provision accommodates the desire of
some customers to trade only at a specific size associated with a
specific price.
iii. ECN Display Alternative
Pursuant to the amendment as adopted, a priced order entered
by a market maker or specialist into an ECN that widely
disseminates the order is deemed to be a bid or offer for the
purposes of the market maker's or specialist's quotation
reporting obligations under the Quote Rule. As a result,
---------FOOTNOTES----------
-[269]- All-or-none and minimum size orders are rarely
used by market makers and specialists in ECNs and
are prohibited from being included in the public
quotes by the registered exchanges and Nasdaq.
==========================================START OF PAGE 126======
specialists and market makers are required to include such orders
in the bids and offers they communicate to their exchange or
association for inclusion in the published quotations made
available by the exchange or association.-[270]-
As discussed above, in response to the concerns of some
commenters, the adopted amendment includes an alternative to the
specialist or market maker itself revising its public quotation
to reflect its better priced order entered in an ECN. This
alternative allows the ECN to act as an intermediary in
communicating to the public quotation system the best price and
size of orders for each security that have been entered into the
ECN by a specialist or market maker. To communicate the
quotations publicly, the ECN must submit the best price entered
by a specialist or market maker to an exchange or association, or
to a securities information processor acting on behalf of one or
more exchanges or associations.
The alternative reduces the impact of the amendment on
specialists and market makers because they have a choice
regarding how to comply with their obligation. This alternative
also reduces the impact of the amendment on ECNs by offering
these systems an opportunity to provide additional services to
their subscribers, and creating an opportunity to generate
additional order flow from non-subscribers. At the same time,
---------FOOTNOTES----------
-[270]- An OTC market maker that places priced orders for
execution into any ECN will in effect be making an
election to communicate quotations to its
association bids, offers and quotation sizes in
the security. See 11Ac1-1(a)(25)(ii)(B).
==========================================START OF PAGE 127======
more accurate prices are provided through public quotation
systems than are currently available.
Under this alternative, consistent with the goals of the
initial proposal, the ECN must comply with two conditions.
First, the ECN must provide the best prices and sizes that market
makers or specialists have entered in the ECN to the public
quotation system for inclusion in the consolidated quotation.
The market maker or specialist responsible for the price does not
have to be identified.-[271]- The ECN must, however, at a
minimum, publicly identify itself as the originating system for
these prices. Accordingly, if a market maker puts an order that
improves the NBBO into an ECN and the ECN disseminates that price
to the public quotation system, the disseminated price must
either be identified as originating from the market maker or from
the ECN.
Second, the ECN must provide non-subscriber brokers and
dealers with a means of access to those prices entered in the ECN
by market makers and specialists. This access must be equivalent
to the access that would have been available for the relevant
security if these prices had been published in the market makers'
---------FOOTNOTES----------
-[271]- An ECN that does not offer the option of anonymity
to its subscribers could choose to include the
identity of the market maker or specialist with
the prices furnished to the SRO for public
dissemination. As discussed below, the ECN also
must provide access to these prices.
==========================================START OF PAGE 128======
or specialists' quotation.-[272]- The extent and form of
this access will depend on the form(s) of access available in the
market to which the ECN supplies the bids and offers for public
dissemination.-[273]-
For example, market makers in Nasdaq NMS and SmallCap
securities typically can be reached through the telephone and
through the NASD's Small Order Execution System. Therefore, an
ECN that chooses, pursuant to the alternative, to act as an
intermediary for its market maker and specialist subscribers for
Nasdaq NMS and Smallcap securities would have to be prepared to
receive and execute telephone orders from broker-dealers against
those market makers' and specialists' orders entered in the ECN.
The ECN will have to execute these orders promptly at the prices
the market makers and specialists have entered into the ECN. In
addition, because a market maker with the best price in a Nasdaq
NMS security is subject to SOES executions, this equivalent
access condition would require the ECN to provide broker-dealers
who use SOES with equivalent automated access to the best priced
---------FOOTNOTES----------
-[272]- For access to be "equivalent", the ECN must enable
non-subscribing broker-dealers to execute against
the ECN's published best price to the same extent
as would be possible had that best price been
reflected in the public quote of a specialist or
market maker. The ECN, however, may impose
charges for access to its system, similar to the
communications and systems charges imposed by
various markets, if not structured to discourage
access by non-subscriber broker-dealers.
-[273]- The extent and form of the access will not
necessarily be the same as the access available in
the market to which the specialist or market maker
would otherwise supply its bid and offers.
==========================================START OF PAGE 129======
market maker orders in the ECN. This could be accomplished
either through an electronic linkage to SOES or by other means
agreed upon with the NASD. For example, the ECN could supply the
NASD with an identifier for the market maker who entered the best
priced order, which the NASD could use in assigning SOES
executions to that market maker.-[274]-
Similarly, in exchange-listed securities, the degree of
access that the ECN must offer would depend on the current access
that the market receiving the information from the ECN offers to
---------FOOTNOTES----------
-[274]- As discussed supra section II., the NASD has
proposed a new facility, NAqcess, which, as part
of its proposed services, would widely disseminate
priced orders for execution in whole or in part.
Supra note 45. As proposed, Naqcess would publish
its best prices in the Nasdaq quotation system
stream and would be accessible to all NASD members
for order entry and execution against those
orders. Thus, NAqcess, as proposed, would appear
to make prices entered by market makers into
NAqcess available, and provide equivalent access
under the alternative. Therefore, a market maker
that entered its best priced order into NAqcess
would comply with the requirements of the ECN
amendment without reflecting the order in the
market maker's own quote. Moreover, a market
maker that entered an order into another ECN at a
price better than its quote could satisfy the
requirements of the ECN amendment by entering an
order reflecting this price into NAqcess, even if
the other ECN does not directly provide the price
to the public quotation system, because this use
of NAqcess, as proposed, would meet the
requirements of the amendment. Similarly, an ECN
availing itself of the ECN display alternative
could provide prices directly to NAqcess. The ECN
and the NASD also could develop mechanisms to
ensure public anonymity of market makers that use
ECNs, while providing to the NASD the identity of
the market makers that are at the inside quote
solely for the purpose of direct order-routing
between NAqcess and the market maker.
==========================================START OF PAGE 130======
broker-dealers in the relevant type of security. If the ECN
communicates prices for exchange-listed securities to an
exchange, the specialist or market maker orders in the ECN must
be accessible to broker-dealers in the same manner as quotes on
that exchange. This access would include any automated execution
features offered to broker-dealers by the exchange. The ECN must
provide to the exchange, or to the exchange specialist in each
security, access to the market maker or specialist orders in the
ECN. Such access must provide broker-dealers with the ability to
enter and obtain executions for their orders at least as promptly
as that exchange offers to its own members through its order-
routing and execution systems. Because the ITS Plan applies to
exchange-trading of listed securities, orders received from other
markets through ITS must have the same ability to trade with ECN
orders whose prices are displayed through the exchange as they
have with the exchange's own quotations. For instance, if the
exchange specialist typically receives incoming ITS commitments
and executes them manually, the ECN must at a minimum enable the
incoming ITS commitment to be manually entered into the ECN for
execution.
If the ECN instead provides orders in exchange-listed
securities to the NASD for inclusion in the public quotation
system, the orders must be as accessible to broker-dealers as the
quotes published by third market makers in exchange-listed
securities. At a minimum, these prices must be included as part
of the third market quotation display and identified as
==========================================START OF PAGE 131======
originating from a named market maker or from a named ECN. For
non-Rule 19c-3 securities, broker-dealers must be able to contact
the ECN by telephone and have an order promptly entered into the
ECN for execution. For Rule 19c-3 securities, the ECN also must
be accessible through the ITS/CAES linkage, operated by the NASD,
in the same manner as other third market maker quotes in those
securities.-[275]-
Under the ECN display alternative, the ECN must furnish to
an exchange or association the full size associated with the best
priced orders placed in the ECN by market makers and specialists
to buy and to sell a security. This full size requirement under
the alternative is intended to give the public information about
the depth of the market at the ECN prices, while maintaining the
anonymity of market makers and specialists. For example, if an
ECN is furnishing quotation information to Nasdaq under this
alternative, and a market maker enters a 4,000-share order into
the ECN at a price that is better than other market maker or
specialist prices for that security in the ECN, the ECN will be
required to provide Nasdaq that price and size of 4,000 shares as
a quotation for public dissemination. If 2,500 shares of this
order is executed, the ECN must display the remaining 1,500
shares. If two market makers enter 4,000-share orders for a
security at the same price, which is the best price in the ECN
---------FOOTNOTES----------
-[275]- As discussed below concerning expansion of the
ITS/CAES linkage, currently non-Rule 19c-3
securities may not be traded via the ITS/CAES
linkage.
==========================================START OF PAGE 132======
for that security, the ECN is required to show all 8,000 shares
publicly. In contrast, if a market maker enters a 100-share
order for a Nasdaq security at the best price in the ECN for that
security, the alternative requires the ECN to furnish the price
for only 100 shares, even though NASD rules require Nasdaq market
makers to display no less than 1000, 500, or 200 shares in
Nasdaq, depending on the characteristics of that security.
The Commission recognizes that the means of providing
equivalent access will vary for different markets, and that ECNs
operating under the ECN display alternative that currently do not
provide access to their systems to non-subscribers will have to
develop methods to provide this access. Meeting this requirement
may be achieved in a variety of ways, including a linkage between
ECNs and one or more of the SROs. The Commission believes an SRO
that accepts the prices provided by an ECN for publication should
be authorized to impose reasonable rules related to the public
dissemination of those prices upon market makers and specialists
who avail themselves of this alternative. The rules an SRO
imposes in this regard, however, may not establish standards for
the dissemination of these prices that are more burdensome for
market makers and specialists using ECNs than the SRO rules that
apply to quotations delivered directly to the SRO by specialists
and market makers.
The Commission looks forward to working closely with all
market participants to effect the necessary market developments
to ensure that this alternative method of compliance with the
==========================================START OF PAGE 133======
Quote Rule is made possible. In order to ensure prompt
implementation of the necessary changes before the effective date
of the rule amendments, the Commission requests each SRO,
individually or jointly as signatories to the CQS Plan, to notify
the Commission in writing by [insert date 45 days from the date
of publication in the Federal Register] regarding its willingness
and its plan to afford ECNs the opportunity to communicate, for
inclusion in the public quotation system, the prices of market
makers and specialists.
In order to implement the changes to the Quote Rule under
new subsection (c)(5), the prices sent to an ECN by market makers
and specialists will have to be displayed in the public
quotations disseminated by SROs, and order routing or access
linkages will have to be in place. After hearing from the SROs,
the Commission will determine whether it will be necessary to use
its authority under Section 11A(a)(3)(B) of the Exchange Act to
require the SROs to act jointly to provide means to accomplish
these objectives.
iv. Minimum Price Variations
In the Proposing Release the Commission recognized that
there may be different minimum price variations in any given
security between the SROs providing a market for the security and
ECNs through which the security is also traded. Currently most
exchange-listed securities tend to be quoted and traded with a
==========================================START OF PAGE 134======
minimum price variation of 1/8 point or 1/16 point.-[276]-
Nasdaq securities can be publicly reported in variations as low
as 1/64, and can be quoted in minimum variations as low as 1/32,
depending on the price at which the security
trades.-[277]- Some ECNs allow priced orders in
variations as low as 1/256; other systems provide for orders
priced in decimals as small as one cent.
Most commenters did not address the issue of ECN minimum
price variations. Some commenters that did address the issue,
however, recommended that the ECN quote be rounded for public
dissemination either downward from or upward to better prices in
increments of 1/16 or smaller.-[278]- Other commenters
recommended rounding in decimals,-[279]- while still
---------FOOTNOTES----------
-[276]- NYSE Rule 62 provides that bids or offers in
stocks selling above one dollar per share may not
be made at a variation of less than one-eighth of
a dollar or twelve and a half cents; Amex Rule 127
allows for one-sixteenth spreads for stocks priced
under ten dollars, and one-eighth spreads for
stocks priced ten dollars and over.
-[277]- The NASD does not have a minimum variation policy
for Nasdaq stocks. Nasdaq, however, is designed
to process quotes and trades in particular minimum
variations.
-[278]- See, e.g., NASD Letter; Lehman Letter; Instinet
Letter.
-[279]- See, e.g., Letter from Leslie M. Marx, Assistant
Professor of Economics and Management, and Eugene
Kandel, William E. Simon Graduate School of
Business Administration, University of Rochester,
to Commissioner Steven Wallman, SEC, dated
November 27, 1995 ("Marx and Kandel Letter"),
concluding that the markets should move toward
decimal pricing.
==========================================START OF PAGE 135======
others strongly opposed the use of decimals.-[280]- One
commenter asserted that non-standard increments (i.e., increments
not approved by the primary market for the relevant security)
should be prohibited in non-primary markets.-[281]- To
address situations where the priced order in an ECN is at a non-
standard increment, the Commission has determined that it is
appropriate to interpret the ECN amendment to allow market makers
and specialists to comply with the amendment (either individually
or through the ECN) by rounding up or down to the nearest
fraction accepted by the market disseminating the quote provided
by the ECN.-[282]- The Commission believes, however, that
rounding is appropriate only if the rounded public quotes are
accompanied by an identifier that marks the quote as
rounded.-[283]- Market makers, specialists, and ECNs will
---------FOOTNOTES----------
-[280]- See CHX Letter.
-[281]- See Madoff Letter.
-[282]- The Commission believes this alternative is
preferable to imposing particular trading
increments on the markets. At the same time,
however, this alternative will provide the markets
with an incentive to voluntarily move towards
finer trading increments.
-[283]- In order to facilitate compliance with the rule,
it will be necessary for SROs to provide a means
for rounded prices to include a "rounded"
identifier that makes clear that a better price is
available in the ECN. The Commission notes that
SROs, and the public quotation system, may not
currently have such a field available for
identifying quotations as rounded. The
Commission, therefore, requests that the SROs work
jointly to modify the public quotation system to
ensure that specialists, market makers, and ECNs
(continued...)
==========================================START OF PAGE 136======
be permitted to round the prices of ECN buy orders down to the
nearest quote increment, and round the prices of ECN sell orders
up to the nearest increment. For example, under this
interpretation, if a market maker or specialist enters a priced
buy order into an ECN at 10 5/16 and the market receiving the
price from the ECN for dissemination has a minimum quote
increment of 1/8, a bid of 10 1/4 will be displayed in the public
market and identified as a rounded price. This result reflects
an SRO rule that prohibits dissemination of quotes in 1/16
variations. If the market maker or specialist already is bidding
publicly at 10 1/4 when it enters the 10 5/16 buy order in an
ECN, the market maker or specialist publishing a quote must
reflect the ECN order by identifying its 10 1/4 bid as rounded.
In addition, market makers and specialists entering orders
into ECNs that are reflected at rounded prices in the public
quote will be expected to give their customers an execution at
the superior non-rounded price. Thus, the market maker or
specialist quoting a rounded price of 10 1/4 to reflect a 10 5/16
buy order must give a customer sell order an execution at 10 5/16
up to the published size. Similarly, an ECN providing market
maker or specialist prices pursuant to the rounding alternative
must execute an incoming order at the non-rounded price. The
Commission recognizes that it may not be feasible for market
makers or specialists that have not entered the rounded order
---------FOOTNOTES----------
-[283]-(...continued)
that are disseminating rounded prices have the
ability to distinguish those rounded quotes.
==========================================START OF PAGE 137======
into an ECN to determine, in an efficient manner, the actual
price of the better order in the ECN. This may particularly be
true with respect to market makers or specialists operating
automated execution systems. The Commission believes that it is
appropriate in such instances for such market makers and
specialists that did not enter the rounded order to execute
orders at the displayed rounded price.-[284]-
The Commission recognizes that this interpretation will
allow prices in ECNs that are denominated in non-standard
quotation increments not to be fully displayed, but believes this
interpretation is appropriate to accommodate ECN prices in the
existing public quotation system without imposing uniform trading
increments.-[285]- The rounding identifier will inform
investors that a better price is behind the rounded quote. Thus,
even though the actual price cannot be readily displayed,
investors will be aware of, and will be able to obtain, the
better price in the ECN or from the market maker or specialist.
v. Effect on the Voluntary Aspect of the
Quote Rule
If an OTC market maker uses an ECN that does not rely on the
alternative of communicating that market maker's best prices to
the public quotation system, then the market maker must publish
---------FOOTNOTES----------
-[284]- See also, section III.C.2. for a discussion of
best execution, infra.
-[285]- If primary markets in the future allow narrower
quotation increments, these ECN prices between the
existing quotation increments could be more
accurately displayed in the public quote.
==========================================START OF PAGE 138======
in its own quote that better priced order entered into the ECN.
Once a market maker publishes a quote through its association to
reflect a priced order it entered into an ECN, pursuant to Rule
11Ac-1(c)(5)(i)(A), it will be deemed to have elected to publish
quotations in that security,-[286]- and will therefore be
subject to the quotation provisions of the Quote Rule. Moreover,
pursuant to certain existing SRO rules,-[287]- withdrawal
of that quotation after the ECN order has been executed or
withdrawn prevents the market maker from immediately reinstating
quotes in that security.-[288]- As a practical matter,
once electing to quote, a withdrawal then precludes the market
---------FOOTNOTES----------
-[286]- 17 CFR 240.11Ac1-1(b)(5), as amended. See also,
17 CFR 240.11Ac1-1(a)(25), 17 CFR 240.11Ac1-
1(c)(4)(ii), and 11Ac1-1(c)(5)(ii), as amended,
acting jointly to ensure that OTC market makers
publish quotations pursuant to the Quote Rule in
securities they trade via ECNs.
-[287]- See NASD Manual, Marketplace Rules, Rule 4600 et.
seq., Nasdaq Market Maker Requirements (requiring
members to maintain continuous two-sided
quotations in the Nasdaq securities for which they
are registered as market makers). See also, ITS
Plan, Section 6(A)(i)(B), Furnishing Quotations
(requiring each ITS Participant to furnish the
current bid-asked quotation emanating from its
floor or, in the case of the NASD, the best bid
and offer emanating from ITS/CAES market makers in
eligible securities). Unexcused withdrawal of
quotations violates these NASD rules and ITS
provisions.
-[288]- This will be true even if the market maker traded
less than 1% of the share volume in the security
in the previous quarter because the 1% threshold
of the Quote Rule for mandatory quotes would not
exempt the market maker from disseminating quotes
once the market maker has "elected" to quote the
security by using the ECN.
==========================================START OF PAGE 139======
maker from continuing to enter priced orders for the security in
an ECN because of the SRO prohibition on re-entering quotes after
withdrawal.
The Commission solicited comment on this aspect of the ECN
proposal. Although most commenters were silent concerning this
issue, certain comments indicate confusion as to the effect on
market makers who currently use ECNs but who do not voluntarily
quote under the existing Quote Rule.-[289]- The
Commission, therefore, reiterates that the combined operation of
the ECN amendment and SRO rules may require a market maker or
specialist who enters an order into an ECN that does not rely on
the ECN display alternative, and publishes a quote reflecting
that price, to continue to publish quotes in the public market
regardless of the number of shares traded by the market maker or
specialist in the security during the previous quarter.
In determining whether a market participant will be required
to publish quotes after entering orders in an ECN, the Commission
notes that, with respect to any given security, the quote rule
requirements only apply if the market participant falls within
---------FOOTNOTES----------
-[289]- See, e.g., Madoff Letter; Instinet Letter. In its
comment letter, Instinet notes that some market
makers that make a continuous market in a
security, but do not normally publish quotations
in that security, will now be required to
disseminate quotations for that security if the
market maker places a priced order for that
security on an ECN. The Commission recognizes
this result, but notes the ECN display alternative
of allowing such market makers to continue to
place orders in a security into an ECN without
having to directly publish quotes in that
security.
==========================================START OF PAGE 140======
the definition of the term "OTC market maker" for that security.
To be an OTC market maker, the participant must hold itself out
as willing both to buy and sell on a regular or continuous
basis.-[290]-
The "OTC market maker" definition is not intended to capture
subscribers who enter orders into ECNs on one side of the market
to limit or offset their risk, such as options market makers who
use ECNs to hedge their positions in the securities underlying
the options they trade. They would not be required to publish
public quotes in a security simply because they had entered an
order for the security into an ECN, unless they regularly or
continuously hold themselves out as willing to buy and sell the
security. An entity that holds itself out via contract,
marketing, or other communications with its customers, as being
willing both to buy and sell a specific security on a regular or
continuous basis would be an "OTC market maker" for the security.
This latter market maker's entry of a superior priced order into
an ECN for a security that itself does not publish quotes would
compel the market maker to publish a quote and potentially,
depending on SRO rules, trigger on-going quotation obligations.
vi. Exemptive Relief
Finally, the Commission is amending Section (d) of the Quote
Rule concerning exemptive relief. Under that section, the
Commission previously could exempt from the provisions of the
Quote Rule, either conditionally or on specified terms and
---------FOOTNOTES----------
-[290]- Rule 11Ac1-1(a)(8), as amended.
==========================================START OF PAGE 141======
conditions, any responsible broker or dealer (which now will
include a specialist or market maker under the ECN amendment),
exchange, or association if the Commission determined that such
an exemption was consistent with the public interest, the
protection of investors and the removal of impediments to and
perfection of an NMS. The Commission is adding a provision
allowing it to exempt an ECN from the definition in the rule.
The Commission did not solicit comment on expanding its authority
to grant exemptive relief in this manner. The Commission
believes, however, that the added exemptive authority is
appropriate because it provides flexibility in applying the ECN
amendment.
3. Amendments to the Quote Rule Concerning
Definitions
a. Introduction
In the Proposing Release the Commission proposed to expand
the Quote Rule's existing requirements to include quotation
information from broker-dealers that, while internalizing order
flow, hold themselves out as willing to buy and sell on a regular
or continuous basis. This expansion of the Quote Rule would be
accomplished by amending the definition of OTC market maker. The
Proposing Release also recommended that quotation requirements be
imposed on substantial broker-dealers in non-Rule 19c-3
securities by amending the definition of subject security, and on
broker-dealers in Nasdaq SmallCap securities by amending the
==========================================START OF PAGE 142======
definition of covered security.-[291]- In putting forward
this proposal, the Commission noted that some dealers quote on a
selective basis, choosing not to display quotes for securities
that they actively trade because these securities are subject
only to the voluntary quote provisions of the Quote Rule.
The amendments adopted by the Commission today are
substantially the same as those proposed.-[292]- The
---------FOOTNOTES----------
-[291]- OTC market makers and specialists are not required
by the Quote Rule to provide continuous two-sided
quotations for any Nasdaq security. As amended,
an OTC market maker or specialist may make an
election, pursuant to paragraph (b)(5)(i) of the
Quote Rule, to collect, process, and make
available quotations for Nasdaq NMS or Nasdaq
SmallCap securities. The Commission is soliciting
comment on a proposed amendment which would
require continuous two-sided quotations from OTC
market makers and specialists responsible for more
than 1% of the aggregate transaction volume for a
Nasdaq security. See Companion Release.
-[292]- The only substantive difference between the
amendments as adopted today and as proposed is the
definition of the term "OTC market maker." The
definition as proposed read "...sell to a
customer...." but has been modified to read
"... sell to its customers...." Rule 11Ac1-
1(a)(13), 17 CFR 140.11Ac1-1(a)(13). See infra
note 308.
In addition to the amendments discussed in detail herein,
the Commission is making technical, non-substantive
amendments to the Quote Rule. The terms "association",
"revised bid or offer", and "revised quotation size" will be
separately defined in the rule. The definition of
"exchange-traded security" has been revised to exclude OTC
securities traded on an exchange pursuant to unlisted
trading privileges. The definition of "plan processor" has
been amended to reflect the appropriate cross-reference.
The definition of "principal market" has been removed from
the Quote Rule because it is no longer applicable. In
addition, the definitions have been arranged in alphabetical
order.
(continued...)
==========================================START OF PAGE 143======
Commission believes these amendments will benefit investors by
improving price discovery and liquidity, and increasing
competition between OTC market makers and specialists. The
Commission further believes that these amendments are in keeping
with Congress's directive that the Commission use its rulemaking
authority to remove impediments to competition.
b. Basis for Amendments to Rule 11Ac1-1(a)
i. Amendment to 11Ac1-1(a)(25) (definition
of a "subject security")
The Commission is amending the Quote Rule's definition of
subject security to require continuous two-sided quotations from
---------FOOTNOTES----------
-[292]-(...continued)
Paragraph (b)(1)(i) of the rule has been reorganized to
separately set forth the exclusions in subparagraphs (A) and
(B). Paragraph (b)(1)(iii) has been eliminated and the
substance of the provision has been incorporated into
paragraphs (b)(1)(i) and (b)(1)(ii).
The Commission is also amending the definition of the term
"reported security" as it appears in Rule 11A3-1(a)(4). The
amendment alters the form but not the meaning of the term or
its application. The amendment will make the term
consistent with the definition of "reported security" in the
Quote Rule.
The amendments to Rule 11Ac1-1(a) are being adopted
prospectively. Outstanding Quote Rule interpretations and
no-action letters continue to be operative, to the extent
that the positions taken therein are not materially in
conflict with the amendments adopted today. Persons seeking
clarification regarding the status of outstanding no-action
letters should contact the Office of Market Supervision,
Division of Market Regulation, Securities and Exchange
Commission.
==========================================START OF PAGE 144======
OTC market makers and exchanges that are responsible for more
than 1% of the volume in a non-Rule 19c-3 security. The
Commission believes that this amendment removes an impediment to
competition that exists under the current rule. Broker-dealers
that held themselves out as willing to buy and sell non-Rule 19c-
3 securities on a regular or continuous basis were not previously
required to disseminate quotation information unless they
transacted the largest percentage of the aggregate trading volume
in a particular security. Consequently, regardless of the volume
transacted by other exchanges or OTC market makers, the primary
market, which was the market responsible for transacting the
largest percentage of the aggregate trading volume, was the only
market participant required to disseminate quotations in these
securities.-[293]-
As noted in the Proposing Release, third market trading in
non-Rule 19c-3 securities has increased considerably since the
Quote Rule was last amended.-[294]- Third market trading
---------FOOTNOTES----------
-[293]- An OTC market maker or specialist, although not
the principal market for a listed security, could
elect to disseminate quotes for the security.
Under the amended 11Ac1-1(a)(25) an OTC market
maker or specialist may still elect to disseminate
quotations if it is responsible for 1% or less of
the volume in that security.
-[294]- Third market maker trading interest is more
concentrated in non-Rule 19c-3 securities, as
evidenced by the fact that the percentage of third
market quotes in non-Rule 19c-3 securities (36%)
is greater than that for Rule 19c-3 securities
(28%). See Fragmentation vs. Consolidation of
Securities Trading: Evidence of the Operation of
Rule 19c-3, Office of Economic Analysis, SEC, at 5
(continued...)
==========================================START OF PAGE 145======
in Rule 19c-3 securities now accounts for a greater number of
stocks and a more substantial percentage of U.S. trading volume
than it did when the Commission initially established disparate
regulatory treatment under the Quote Rule for Rule 19c-3
securities and non-Rule 19c-3 securities.-[295]- In view
of the growth of third market trading volume, the Commission
believes that requiring all broker-dealers trading more than 1%
of the volume in a listed security to publish quotations will
provide more accurate and comprehensive quotation information for
non-Rule 19c-3 securities.
The Commission believes that disparate regulatory
requirements for Rule 19c-3 and non-Rule 19c-3 securities can no
longer be justified by differences in the trading of the two
types of securities. Moreover, the Commission finds that
differences in regulatory treatment have impaired transparency.
Because of the growth of third market trading in non-Rule 19c-3
securities, the absence of quotes revealing the substantial third
market makers in a security and the prices they are prepared to
publicly quote results in the consolidated quotations in the
---------FOOTNOTES----------
-[294]-(...continued)
(March 29, 1995)("Fragmentation vs.
Consolidation").
-[295]- Third market trading volume has grown, at least in
part, because the universe of securities subject
to Rule 19c-3 has increased considerably. For
example, nearly 60% of the stocks listed on the
NYSE are subject to Rule 19c-3, accounting for
approximately 48% of the total NYSE volume. See
Fragmentation vs. Consolidation at 4-5.
==========================================START OF PAGE 146======
security being incomplete.-[296]- The Commission
therefore believes that significant dealers in non-Rule 19c-3
securities should become subject to the same standards required
for trading Rule 19c-3 securities.-[297]- As a result of
this amendment, market participants will have more complete
information about significant OTC market makers and specialists
in a security and the prices at which they are willing to trade.
The majority of commenters who addressed the amendment to Rule
11Ac1-1(a)(25) endorse the Commission's proposal to end the
disparity between Rule 19c-3 securities and non-Rule 19c-3
securities, noting that there is no basis for continuing to draw
a regulatory distinction between Rule 19c-3 and non-Rule 19c-3
securities, and that the extension of the Quote Rule will provide
meaningful information about significant market makers in listed
securities.-[298]- One commenter asserts that requiring
---------FOOTNOTES----------
-[296]- See, e.g., supra note 294.
-[297]- OTC market makers that trade a significant volume
in non-Rule 19c-3 securities have not been subject
to the same requirements as third market makers
that meet the 1% threshold for Rule 19c-3
securities. For example, an OTC market maker
meeting the 1% threshold is required to quote in a
Rule 19c-3 security and therefore must register as
a CQS market maker with the NASD. NASD Manual,
Rule 6320. CQS market makers are subject to the
NASD's CQS market maker rules, which include firm
and continuous two-sided quote obligations and
mandatory participation in the ITS through
Nasdaq's Computer Assisted Execution System. NASD
Manual, Rules 6320 and 6330.
-[298]- See, e.g., Amex Letter; Blume Letter; BSE Letter;
CHX Letter; CSE Letter; NASD Letter; PSE Letter;
Alex. Brown Letter; Schwab Letter; D.E. Shaw
(continued...)
==========================================START OF PAGE 147======
quotations from all significant OTC market makers will succeed in
improving the quality of the NMS for all listed securities while
at the same time leveling the playing field for all market
makers.-[299]-
Nevertheless, many commenters suggest modifications to the
1% volume threshold. Some commenters suggest that Nasdaq, on
behalf of all third market makers, should be viewed as one market
participant, and that once its volume exceeds 1% for a listed
security, all OTC market makers in that security should be
required to maintain continuous two-sided
quotations.-[300]- Other commenters believe that the
---------FOOTNOTES----------
-[298]-(...continued)
Letter; Dean Witter Letter; Lehman Letter; Madoff
Letter; Merrill Letter; PaineWebber Letter;
Salomon Letter; Smith Barney Letter; STA Letter.
There were some commenters who did not support the extension
of the Quote Rule's requirements to non-Rule 19c-3
securities. See, e.g., NYSE Letter; and Specialists Assoc.
Letter, which note that the Commission, rather than
expanding the Quote Rule to include non-Rule 19c-3
securities, should re-examine the validity of Rule 19c-3.
See, e.g., Letter from Alexander H. Slivka, Executive Vice-
President, National Securities Corporation, to Jonathan G.
Katz, Secretary, SEC, dated October 25, 1995 ("NSC Letter");
Fahnestock Letter; Letter from Samuel Lieberman, President,
Rothschild Lieberman Ltd., to Jonathan G. Katz, Secretary,
SEC ("Rothschild Letter"); Letter from Mark T. DeFelice,
Vice President, Roosevelt & Cross, Inc., to Jonathan G.
Katz, SEC, dated January 24, 1996 ("Roosevelt Letter"),
which note that the extension of the quotation requirements
to include non-Rule 19c-3, will have an impact on small
firms. See infra note 307.
-[299]- Madoff Letter.
-[300]- See PSE Letter; Specialists Assoc. Letter.
A comparable alternative is to require quotations from all
(continued...)
==========================================START OF PAGE 148======
Commission should adopt a "continuousness of execution" standard
rather than a rigid 1% volume threshold.-[301]- This
suggestion would require a dealer to quote if it executes orders
on a regular or continuous basis, even if it accounts for less
than 1% of the volume, while excluding from quotation
requirements a dealer that executes a few large trades that
account for more than 1% of the volume. The NYSE suggests an
additional threshold, to be used in the alternative with the 1%
of volume threshold.-[302]- This alternative would have
the effect of requiring public quotations from market makers who,
while not accounting for more than 1% of the aggregate
transaction volume, have an active retail business in small-sized
trades.
The Commission believes that extending the 1% threshold
based on quarterly aggregate trading volume to non-Rule 19c-3
---------FOOTNOTES----------
-[300]-(...continued)
OTC market makers who account for more than 1% of the
Nasdaq-reported volume in a security. See Investors Research
Letter.
In the same vein, two commenters suggest that once an OTC
market maker or specialist displays a quotation in a listed
security, it should be subject to the requirements of the
rule. See BSE Letter; CSE Letter.
The NYSE and CSE suggest further application of the rule to
include brokers and their private trading systems. See NYSE
Letter; CSE Letter.
-[301]- See CHX Letter; Fahnestock Letter; Jefferies
Letter; Salomon Brothers Letter; STA Letter. See
also Rothschild Letter.
-[302]- NYSE Letter. See also RPM Letter; Specialists
Assoc. Letter.
==========================================START OF PAGE 149======
securities is a reasonable method to improve the scope of
quotation information to include significant OTC market makers
and specialists. This 1% threshold, currently in effect for Rule
19c-3 securities, has proved effective in supplying comprehensive
quotation information to the market at large. Moreover, based on
the increase in third market trading volume for these securities,
the Commission does not believe this standard is unduly
burdensome on OTC market makers or specialists.-[303]-
Rather, the Commission believes this threshold strikes a balance
between requiring the dissemination of all quotation interest and
accommodating those specialists and OTC market makers that are
small entities. The Commission believes that OTC market makers
and specialists that account for 1% or less of the aggregate
volume are not active enough to justify the additional expense of
providing continuous quotation display.-[304]-
---------FOOTNOTES----------
-[303]- The Commission seeks to avoid imposing burdens on
market participants that are not necessary to
achieve the Quote Rule's objective of reliable
public quotations from all significant markets in
a security. The Commission notes that the 1%
threshold for quotations in Rule 19c-3 securities
has not impaired trading in these securities.
Since the Quote Rule was amended, OTC market
makers' volume in Rule 19c-3 securities has
increased. See Fragmentation vs. Consolidation at
4-5. The Commission has no reason to believe that
imposing mandatory quotations on specialists and
OTC market makers that are responsible for more
than 1% of the volume in a non-Rule 19c-3 security
will affect market making in these securities.
-[304]- A few commenters expressed concern that the
amendment to the Quote Rule would have a
detrimental impact on small firms. See Fahnestock
Letter; NSC Letter; Roosevelt Letter; Rothschild
(continued...)
==========================================START OF PAGE 150======
Similarly, the Commission believes that applying the 1%
threshold to the total over-the-counter volume in a listed
security would extend the quotation requirements to inactive
market makers. The Commission questions whether the added
quotation information would justify the added
burden.-[305]- The Commission also believes that reliance
on something other than a numerical standard in this circumstance
would lead to confusion in the marketplace. Accordingly, the
Commission believes the "greater than 1% aggregate trading
volume" threshold for mandatory quotations continues to be
appropriate.
ii. Amendment to 11Ac1-1(a)(13) (definition
of an "OTC market maker")
Amended Rule 11Ac1-1(a)(13)-[306]- revises the
---------FOOTNOTES----------
-[304]-(...continued)
Letter. The Commission believes the requirement
that a dealer must transact greater than 1% of the
volume in a security before quotations are
mandated prevents the rule from becoming
unnecessarily burdensome on small firms. For
example, a firm would not have to publish
continuous two-sided quotations in AT&T unless it
transacted more than 1% of the aggregate
transaction volume, which the Commission considers
more than modest volume.
-[305]- In a related release issued today, the Commission
is proposing an amendment that would require
continuous two-sided quotations from OTC market
makers and specialists provided that the OTC
market maker or specialist is responsible for more
than 1% of the aggregate transaction volume for a
security included on the Nasdaq Stock Market. See
Companion Release for a detailed discussion on the
proposed amendment to the Quote Rule.
-[306]- 17 CFR 240.11Ac1-1(a)(13).
==========================================START OF PAGE 151======
definition of "OTC market maker" to include any dealer who holds
itself out as willing to buy from and sell to its customers, or
otherwise, a covered security for its own account on a regular or
continuous basis otherwise than on an exchange in amounts of less
than block size.-[307]- Accordingly, dealers that
internalize customer order flow in particular stocks, by holding
themselves out to customers as willing to buy and sell on an
ongoing basis, would fall within the definition even though they
may not hold themselves out to all other market participants. In
addition, dealers that hold themselves out to particular firms as
willing to receive customer order flow, and execute those orders
on a regular or continuous basis, also would fall within the
definition of an OTC market maker.
Most commenters addressing this issue assert that it is
appropriate to include in the definition of OTC market maker
those dealers who internalize customer order flow because they
believe that dealers that hold themselves out to their customers
---------FOOTNOTES----------
-[307]- The definition, as proposed, read "...sell to a
customer..." but has been modified to read
"...sell to its customers...." This change was in
response to the requests of commenters for
consistency in the definition of OTC market maker
between proposed Rule 11Ac1-1(a)(13) and proposed
Rule 11Ac1-4(a)(9). See, e.g., NASD Letter.
Additionally, the Commission stated in the
Proposing Release that "[a]s in the past, broker-
dealers will not be considered to be holding
themselves out as regularly or continuously
willing to buy or sell a security if they
occasionally execute a trade as principal to
accommodate a customer's request." Proposing
Release at 24. The Commission believes the new
language more accurately reflects that premise.
==========================================START OF PAGE 152======
as willing to buy and sell securities on a continuous basis
should be required to publish quotations.-[308]- One
commenter asserts that the amendment will broaden the definition
of who should be required to provide transparency and liquidity
to the NMS to include dealers that transact business with other
firms' order flow and with their own customers, thus ensuring a
minimum level of quotation commitment from those NMS participants
vying for public order flow.-[309]- Some commenters,
however, advocate that more than internalization of order flow
should be required before a dealer is deemed an OTC market maker.
These commenters suggest the Commission adopt some form of a
"holding itself out" standard, so that the rule would capture the
quotations of professional liquidity providers but not dealers
that occasionally accommodate a customer's request.-[310]-
Other commenters, deeming the definition too inclusive, suggest
the Commission add an exception for broker-dealers that act
---------FOOTNOTES----------
-[308]- See Amex Letter; BSE Letter; CHX Letter; CSE
Letter; D.E. Shaw Letter; Madoff Letter; NYSE
Letter; PSE Letter; RPM Letter; SIA Letter; STA
Letter.
-[309]- Madoff Letter.
-[310]- See NASD Letter; Jefferies Letter; SIA Letter;
PaineWebber Letter; STA Letter. It should be
noted that the amended definition includes a
requirement that the broker-dealer hold itself out
to, at a minimum, its customers on a regular and
continuous basis in order to be an OTC market
maker.
==========================================START OF PAGE 153======
solely as agents.-[311]-
One commenter believes that excluding firms that transact
primarily block size orders and therefore account for significant
volume is inconsistent with the Commission's goals for increased
transparency.-[312]- However, several commenters note
that block size orders are excluded from the existing definition
of OTC market maker and argue strongly that it is consistent with
the purposes of the rule to continue to exclude
them.-[313]-
The Commission believes that adoption of the amendment is
warranted to ensure the availability of quotation information
that accurately reflects the interests of all significant market
participants. Increased transparency is fundamental to the
fairness and efficiency of the securities markets. As noted in
the Market 2000 Study, enhanced transparency helps link various
market segments.-[314]- Currently, a dealer can receive
order flow from internalization or pre-existing order routing
arrangements but avoid publishing quotations, even when it
accounts for more than 1% of the volume in a non-Rule 19c-3
security, because it is not currently deemed to be an OTC market
---------FOOTNOTES----------
-[311]- See Fahnestock Letter; Salomon Brothers Letter;
Rothschild Letter; Investors Research Letter.
-[312]- Amex Letter.
-[313]- See Fahnestock Letter; Dillon Letter; Goldman
Sachs Letter; Merrill Letter; Salomon Brothers
Letter.
-[314]- See Market 2000 Study at III - 7.
==========================================START OF PAGE 154======
maker.-[315]- Allowing significant market makers that
deal actively in securities without publicizing their activity or
making available their prices undermines the NMS goal of
transparency. The Commission believes that those dealers should
be classified under the rule as market makers and be required to
publicize their quotations so that investors may know of, and
trade on similar terms with, those market makers.
The Commission has considered commenters' suggestions
regarding alternative definitions. In fact, in response to the
suggestions of some commenters, the Commission has modified the
proposed amendment to make clear that more than an isolated
transaction is necessary before a dealer is designated an OTC
market maker.
The Commission, in regard to orders of block size, has
determined to continue to exclude dealers that hold themselves
out as only willing to deal in orders equal to or greater than
10,000 shares. Orders of block size are generally negotiated
with the dealer and exposed upon execution. Block positioners
usually do not maintain prices at which they are willing to buy
and sell a particular security; rather, they make known their
role of assisting in the purchase and sale of large positions in
---------FOOTNOTES----------
-[315]- Although NASD rules require dealers who are
registered as CQS market makers to provide
quotations, registration is not mandated. A
dealer in reported securities may elect to
disseminate quotations by registering as a NASD
market maker and "communicating" its best bids and
offers to the association by entering two-sided
quotations in the Nasdaq System. See NASD Manual,
Rule 4611.
==========================================START OF PAGE 155======
securities at some price. Consequently, these dealers do not
function as typical dealers that maintain a regular or continuous
price quote. The Commission has concluded that requiring
quotations from these dealers would not provide useful price
information and therefore a dealer that acts solely as a block
positioner should remain excluded from the definition.
iii. Amendment to 11Ac1-1(a)(6) (definition
of a "covered security")
As amended, Rule 11Ac1-1(a)(6)-[316]- defines
"covered security" to include any security for which a
transaction report, last sale data or quotation information is
disseminated through an automated quotation system as described
in Section 3(a)(51)(A)(ii) of the Exchange Act.-[317]-
This amendment would extend the Quote Rule provisions to OTC
market makers and exchange specialists quoting in Nasdaq SmallCap
securities.
The Proposing Release noted that the Quote Rule presently
does not reflect certain developments in the Nasdaq market,
including the large number of securities included on the Nasdaq
SmallCap market. Only one commenter addressed this amendment.
That commenter, MJT, expressed strong support for the proposal,
noting that it is both fair and equitable to apply the Quote Rule
to Nasdaq SmallCap securities.-[318]- The Commission
---------FOOTNOTES----------
-[316]- Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1(a)(6).
-[317]- 15 U.S.C. 78c(a)(51)(A)(ii).
-[318]- MJT Letter.
==========================================START OF PAGE 156======
believes it is appropriate to extend coverage of the Quote Rule
to these securities in recognition of the development of a liquid
trading market and increased investor demand for these
securities. NASD rules concerning quotations already require
firm quotations for both Nasdaq SmallCap securities and
Nasdaq/National Market securities.-[319]- Thus, the
amendment simply extends coverage of the Quote Rule requirements
to the same range of securities as existing NASD firm quote
requirements.-[320]-
c. Response to Other Specific Requests for
Comments
In addition to the Quote Rule amendments discussed above,
the Proposing Release solicited comment on whether: (1) revisions
are necessary to an NASD rule that restricts certain computer
generated quotations;-[321]- and (2) whether the ITS
---------FOOTNOTES----------
-[319]- See NASD Manual, Rule 4613.
-[320]- Section 11A(c)(1) of the Exchange Act grants the
Commission the authority to prescribe, among other
matters, rules and regulations to assure accurate
and reliable quotations "with respect to any
security other than an exempted security." The
Commission believes that extending the
requirements of the Quote Rule to Nasdaq SmallCap
securities will further these interests. No new
costs should be imposed on market participants
because the NASD rules concerning quotations
already treat Nasdaq/National Market and SmallCap
securities similarly.
-[321]- NASD Manual, Rule 6330. The NASD, however,
provides an automated quotation update capability
("auto-refresh") as part of the Small Order
Execution System which market makers may elect to
(continued...)
==========================================START OF PAGE 157======
linkage should be expanded to allow NASD CAES members access to
the linkage in non-Rule 19c-3 securities.
i. Automatic Generation of Quotations
Requiring active third market makers in non-Rule 19c-3
securities to quote also raises the issue of whether NASD members
should continue to be prohibited from using computer systems to
generate quotations automatically.-[322]- Currently,
exchange specialists may use automated mechanisms to track the
NBBO in a security if they maintain a quotation size of no more
than 100 shares.-[323]- OTC market makers, however, are
prohibited by NASD requirements from using automated quotation
tracking systems.
The Commission requested comment on whether computer
generated quotations should be permitted if active third market
makers are required to quote in non-Rule 19c-3 securities, and if
so, under what conditions. Commenters in favor of lifting the
NASD's automated quotation ban believe that worthwhile computer
---------FOOTNOTES----------
-[321]-(...continued)
use. Specifically, the quote of a market maker
using auto-refresh will be automatically updated
when the market maker exhausts its exposure limit
in the NASD's Small Order Execution System.
-[322]- See supra note 288, concerning the impact of the
ECN amendment to the 1% rule.
-[323]- The 100-share limitation follows the ITS Plan
requirement that no ITS Participant may use an
automated computer tracking system to generate
quotes for more than 100 shares in any security
the Participant trades through the ITS system.
==========================================START OF PAGE 158======
generated quotes should be permitted.-[324]- For example,
one commenter stresses that a ban on all computer generated
quotations impedes technological innovation, protecting the
franchise of inefficient market makers at the expense of the
investing public. Moreover, the commenter asserts, given the
same regulatory environment, there is no reason to believe that
firms that make automated markets will quote away from the market
any more than firms posting quotes manually.-[325]-
Certain commenters, including the NASD, believe that the ban
should continue in effect. In general, these commenters believe
that lifting the ban could create systems capacity and data
traffic problems, and result in useless quotations that are
automatically maintained away from current market
prices.-[326]-
Even commenters in favor of lifting the ban tend to believe
that, while some types of computer generated quotes are
appropriate, others, such as quotations automatically maintained
away from the best market quotation, should not be permitted.
The NASD, which generally favors the ban on automated quotes,
believes it may be appropriate to revise its autoquote policy to
permit a market maker to automatically update its quote to match
---------FOOTNOTES----------
-[324]- See, e.g., BSE Letter; CSE Letter; D.E. Shaw
Letter; Investors Research Letters; Lehman Letter;
Madoff Letter; Merrill Letter; NSC Letter; NYSE
Letter; Smith Barney Letter.
-[325]- D.E. Shaw Letter.
-[326]- See, e.g., Dean Witter Letter; NASD Letter; PSE
Letter; RPM Specialist Letter.
==========================================START OF PAGE 159======
either the best bid or best offer, provided liquidity is not
withdrawn from the contra-side of the quotation. In this
situation, the NASD believes a market maker will be exposed to an
execution and will be genuinely contributing to market liquidity.
The Commission believes that a total prohibition on the use
of computer generated quotes is not appropriate. Such an
approach excessively limits the use of sophisticated trading
strategies that rely on automation in the quotation process for
their success, and it also may act as a competitive disadvantage
to market makers and specialists that would otherwise rely on
technology to meet their quotation obligations more efficiently.
In the latter instance, broad prohibitions on the use of computer
generated quotes may cause some market makers and specialists to
restrict the number of stocks in which they are willing to make
markets.
While the Commission recognizes traditional concerns related
to the accessibility of computer generated quotes and the impact
of such quotes on systems capacity, it believes that more can and
should be done in this area. This is particularly true given the
enhanced quotation obligations that will be imposed on some
market participants under the revised Quote Rule. The Commission
urges the NASD, ITS Participants,-[327]- and other
---------FOOTNOTES----------
-[327]- The ITS Plan also places certain restrictions on
the use of computer generated quotes. See supra
note 323. Given the technologies that have
developed during the nearly 20 years that these
ITS Plan restrictions have been in place, the
Commission requests that the ITS Participants
(continued...)
==========================================START OF PAGE 160======
interested market participants to develop revised standards that
would permit the use of computer generated quotes that contribute
value to the market. Specifically, the Commission requests that
the NASD and ITS Participants resolve this issue before the
effective date of the Quote Rule amendments. In the absence of
such progress, the Commission recognizes that it will consider
invoking its own authority to address this issue.
ii. Expansion of ITS/CAES Access
As discussed in the Proposing Release, the uniform
application of the Quote Rule to all exchange-listed securities
raises the issue of the disparate treatment of Rule 19c-3 and
non-Rule 19c-3 securities under the ITS Plan. The Commission
solicited comment on this disparate treatment. The same issue
arises with the provision allowing the use of an ECN as an
intermediary in communicating quotes to the public quotation
system if equivalent access is provided.
Currently, the ITS Plan provides access to the ITS System to
any Participant in any Rule 19c-3 security in which the
Participant disseminates continuous two-sided quotations, but
excludes OTC market makers from ITS access for non-Rule 19c-3
securities. In the past, market makers in non-Rule 19c-3
securities were not subject to mandatory quote requirements. The
---------FOOTNOTES----------
-[327]-(...continued)
review these limitations and whether they continue
to be appropriate, in whole or in part, and
whether new limitations should replace the
existing provisions or whether there should be any
ITS Plan limitations on automated quotes.
==========================================START OF PAGE 161======
amendments to the Quote Rule adopted today will subject OTC
market makers and exchange specialists to the same quotation
requirements for all exchange-listed securities.
The Commission requested comment on whether the Quote Rule
amendments justify an expansion of the linkage between ITS and
the NASD's CAES interface to provide ITS access to and from any
market maker for any exchange-listed security in which that
market maker disseminates continuous two-sided quotations.
Numerous commenters support expanding the linkage in this manner
because they believe an expansion will enhance fair competition
and increase opportunities for best execution.-[328]-
Several commenters also assert that arguments previously made to
exclude OTC market maker quotes in non-Rule 19c-3 securities from
ITS are no longer valid.-[329]-
One commenter specifically argues that adoption of the
Commission's proposals should end any objection to the NASD's
full participation in ITS because the operation of the Quote Rule
will reduce opportunities for OTC market makers to trade in ECNs
while simultaneously availing themselves of the voluntary aspect
of the Quote Rule, and therefore, will expand the imposition of
NASD quotation requirements upon OTC market makers. These
requirements, according to the commenter, are equal to those of
---------FOOTNOTES----------
-[328]- See, e.g. D.E. Shaw Letter; Investors Research
Letter; Lehman Letter; NASD Letter; NSC Letter;
Madoff Letter; Rothschild Letter; Schwab Letter;
STA Letter.
-[329]- See, e.g., Madoff Letter.
==========================================START OF PAGE 162======
any other market and add greater transparency and liquidity to
the markets for exchange-listed securities as well as the
NMS.-[330]-
Those commenters opposed to the expansion generally believe
that the existing limitation on ITS access is justified in view
of disparities in customer protections afforded by exchanges and
exchange members when compared to customer protections mandated
by NASD rules.-[331]-
The Commission recognizes that the expansion of ITS/CAES is
a significant issue of concern to many market participants. The
Commission therefore encourages a continuing dialogue among the
ITS Participants to solve this issue on a timely basis and in a
manner beneficial to the market as a whole.
d. Operation of the Rule with Amended
Definitions
i. Amendment to 11Ac1-1(a)(25) (definition
of a "subject security")
As a result of the amendment adopted today, OTC market
makers and exchange specialists who hold themselves out as
willing to buy and sell non-Rule 19c-3 securities on a regular or
---------FOOTNOTES----------
-[330]- Id. Madoff states that the NASD now requires
every OTC market maker to conform with NMS
principles, respect all other NMS quotations in
listed securities, and not trade through better
quotes in the NMS. Madoff further notes that, in
contrast, exchanges do not impose similar
restrictions with respect to trading through off-
exchange quotations.
-[331]- See Amex Letter; BSE Letter; CHX Letter; CSE
Letter; PSE Letter; Specialists Assoc. Letter.
==========================================START OF PAGE 163======
continuous basis, and that account for more than 1% of the
quarterly aggregate trading volume, will be subject to the Quote
Rule and required to make continuous two-sided quotations
available to the public, even if they have not previously elected
to register as CQS market makers with the NASD. This amendment
will close a significant gap in the quotation information that
has been available heretofore to market participants and
investors. In a parallel action, the Commission is proposing for
comment an additional amendment to the Quote Rule.-[332]-
The Commission believes that the additional proposal, if adopted,
would further improve transparency by providing investors with
quotation information on Nasdaq securities from significant OTC
market makers and specialists.
ii. Amendment to 11Ac1-1(a)(13) (definition
of an "OTC market maker")
The definition of OTC market maker now includes any dealer
holding itself out as willing to transact business for its own
account on a regular or continuous basis, whether it transacts
exclusively with its own customers or with the customers of other
dealers. Those dealers that hold themselves out to customers as
willing to execute orders on a regular or continuous basis,
whether by the internalization of customer order flow in
particular stocks or through arrangements with particular firms
to execute their customer order flow, now fall within the
definition of OTC market maker. Therefore, obligations under the
---------FOOTNOTES----------
-[332]- See Companion Release.
==========================================START OF PAGE 164======
Quote Rule will now apply to dealers that internalize customer
order flow or hold themselves out to particular firms as willing
to execute their customer order flow, and that execute those
orders on a regular or continuous basis. As in the past, broker-
dealers will not be considered to be holding themselves out as
regularly or continuously willing to buy or sell a security if
they occasionally execute a trade as principal to accommodate a
customer's request.
iii. Amendment to 11Ac1-1(a)(6) (definition
of a "covered security")
The amendment extends the coverage of the Quote Rule to all
Nasdaq securities where the rule had previously applied only to
Nasdaq/National Market securities. As noted previously, NASD
rules already require a dealer that makes a market in a Nasdaq
SmallCap security to provide quotations.-[333]- The
Commission, therefore, does not believe extending the Quote Rule
to include securities covered by an existing NASD rule will
result in additional burdens on OTC market makers. Although the
definition of covered security has been amended to include Nasdaq
SmallCap securities, an exchange specialist or OTC market maker
still must make an election, pursuant to paragraphs (b)(5)(i) and
(ii), respectively, of the Quote Rule.-[334]-
Accordingly, although the definition has been amended, an OTC
market maker or specialist is not mandated by the Quote Rule to
---------FOOTNOTES----------
-[333]- See NASD Rule 4613.
-[334]- 17 CFR 240.11Ac1-1(b)(5)(i)
==========================================START OF PAGE 165======
provide quotations on Nasdaq SmallCap securities. If, however,
an exchange specialist or OTC market maker makes an election to
make available quotations, the firmness obligations under
paragraph (c) of the Quote Rule become operative.
e. Effective Date
The amendments to Rule 11Ac1-1 adopted by the Commission
today will become effective on [insert date 120 days from the
date of publication in the Federal Register].
C. Price Improvement for Customer Market Orders
1. Proposed Rule
In the Proposing Release, the Commission sought comment on a
market-wide Price Improvement Rule for customer market orders.
The proposed rule was designed to apply across exchange and OTC
markets to promote the execution quality of orders by providing
increased opportunities for customer orders to interact at better
prices without the intervention of a dealer. The proposal
included a non-exclusive safe harbor as one means by which a
specialist or OTC market maker could be assured that an order
received a sufficient opportunity for price improvement for
purposes of the rule.
The proposed rule was intended to encourage market
participants to take advantage of current technologies and
provide customer market orders with improved access to price
improvement opportunities, regardless of where such orders are
routed for execution. Although the proposed rule would have
required specialists and OTC market makers to provide price
==========================================START OF PAGE 166======
improvement opportunities for customer orders, the Commission did
not prescribe any particular method of achieving price
improvement in recognition of the fact that competition can
produce innovative price improvement mechanisms. The Commission
proposed a non-exclusive safe harbor, however, to provide
certainty regarding one alternative by which a specialist or OTC
market maker would be deemed to have satisfied its price
improvement obligation.
Under the safe harbor, a specialist or OTC market maker
would have been deemed in compliance with the proposed price
improvement rule if it exposed, in its quote, a customer market
order at an improved price and provided the customer with a
guaranteed execution at the "stop" price.-[335]- This
procedure was designed to promote the interaction of exposed
orders at prices better than the NBBO with orders or trading
interest in other markets. The safe harbor also was intended to
lead to increased competition by encouraging specialists and OTC
market makers to compete more actively for order flow on the
basis of their published quotations. The Commission made clear,
however, that the order exposure procedures set out in the
proposed safe harbor neither would be mandatory, nor the
exclusive means by which to satisfy the obligation to provide an
---------FOOTNOTES----------
-[335]- The proposed safe harbor provided for an order to
be "stopped" at the national best bid (for a sell
order) or offer (for a buy order) for the lesser
of either the full size of the order, or the size
associated with the national best bid (for a sell
order) or offer (for a buy order).
==========================================START OF PAGE 167======
opportunity for price improvement.
Many of the 145 commenters discussed the proposed Price
Improvement Rule. The commenters raise numerous questions and
concerns regarding the proposed rule. For example, some
commenters claim that an absolute rule would reduce the broker-
dealer's fiduciary obligation of best execution to an algorithm,
eliminating the exercise of professional judgment in identifying
price improvement opportunities.-[336]- Instead, the
commenters argue that customers and market professionals should
be able to use discretion in deciding when and how price
improvement should be sought.-[337]-
In addition, several commenters are concerned that the
proposed safe harbor would become the industry standard. These
commenters believe that, although non-exclusive, the proposed
safe harbor would dictate the minimum acceptable standard to
follow, thereby stifling innovation and
competition.-[338]- Many commenters also are troubled by
---------FOOTNOTES----------
-[336]- See, e.g., Goldman Sachs Letter; Jefferies Letter;
Madoff Letter; Merrill Letter; NYSE Letter;
PaineWebber Letter; PSE Letter.
-[337]- See, e.g., CSE Letter; Goldman Sachs Letter;
Madoff Letter; Merrill Letter; NSC Letter; NYSE
Letter; PSE Letter.
-[338]- See, e.g., AZX Letter; Blume Letter; HHG Letter;
Lehman Letter; Merrill Letter; Morgan Stanley
Letter; NASD Letter; Salomon Letter; Schwab
Letter; Smith Barney Letter; PaineWebber Letter;
Ruane Letter.
Some commenters believe their current operations would
satisfy the rule and, therefore, they would not need to
(continued...)
==========================================START OF PAGE 168======
various technical aspects regarding the application of the safe
harbor. For example, some commenters believe the 30-second
exposure period would be insufficient to allow other market
participants to respond to the exposed order, even with today's
technology.-[339]- Other commenters are concerned with
the mechanics of the "stopping" procedures.-[340]- At
least one commenter argues that the requirement to stop stock
blurs the distinction between price guarantees and price
improvement opportunities.-[341]-
The potential costs associated with the proposed rule also
concern many commenters. They claim that necessary systems
upgrades would be expensive.-[342]- In addition, several
commenters claim that the number of quotes generated as a result
of the safe harbor would pose a serious threat to system
---------FOOTNOTES----------
-[338]-(...continued)
utilize the safe harbor procedures. See, e.g., Amex Letter;
BSE Letter; CHX Letter; NYSE Letter; PSE Letter.
-[339]- See, e.g., Amex Letter; Blume Letter; BSE Letter;
CHX Letter; CSE Letter; NYSE Letter; PSE Letter;
Schwab Letter;. But see, e.g., Letter from
Raymond E. Wooldridge, Chief Executive Officer,
Southwest Securities, to Mr. Jonathan G. Katz,
Secretary, SEC, dated January 9, 1996 ("Southwest
Letter"); STANY Letter.
-[340]- See, e.g., Madoff Letter; MJT Letter; Smith Barney
Letter.
-[341]- See Sutro Letter.
-[342]- See, e.g., Blume Letter; Dean Witter Letter;
Fahnestock Letter; Goldman Sachs Letter; LJR
Letter; NASD Letter; PaineWebber Letter; Ruane
Letter; Salomon Letter; Schwab II Letter; SIA
Letter.
==========================================START OF PAGE 169======
capacity.-[343]- Many commenters warn that the increased
traffic would reduce trading efficiency, decrease transparency
and increase overall risk.-[344]- Some commenters also
state that market price integrity would be reduced due to the
proliferation of flickering, ephemeral quotations.-[345]-
A common suggestion from the commenters is that the
Commission not adopt the proposed rule prior to evaluating the
effects of the other initiatives contained in the
proposal.-[346]- Some commenters believe that the
amendments to the Quote Rule and the proposed Limit Order Display
Rule should act to narrow spreads by eliciting the true market
for a given security, thereby decreasing the utility and
necessity of seeking better prices for customer orders.
According to these commenters, if such results are achieved
through the other initiatives, the potential costs and
significant market operations changes associated with the
---------FOOTNOTES----------
-[343]- See, e.g., Bear Stearns Letter; FIF Letter;
Merrill Letter; PSE Letter; STANY Letter.
-[344]- See, e.g., Amex Letter; Bear Stearns Letter; Blume
Letter; FIF Letter; LJR Letter; Madoff Letter;
Merrill Letter; Morgan Stanley Letter; NASD
Letter; PSE Letter; Salomon Letter; STA Letter;
STANY Letter; Specialist Assoc. Letter.
-[345]- See, e.g., Dean Witter Letter; ICI Letter; Merrill
Letter; Morgan Stanley Letter; NASD Letter; NYSE
Letter; PSE Letter; Salomon Letter; Schwab II
Letter; Specialist Assoc. Letter; STANY Letter.
-[346]- See, e.g., Bear Stearns Letter; Dean Witter
Letter; DOJ Letter; Goldman Sachs Letter; Lehman
Letter; Madoff Letter; Morgan Stanley Letter; NASD
Letter; NSC Letter; Schwab II Letter; SIA Letter;
Sutro Letter.
==========================================START OF PAGE 170======
proposed Price Improvement Rule would far outweigh any potential
benefit.
Although the Commission continues to believe that the
opportunity for price improvement can contribute to providing
customer orders with enhanced executions, the Commission has
determined to defer action on the proposed Price Improvement Rule
for the present time. The Commission believes that the other
initiatives adopted today will greatly improve the price
discovery process and the opportunity for customer orders to
receive enhanced execution prices. These initiatives should act
to narrow spreads by making available to all market participants
the true buying and selling interest in a given security. The
Commission believes, therefore, that the most appropriate course
of action is to monitor the operation of the initiatives adopted
today, and assess their impact on spreads, the quality of
markets, and the quality of executions. This assessment will
enable the Commission to better determine the need for further
Commission action regarding specific price improvement
obligations.
2. Best Execution Obligations
The proposed Price Improvement Rule was designed to
complement the long-standing duties of broker-dealers to seek to
obtain best execution of their customer orders; the Commission
did not intend for the proposed rule to modify this existing best
execution obligation.-[347]- Therefore, the Commission's
---------FOOTNOTES----------
-[347]- Proposing Release at 49.
==========================================START OF PAGE 171======
decision to defer consideration of the proposed rule in no way
should be taken as an indication that the duty of best execution
has been altered.
A broker-dealer's duty of best execution derives from common
law agency principles and fiduciary obligations, and is
incorporated both in SRO rules and, through judicial and
Commission decisions, in the antifraud provisions of the federal
securities laws.-[348]- This duty of best execution
requires a broker-dealer to seek the most favorable terms
reasonably available under the circumstances for a customer's
transaction.-[349]- The scope of this duty of best
execution must evolve as changes occur in the market that give
rise to improved executions for customer orders, including
opportunities to trade at more advantageous prices. As these
changes occur, broker-dealers' procedures for seeking to obtain
best execution for customer orders also must be modified to
consider price opportunities that become "reasonably
available."-[350]-
In the past the Commission has recognized the practical
necessity of automating the handling of small orders, and has
indicated that automated routing or execution of customer orders
---------FOOTNOTES----------
-[348]- See Market 2000 Study, Study V at V-1, 2 and
sources cited therein.
-[349]- See Market 2000 Concept Release, supra note 10;
Market 2000 Study, Study V.
-[350]- Proposing Release at 7-10.
==========================================START OF PAGE 172======
is not necessarily inconsistent with best
execution.-[351]- At the same time, the Commission has
emphasized that best execution obligations require that broker-
dealers routing orders for automatic execution must periodically
assess the quality of competing markets to assure that order flow
is directed to markets providing the most beneficial terms for
their customers' orders.-[352]- While in the past quote-
based executions in OTC securities were generally recognized as
satisfying best execution obligations, the development of
efficient new facilities has altered what broker dealers must
consider in seeking best execution of customer
orders.-[353]- The Commission thus noted the importance
of the opportunity for price improvement as a factor in best
execution, speaking in the context of aggregate order handling
decisions for both listed and OTC stocks.-[354]-
Therefore, the Commission believes that routing order flow for
automated execution, or internally executing order flow on an
---------FOOTNOTES----------
-[351]- Id. at 8.
-[352]- Payment for Order Flow Release, supra note 23, at
n. 30 and accompanying text; See Securities
Exchange Act Release No. 37046 (March 29, 1996),
61 FR 15322 (April 5, 1996) ("CSE Approval
Order"); Securities Exchange Act Release No. 37045
(March 29, 1996), 61 FR 15318 (April 5, 1996)
("BSE Approval Order").
-[353]- Proposing Release at 10.
-[354]- Id.; see also Payment for Order Flow Release,
supra note 23 at text accompanying notes 31-33.
See CSE Approval Order, supra note 352; BSE
Approval Order, supra note 352.
==========================================START OF PAGE 173======
automated basis, at the best bid or offer quotation, would not
necessarily satisfy a broker-dealer's duty of best execution for
small orders in listed and OTC securities.-[355]-
Both the rule and the amendments adopted today should
further improve a broker-dealer's ability to obtain improved
executions for customer orders. These changes will enhance the
public quote by including in the public quotation system many
superior prices not currently reflected there. The ECN amendment
is intended to publicize superior market maker ECN prices in the
public quote, which should make these prices more easily
accessible. Similarly, the Display Rule will include more
customer prices in the public quote through requiring the display
of customer limit orders.
Nonetheless, various markets and market makers may continue
to provide opportunities for executions at prices superior to the
enhanced national best bid and offer for their customer
orders.-[356]- For example, some markets or market makers
may continue to offer price improvement opportunities, based on
internal order flow or execution algorithms. The Commission
believes that broker-dealers deciding where to route or execute
small customer orders in listed or OTC securities must carefully
evaluate the extent to which this order flow would be afforded
better terms if executed in a market or with a market maker
---------FOOTNOTES----------
-[355]- Proposing Release at 9-10; see also note 360 and
accompanying text (factors relevant to best
execution).
-[356]- Id.
==========================================START OF PAGE 174======
offering price improvement opportunities. In conducting the
requisite evaluation of its internal order handling procedures, a
broker-dealer must regularly and rigorously examine execution
quality likely to be obtained from the different markets or
market makers trading a security.-[357]- If different
markets may be more suitable for different types of orders or
particular securities, the broker-dealer will also need to
consider such factors.
Where material differences exist between the price
improvement opportunities offered by markets or market makers,
these differences must be taken into account by the broker-
dealer. Similarly, in evaluating its procedures for handling
limit orders, the broker-dealer must take into account any
material differences in execution quality ( e.g., the likelihood
of execution) among the various markets or market centers to
which limit orders may be routed. The traditional non-price
factors affecting the cost or efficiency of executions also
should continue to be considered;-[358]- however, broker-
dealers must not allow an order routing inducement, such as
---------FOOTNOTES----------
-[357]- CSE Approval Order, 61 FR at 15329. "Price
improvement" in this context is defined as the
difference between execution price and the best
quotes prevailing in the market at the time the
order arrived at the market or market maker. Any
evaluation of price improvement opportunities
would have to consider not only the extent to
which orders are executed at prices better than
the prevailing quotes, but also the extent to
which orders are executed at inferior prices.
-[358]- See Market 2000 Study, Study V at V-2, 3.
==========================================START OF PAGE 175======
payment for order flow or the opportunity to trade with that
order as principal, to interfere with its duty of best
execution.-[359]- Of course, as the Commission has
previously noted, in light of a broker-dealer's obligation to
assess the quality of the markets to which it routes packaged
order flow absent specific instructions from customers, the
Commission does not believe that a broker-dealer violates its
best execution obligation merely because it receives payment for
order flow or trades as principal with customer orders.
-[360]-
Prices superior to the public quote may at times be
available in ECNs, even after adoption of the ECN amendment,
based, for example, on orders of institutional participants and
others not covered by the ECN amendment. Superior prices also
may be available in other systems not classified as ECNs. As the
Commission noted in the Proposing Release in September, 1995, and
reiterates today, where reliable, superior prices are readily
accessible in such systems, broker-dealers should consider these
prices in making decisions regarding the routing of customer
orders.-[361]- The Commission recognizes that many of
these systems are less accessible and involve higher costs for
broker-dealers than the public markets. In addition, in many
cases it is not currently feasible to efficiently obtain price
---------FOOTNOTES----------
-[359]- Payment for Order Flow Release, supra note 23.
-[360]- Id.
-[361]- Proposing Release at 10.
==========================================START OF PAGE 176======
information from these systems or link to these systems on an
automated basis. The Commission is not suggesting that broker-
dealers must engage in manual handling of small orders if
necessary to access these systems.-[362]- Nonetheless, the
Commission believes that because technology is rapidly making
these systems more accessible, broker-dealers must regularly
evaluate whether prices or other benefits offered by these
systems are reasonably available for purposes of seeking best
execution of these customer orders. For example, if an ECN
provides an automated link that makes it cost effective for a
broker-dealer to access these systems for its retail orders on an
automated basis, the broker-dealer must take the prices and other
relevant costs in that system into account in handling these
customer orders.
Pursuant to the Display Rule, most customer limit orders at
superior prices will be required to be displayed and included in
the public quote.-[363]- The display of a limit order by
a market maker directly affects its responsibilities in handling
other customer orders. The Commission has long said that broker-
---------FOOTNOTES----------
-[362]- The Commission has recognized that it may be
impractical, both in terms of time and expense,
for a broker that handles a large volume of orders
to determine individually where to route each
order it received. Proposing Release at 8.
-[363]- The Commission notes that the NASD's
interpretation prohibiting market makers from
trading ahead of customer limit orders applies
both to displayed and nondisplayed customer limit
orders held by the market maker. See NASD Conduct
Rule IM 2110-2 (Trading Ahead of Customer Limit
Orders).
==========================================START OF PAGE 177======
dealers must consider quotation information contained in the
public quotation system in seeking best execution of customer
orders.-[364]- In executing customer market orders, a
market maker must give no less consideration to the price of its
own displayed customer limit order than any other public
quotation price. Therefore, under the new Display Rule, a market
maker that has displayed a customer limit order would be expected
to provide an offsetting customer market order an execution at
that limit price at least up to the size of the limit order.
In addition, the Commission notes that currently, some
market makers that hold a customer limit order on one side of the
market, priced better than the market maker's own quote, and a
customer market order on the other side of the market, will
execute both orders as principal rather than crossing the two
orders. As a result, the market order customer receives the best
bid and offer rather than receiving the benefit of a better limit
order price. In light of the increased opportunities for price
improvement now available and the rules the Commission is
adopting today, the Commission believes that going forward this
practice is no longer appropriate given the broker-dealer's
obligation, as part of its duty of best execution, to its market
order customer.-[365]-
---------FOOTNOTES----------
-[364]- See Quote Rule Adopting Release, supra note 208.
-[365]- Cf., NASD Notice to Members 96-10 (February, 1996)
at 43; NASD Notice to Members 95-67 (August, 1995)
at 417.
==========================================START OF PAGE 178======
In conclusion, although the Commission has determined for
the present to defer final action on the proposed Price
Improvement Rule, the Commission's adoption of the Display Rule
and the Quote Rule amendments should substantially improve public
quotations. Moreover, the Commission firmly believes that
broker-dealers, when deciding where to route or execute customer
orders, must carefully consider and evaluate opportunities for
obtaining improved executions.
IV. Authority
As discussed above, the 1975 Act Amendments to the Exchange
Act set forth Congress' goals for a national market system.
Several commenters argue that the proposed rules violate
Congress's direction that the Commission facilitate the
establishment of, rather than design, a national market
system.-[366]- Many of these comments were directed at
the proposed Price Improvement Rule and in particular the
proposed price improvement safe harbor. The Commission today is
deferring action on that rule proposal. To the extent that the
comments relate to the rule and amendments adopted today,
however, they reflect a fundamental misunderstanding regarding
the purpose of the rules and the Commission's role in
facilitating a national market system.
The Commission's adoption of these rules is fully consistent
with the role that Congress envisioned in 1975 for the
---------FOOTNOTES----------
-[366]- See, e.g., ABA Letter; Fahnestock Letter; HHG
Letter; LJR Letter; NSC Letter; PaineWebber
Letter; RPM Letter; Ruane Letter; SIA Letter.
==========================================START OF PAGE 179======
Commission. Congress's direction to the Commission to
"facilitate" the establishment of a national market system for
securities that implemented Congressionally enumerated objectives
was not intended as a limitation on the Commission's authority
but rather was "designed to provide maximum flexibility to the
Commission and the securities industry in giving specific content
to the general concept of the national market system."
-[367]- Congress granted the Commission broad rulemaking
authority over the national market system and market participants
and this grant of specific rulemaking authority was not
conditioned on the expectation that the Commission refrain from
using it.
Although Congress expressed a preference that where possible
the national market system evolve through the interplay of
competitive forces, it recognized that "competition may not be
sufficient" and that in such cases, the Commission should act
"promptly and effectively to insure that the essential mechanisms
of an integrated secondary trading system [be] put into place * *
---------FOOTNOTES----------
-[367]- Conference Report, supra note 213, at 92. See
Senate Report, supra note 31, at 8-9 ("the sounder
approach appeared * * * to be to establish a
statutory scheme clearly granting the Commission
broad authority to oversee the implementation,
operation, and regulation of the national market
system and at the same time to charging it with
the clear responsibility to assure that the system
develops and operates in accordance with
Congressional determined goals and objectives.").
The Conference Committee report on the 1975 Act
Amendments indicates that the conferees adopted
with minor revisions the Senate's provisions
concerning the national market system. Conference
Report, supra note 213, at 92.
==========================================START OF PAGE 180======
*." -[368]- Congress specifically identified in 1975 some
of the concerns addressed today and the Commission has examined
these issues on several occasions over the intervening years in
response to evolving market conditions and technologies. In view
of the caution and deliberation with which the Commission has
proceeded over the past 21 years, its actions today cannot fairly
be viewed as arresting natural competitive forces, but rather
should be regarded as an attempt to foster efficiency and redress
shortcomings in the national market system that have developed
since then, or that the securities industry on its own has been
unable to resolve over this time.
The subject matter of these rule and rule amendments is an
area of the national market system in which Congress itself
recognized that the Commission's expertise and authority were
paramount. Indeed, Section 11A was specifically enacted to
eliminate "arguments about the SEC's authority" in this area.
For that reason, the Commission was given "pervasive rulemaking
power" with respect to the business of collecting, processing, or
publishing information relating to quotations for and
transactions in securities. -[369]- The rules adopted
today implement Congress' goals as to dissemination of trading
information: "to insure the availability of prompt and accurate
trading information, to assure that these communications networks
are not controlled or dominated by any particular market center,
---------FOOTNOTES----------
-[368]- Conference Report, supra note 213 at 92.
-[369]- Conference Report, supra note 213, at 93.
==========================================START OF PAGE 181======
to guarantee fair access to such systems by all brokers, dealers
and investors, and to prevent any competitive restriction on
their operation not justified by the purposes of the Exchange
Act." -[370]-
It bears noting that the standards adopted by the Commission
today are intended to allow markets to adapt and evolve in
meeting the objectives of the national market system; the rules
establish performance standards but do not dictate market
structure. With regard to the Quote Rule, the rules do not
determine how non-Rule 19c-3 market makers may make markets or
how electronic communications networks may operate. Non-Rule
19c-3 market makers are free to operate as they please so long as
they report their quotations to the extent they execute a certain
level of volume in a security. Likewise, market makers and
specialists may place priced orders in ECNs of many different
designs as long as they change their quotes to reflect the orders
in the ECN or the ECNs publicly report the quotes and provide
access to such priced orders. With regard to the Limit Order
Display Rule, the rule does not seek to create a central limit
order book or central limit order file. Broker-dealers are free
to satisfy the rule in several different ways, so long as the
result is that customer limit orders priced at or better than the
NBBO are publicly displayed.
Some commenters also argue that the proposed rules are
contrary to Congress' direction to assure fair competition
---------FOOTNOTES----------
-[370]- Senate Report, supra note 31.
==========================================START OF PAGE 182======
between auction and dealer markets as structures for the trading
of securities-[371]- and inappropriately introduce auction
market principles into dealer markets. Although requiring
display of superior-priced customer limit orders could be viewed
as an auction market principle, such a requirement does not
supplant the basic features of a dealer market or undermine
competition between the exchange and OTC markets. Congress
clearly intended that dealer markets would benefit from use of
some auction market principles -[372]- and the 1975
Amendments specifically announce as a goal of the national market
system that customer orders be able to interact without the
intervention of a dealer to the extent that such a goal is
consistent with other national market system
objectives.-[373]- At a minimum, where feasible, customer
limit orders should have a meaningful opportunity to interact
with customer market orders.-[374]-
One of the main benefits contemplated by Congress was that
the national market system would enable investors in dealer
markets to execute against another limit order or market order at
a better price than currently being quoted by a dealer for his
---------FOOTNOTES----------
-[371]- See, e.g., Goldman Sachs Letter; Jefferies Letter;
Merrill Lynch Letter; RPM Letter; Schwab I Letter;
Schwartz & Wood Letter; SIA Letter; Specialist
Assoc. Letter; see also Exchange Act Section
11A(a)(1)(C)(ii), 15 U.S.C. 78k-1(a)(1)(C)(ii).
-[372]- Senate Report, supra note 31, at 16.
-[373]- Exchange Act Section 11A(a)(1)(C)(v).
-[374]- Exchange Act Section 11A(a)(1)(C)(v).
==========================================START OF PAGE 183======
own account.-[375]- Display of superior-priced limit
orders would permit investors to compete in some cases with
market makers and specialists, thereby increasing the
competitiveness of dealer markets in these securities and
enhancing the quality of customer limit order execution. Display
of customer limit orders, however, would not compromise the
essential features of dealer markets. In the absence of any
superior-priced customer limit orders, dealers would continue to
compete for market orders at their published quotations and would
be able to execute against customer limit orders that would
otherwise prevent the market maker from trading with a market
order. Further, the widespread use by OTC dealers of ECNs to
trade at prices better than the dealers' published quotes is of
such recent vintage that it can hardly be viewed as a necessary
part of a dealer market structure.-[376]-
V. Summary of Final Regulatory Flexibility Act Analysis
This following discussion summarizes the Commission's
analysis of the rules adopted today under the Regulatory
Flexibility Act. A complete final copy of the Final Regulatory
Flexibility Act is available in the Public File.
---------FOOTNOTES----------
-[375]- Senate Report supra note 31, at 16.
-[376]- While the rule and rule amendments adopted today
function as an integrated response to the problems
the Commission has identified in the
implementation of a NMS, each separately advances
the Congressional goals of market efficiency, fair
competition, transparency, and best execution, and
accordingly the Commission intends that they be
treated as severable for purposes of review.
==========================================START OF PAGE 184======
The rules adopted today by the Commission are intended to
allow markets to adapt and evolve in meeting the objectives of
the national market system. In this regard, the rules establish
performance standards but do not dictate market structure. The
Quote Rule does not dictate how market makers or specialists that
trade non-Rule 19c-3 securities may conduct their market making
activities or how ECNs may service their subscribers. Market
makers will be able to continue their regular market making
activities so long as they report their quotations if they trade
more than 1% of the transaction volume in a security. Likewise,
market makers and specialists may place priced orders in ECNs of
many different designs as long as they change their quotes to
reflect better priced orders they have entered in ECNs or,
alternatively, such ECNs provide for the public reporting of
these prices and provide access to such priced orders. Moreover,
broker-dealers are free to satisfy the Display Rule in several
different ways, so long as the result is that customer limit
orders priced at or better than the NBBO are publicly displayed
in accordance with the rule.
A. Display Rule
The Commission considered several significant alternatives
to Rule 11Ac1-4 consistent with the Rule s objectives and
designed to minimize the impact of the rule on small entities.
The Commission solicited comment on, among other things: (i)
whether the display requirement should be based on a de minimis
threshold; (ii) the classes of securities to which the Rule
==========================================START OF PAGE 185======
should apply; (iii) whether to permit limit orders to be
delivered to an exchange- or association-sponsored system that
displays limit orders in accordance with the rule; and (iv)
whether to permit limit orders to be delivered to an ECN or a
PTS. The Commission believes that the rule as adopted imposes a
smaller burden upon small brokers and dealers than do other
alternatives considered.
The Commission believes that the ability of brokers and
dealers to send a limit order to another party or system that
will display that order provides all brokers and dealers,
including small brokers and dealers, with the greatest possible
flexibility to satisfy the NMS objectives embodied in the rule in
the most economical manner. In this regard, the Commission
decided to expand one of the exceptions to the display
requirement that will permit market makers to comply with the
rule by delivering customer limit orders to an ECN that complies
with the ECN amendment to the Quote Rule. Furthermore, the
Commission added a new exemptive provision that enables the
Commission to exempt any responsible broker or dealer, ECN,
exchange, or association from the requirements of the Display
Rule.
The Commission considered allowing display of a
representative size of a limit order rather than the full size,
but concluded that display of the full size will provide the most
accurate picture of the depth of the market at a particular
price. The Commission does not believe that it is practicable to
==========================================START OF PAGE 186======
exempt small entities from the Display Rule because to do so
would be inconsistent with the Commission's statutory mandate to
protect investors. In that regard, the Commission believes that
the pricing and size conventions documented in the 21(a) Report
referenced above make it imperative that the requirements of the
Display Rule apply to all market participants with equal force.
The Commission notes that any exception for small brokers and
dealers could create an incentive for Nasdaq market makers to
create special market making subsidiaries qualifying as small
broker-dealers which would be free to engage in the anti-
competitive practices identified in the 21(a) Report.
B. Quote Rule
Allowing market makers that deal actively in securities
without publicizing their activity or making available their
prices undermines the NMS goal of transparency. The Commission
believes that those dealers should be recognized as market makers
and their quotations publicized so that investors may know of,
and trade on similar terms with, those market makers. Therefore,
the definition of OTC market maker now includes any dealer
holding itself out as willing to transact business for its own
account on a regular or continuous basis, whether it transacts
exclusively with its own customers or with the customers of other
dealers. Thus, those dealers that internalize customer order
flow in particular stocks or through arrangements with other
firms to execute that order flow, now fall within the definition
of OTC market maker and are subject to the obligations under the
==========================================START OF PAGE 187======
Quote Rule. As in the past, broker-dealers will not be
considered to be holding themselves out as regularly or
continuously willing to buy or sell a security if they
occasionally execute a trade as principal to accommodate a
customer's request. In response to the suggestions of some
commenters, the Commission has modified the amendment to make
clear that more than one isolated transaction is necessary before
a dealer is designated an OTC market maker.
In addition, the Commission believes that extending the 1%
threshold based on quarterly aggregate trading volume to non-Rule
19c-3 securities is a reasonable method to improve the scope of
quotation information to include significant OTC market makers
and specialists. This 1% threshold, currently in effect for Rule
19c-3 securities, has proved effective in supplying comprehensive
quotation information to the market at large. Moreover, based on
the increase in third market trading volume for these securities,
the Commission does not believe this standard is unduly
burdensome on OTC market makers. Rather, the Commission believes
this threshold strikes a balance between requiring the
dissemination of all quotation interest and accommodating those
specialists and OTC market makers that may be small entities.
The Commission believes that OTC market makers and specialists
that account for 1% or less of the aggregate volume are not
active enough to justify the additional expense of providing
continuous quotation display. Accordingly, the Commission
believes the "greater than 1% aggregate trading volume" threshold
==========================================START OF PAGE 188======
for mandatory quotations continues to be appropriate. To limit a
possible inconsistency in the treatment of exchange-listed and
Nasdaq securities, the Commission today is proposing that the 1%
test be extended from all exchange-listed securities to all
Nasdaq-listed securities.
The Commission considered several significant alternatives
to the proposed amendments to the Quote Rule consistent with the
Rule's objectives and designed to minimize the impact of the
amendments on small entities. The Commission solicited comment
on numerous alternatives to the amendments proposed to ensure
that investors receive consolidated quotations that truly reflect
the best prices available for a security. The Commission
solicited comment on, among other issues: (i) whether the
Commission should require SROs to amend their rules to permit
computer-generated quotations; (ii) whether there existed
alternatives to the ECN proposal that minimized certain
consequences of the rule while assuring public dissemination of
the best priced orders in such systems; (iii) whether there
should be exceptions to the ECN proposal and under what
circumstances; and (iv) whether the objectives of the Quote Rule
and the ECN amendment could be achieved by allowing ECNs to
furnish prices to the applicable SRO, while providing access to
the prices in their ECN. The Commission believes that the
amendments as adopted impose a smaller burden upon small brokers
and dealers than does any other alternative considered.
In recognition of the concerns raised by some commenters,
==========================================START OF PAGE 189======
the ECN display alternative is designed to preserve the benefits
associated with the anonymity that certain ECNs currently offer
to subscribing market makers and specialists. This alternative
also ensures that the best market maker and specialist prices in
the ECN are publicly disseminated and that non-subscribing
brokers and dealers may trade with the orders represented by
those prices. Under the display alternative, the price of a
specialist's or market maker's order entered into an ECN would be
publicly disseminated while the specialist or market maker
remains anonymous. This alternative not only preserves
anonymity, but also eliminates the risk that a market maker or
specialist may be exposed to multiple executions at the ECN
price. With the addition of the alternative, the ECN amendment
permits the display of the best price either in the specialist's
or market maker's quote or through an ECN that provides for the
dissemination of the best market maker and specialist prices
entered into the ECN.
The Commission also notes that the ECN display alternative
reduces the compliance burden on broker-dealers, including small
entities, by permitting specialists and market makers to comply
with the ECN amendment if the ECN into which the market maker s
order is entered ensures that the best market maker prices
entered therein are communicated to an exchange, association or
securities information processor and the ECN provides a means for
brokers and dealers to trade with the orders market makers and
specialists put in the ECN.
==========================================START OF PAGE 190======
The Commission recognizes that the ECN display alternative
may reduce the content of information that is publicly available
because under this alternative, the identity of the market maker
or specialist that entered the better priced order in the ECN
will be withheld. The Commission believes this result is
justified because the inside prices and full sizes of orders
entered by market makers and specialists will be in the public
quotation system to inform the entire market of these prices and
ECNs will provide equivalent access to those prices. Moreover,
the Commission believes the benefits of facilitating the use of
ECNs, by permitting the continued anonymity of market makers and
specialists, more than offset the reduced information available
on the identity of a particular market maker or specialist.
The Commission believes the data it has reviewed supports
the need for prompt adoption of the ECN amendment to the Quote
Rule. As discussed more fully in the Appendix to the 21(a)
Report, an analysis of data for April through June 1994 shows
that approximately 85% of bids and offers displayed by market
makers on Instinet and 90% of bids and offers displayed on
SelectNet (an ECN sponsored by the NASD) were at better prices
than those disseminated to the public via Nasdaq. In addition,
approximately 77% of trades executed on Instinet and 60% of
trades executed on SelectNet were at prices superior to the
Nasdaq inside spread. Given this strong evidence that investors
would benefit from public dissemination of these hidden prices
that are broadly disseminated to subscribers in these systems,
==========================================START OF PAGE 191======
the Commission believes that it is appropriate to adopt the
amendments to the Quote Rule.
The Commission does not believe that it is practicable to
exempt small entities from the Quote Rule amendments because to
do so would be inconsistent with the Commission's statutory
mandate to protect investors. In this regard, the Commission
notes the clear evidence of a two-tiered market, in which market
makers routinely trade at one price with customers and at better
prices with ECN participants. The Commission believes that it is
imperative to further the long-standing objectives of the 1975
Amendments to ensure reliable and accurate quotes by making these
prices available to the public. The Commission believes that any
exception for small brokers and dealers could create an incentive
for Nasdaq market makers to create special market making
subsidiaries qualifying as small broker-dealers which would be
free to engage in the anti-competitive practices identified in
the 21(a) Report.
A final copy of the Final Regulatory Flexibility Act
analysis is available in the Public File.
VI. Paperwork Reduction Act
As set forth in the Proposing Release,-[377]- the
proposed amendments to Rule 11Ac1-1 and proposed Rule 11Ac1-4
contain collections of information within the meaning of the
Paperwork Reduction Act ("PRA"). Accordingly, proposed
amendments to Rule 11Ac1-1 and proposed Rule 11Ac1-4 were
---------FOOTNOTES----------
-[377]- Proposing Release at 70.
==========================================START OF PAGE 192======
submitted to the Office of Management and Budget ("OMB") for
review pursuant to Section 3507 of the PRA (44 U.S.C. 3507), and
were approved by OMB which assigned the following control
numbers: Amendments to Rule 11Ac1-1, control number 3235-0461;
Rule 11Ac1-4, control number 3235-0462. An agency may not
conduct or sponsor, and a person is not required to respond to, a
collection of information unless it displays a valid OMB control
number. This is the final notice regarding the collection of
information under Rule 11Ac1-4, the Display Rule. A new notice
regarding the collections of information under Rule 11Ac1-1, the
Quote Rule, may be found in the Companion Release (published
elsewhere in the Federal Register today) which proposes an
additional amendment to the Quote Rule. The PRA section in the
preamble of the Companion Release provides new estimates of the
burden in responding to the collections of information under the
Quote Rule as a whole.
The reporting requirement in Rule 11Ac1-4 is found in 17 CFR
240.11Ac1-4. The collection of information is mandatory and
responses are not confidential. The respondents are OTC market
makers, as defined under the rule. (Although exchange
specialists are also required to follow the rule, as noted in the
Proposing Release the Commission does not anticipate any
significant additional burden on exchange specialists in light of
current exchange order handling practices.) The Rule requires
market makers to change their published quotation to reflect the
price and/or size of a customer limit order that would improve
==========================================START OF PAGE 193======
their published bid or offer or otherwise ensure that such limit
order is displayed. The burden on market makers will depend on
the extent and variety of their market-making activities and
their choice of the various compliance options offered by the
regulations. The ability of market makers to utilize facilities
of national securities exchanges, registered national securities
associations, and ECNs to comply with the reporting requirement
should ease the compliance burden. The proposed rule would have
permitted market makers to execute a limit order or send a limit
order to another market maker or exchange or association facility
that would ensure display of such orders in lieu of the market
makers' own display. Rule 11Ac1-4 as adopted maintains these
alternatives and also permits respondents to send a limit order
to an ECN meeting certain criteria. The information reported
will be displayed to all persons who have access to a quotation
montage as that term is defined in 17 CFR 240.11Ac1-2(a)(16).
The Commission carefully considered comments received from
the NASD and SIA concerning the Commission's burden
estimates.-[378]- The NASD stated that the Commission
underestimated the number of limit orders to be displayed per
trading day, given the NASD's view that Rule 11Ac1-4 will lead to
increased limit order exposure. After considering the NASD's
---------FOOTNOTES----------
-[378]- The SIA noted that they join in the concerns
expressed by the NASD that the Commission's
estimates under the PRA are too low, and need to
be revised and extended to include the proposed
safe harbor under Rule 11Ac1-5. SIA Letter at 4.
As noted above, the Commission is not adopting the
Price Improvement Rule at this time.
==========================================START OF PAGE 194======
comment, and based upon further review of the market data, the
Commission is revising its burden estimate for Rule 11Ac1-4 as
follows. There are approximately 570 respondents. Each
respondent on average will respond to the collection of
information 42,000 times per year, based on a 252 trading day
year. The total time burden for each respondent per year is
estimated to be 35 hours, based on an estimate of 3 seconds per
response (i.e., the time it takes to update a quote to reflect a
limit order, or to transmit the order for display
elsewhere).-[379]- The total annual aggregate burden for
all respondents is estimated to be 19,950 hours.
VII. Effects on Competition
Section 23(a)(2) of the Exchange Act-[380]- requires
the Commission to consider the anti-competitive effects of any
rules it adopts thereunder, and to balance them against the
benefits that further the purposes of the Act. As discussed
above, several commenters raised concerns regarding the
---------FOOTNOTES----------
-[379]- The NASD commented that it believes the PRA burden
estimate should include the time market makers
spend analyzing market trends and following
quotation and last sale information. The
Commission has determined not to revise its burden
estimate based on this comment, because market
makers otherwise engage in such activities apart
from the collection of information requirement.
For example, market makers are already required to
monitor the markets to ensure that they do not
trade ahead of customer limit orders.
-[380]- 15 U.S.C. 78w(a)(2).
==========================================START OF PAGE 195======
competitive implications of the order handling
proposals.-[381]- The foregoing discussion contains
extensive analysis of the competitive effects of both the rule
and rule amendments; this section summarizes the Commission's
conclusions. The Commission has considered the proposals in
light of the comments and the standard embodied in Section
23(a)(2) and has concluded any burdens on competition imposed by
the Display Rule and the amendments to the Quote Rule are
necessary and appropriate in furtherance of the purposes of the
Exchange Act, in particular, the purposes of Section 11A.
The Commission notes that the primary burden imposed by the
Display Rule will be to require exchange specialists and OTC
market makers to ensure that customer limit orders improving
their quotes are displayed. The Commission believes that if
systems upgrades are necessary, those systems upgrades reflect
one-time charges. The Commission also notes that ensuring public
dissemination of limit orders enhances market transparency,
increases pricing efficiency, and quote-based competition, and
permits investors' orders to interact with all available market
interest. Moreover, the limit order display rule will provide an
opportunity for investors to compete directly in the market.
This additional competition should limit certain anticompetitive
practices identified in the 21(a) Report and discussed supra. For
the reasons discussed above, the Commission does not believe the
Display Rule will have a significantly different effect on
---------FOOTNOTES----------
-[381]- See ABA Letter; HHG Letter; NASD Letter.
==========================================START OF PAGE 196======
wholesale and retail market makers.-[382]- The Commission
notes that the Antitrust Division of the U.S. Department of
Justice similarly concluded that the Display Rule will promote
competition and will thereby benefit the investing public.
Similarly, the Commission notes that the primary burden
imposed by the ECN Amendment to the Quote Rule will be to require
exchange specialists and OTC market makers to add personnel or
upgrade systems to ensure that their quotes reflect priced orders
entered into those ECNs that do not disseminate order information
to the relevant exchange or association. The Commission believes
that such systems upgrades reflect one-time charges. The
Commission believes that the ECN amendment to the Quote Rule will
impose only limited competitive burdens on ECNs. ECNs which have
attributes that differentiate them from other types of electronic
order routing and order execution systems, will have a choice
whether to disseminate order information to the relevant
exchanges or association. While choosing this alternative will
result in some system costs, the Commission believes that the
alternative will provide ECNs with additional business
opportunities, including increased order flow. The ECN amendment
should allow ECNs to function as valuable facilities for their
subscribers, and should not harm ECNs significantly in their
competition with other order execution systems.-[383]-
---------FOOTNOTES----------
-[382]- See supra note 124 and accompanying text.
-[383]- Although the Antitrust Division of the U.S.
Department of Justice expressed concerns about the
(continued...)
==========================================START OF PAGE 197======
The Commission also notes that ensuring public dissemination of
market makers' and specialists' priced orders entered into ECNs
enhances market transparency, pricing efficiency, price
competition, and allows investors' orders to interact with all
available market interest.
Finally, with respect to the amendments extending the
Mandatory Quote Rule to non-Rule 19c-3 securities, the primary
burden imposed will be to require certain brokers and dealers to
register as CQS market makers and make continuous two-sided
quotes available to the public. The Commission believes that the
benefit to the investing public of ensuring that available market
interest is disseminated to the public will enhance competition
by facilitating the routing of investor orders to the market
center displaying the best quotation for a security. The
Commission believes that the added transparency resulting from
the amendment outweighs any burden to competition that may be
imposed.
---------FOOTNOTES----------
-[383]-(...continued)
effects of the ECN amendment as originally
proposed, the Commission believes that with the
quote dissemination alternative, the amendment
will not impose any unnecessary or inappropriate
burdens on competition.
==========================================START OF PAGE 198======
List of Subjects in 17 CFR Part 240
Broker-dealers, Confidential business information, Reporting
and recordkeeping requirements, and Securities.
TEXT OF THE RULES
For the reasons set out in the preamble, the Commission
amends Part 240 of Chapter II of Title 17 of the Code of Federal
Regulation as follows:
PART 240 -- GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE
ACT OF 1934
1. The general authority citation for Part 240 is revised
to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1, 78l,
78m, 78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-
20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless
otherwise noted.
*****
2. Section 240.11Aa3-1 is amended by revising paragraph
(a)(4) to read as follows:
240.11Aa3-1 Dissemination of transaction reports and last sale
data with respect to transactions in reported securities
(a) Definitions. ***
(4) The term reported security shall mean any security or
class of securities for which transaction reports are collected,
processed and made available pursuant to an effective transaction
reporting plan.
==========================================START OF PAGE 199======
*****
3. Section 240.11Ac1-1 is revised to read as follows:
240.11Ac1-1 Dissemination of quotations.
(a) Definitions. For the purposes of this section:
(1) The term aggregate quotation size shall mean the sum of
the quotation sizes of all responsible brokers or dealers who
have communicated on any exchange bids or offers for a covered
security at the same price.
(2) The term association shall mean any association of
brokers and dealers registered pursuant to Section 15A of the Act
(15 U.S.C. 78o-3).
(3) The terms best bid and best offer shall mean the highest
priced bid and the lowest priced offer.
(4) The terms bid and offer shall mean the bid price and the
offer price communicated by an exchange member or OTC market
maker to any broker or dealer, or to any customer, at which it is
willing to buy or sell one or more round lots of a covered
security, as either principal or agent, but shall not include
indications of interest.
(5) The term consolidated system shall mean the consolidated
transaction reporting system.
(6) The term covered security shall mean any reported
security and any other security for which a transaction report,
last sale data or quotation information is disseminated through
an automated quotation system as described in Section
3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)).
==========================================START OF PAGE 200======
(7) The term effective transaction reporting plan shall have
the meaning provided in 240.11Aa3-1(a)(3).
(8) The term electronic communications network, for the
purposes of 240.11Ac1-1(c)(5), shall mean any electronic system
that widely disseminates to third parties orders entered therein
by an exchange market maker or OTC market maker, and permits such
orders to be executed against in whole or in part; except that
the term electronic communications network shall not include:
(i) Any system that crosses multiple orders at one or more
specified times at a single price set by the ECN (by algorithm or
by any derivative pricing mechanism) and does not allow orders to
be crossed or executed against directly by participants outside
of such times; or
(ii) Any system operated by, or on behalf of, an OTC market
maker or exchange market maker that executes customer orders
primarily against the account of such market maker as principal,
other than riskless principal.
(9) The term exchange market maker shall mean any member of
a national securities exchange ("exchange") who is registered as
a specialist or market maker pursuant to the rules of such
exchange.
(10) The term exchange-traded security shall mean any
covered security or class of covered securities listed and
registered, or admitted to unlisted trading privileges, on an
exchange; provided, however, That securities not listed on any
exchange that are traded pursuant to unlisted trading privileges
==========================================START OF PAGE 201======
are excluded.
(11) The term make available, when used with respect to
bids, offers, quotation sizes and aggregate quotation sizes
supplied to quotation vendors by an exchange or association,
shall mean to provide circuit connections at the premises of the
exchange or association supplying such data, or at a common
location determined by mutual agreement of the exchanges and
associations, for the delivery of such data to quotation vendors.
(12) The term odd-lot shall mean an order for the purchase
or sale of a covered security in an amount less than a round lot.
(13) The term OTC market maker shall mean any dealer who
holds itself out as being willing to buy from and sell to its
customers, or otherwise, a covered security for its own account
on a regular or continuous basis otherwise than on an exchange in
amounts of less than block size.
(14) The term plan processor shall have the meaning provided
in 240.11Aa3-2(a)(7).
(15) The term published aggregate quotation size shall mean
the aggregate quotation size calculated by an exchange and
displayed by a quotation vendor on a terminal or other display
device at the time an order is presented for execution to a
responsible broker or dealer.
(16) The terms published bid and published offer shall mean
the bid or offer of a responsible broker or dealer for a covered
security communicated by it to its exchange or association
pursuant to this section and displayed by a quotation vendor on a
==========================================START OF PAGE 202======
terminal or other display device at the time an order is
presented for execution to such responsible broker or dealer.
(17) The term published quotation size shall mean the
quotation size of a responsible broker or dealer communicated by
it to its exchange or association pursuant to this section and
displayed by a quotation vendor on a terminal or other display
device at the time an order is presented for execution to such
responsible broker or dealer.
(18) The term quotation size, when used with respect to a
responsible broker's or dealer's bid or offer for a covered
security, shall mean:
(i) The number of shares (or units of trading) of that
covered security which such responsible broker or dealer has
specified, for purposes of dissemination to quotation vendors,
that it is willing to buy at the bid price or sell at the offer
price comprising its bid or offer, as either principal or agent;
or
(ii) In the event such responsible broker or dealer has not
so specified, a normal unit of trading for that covered security.
(19) The term quotation vendor shall mean any securities
information processor engaged in the business of disseminating to
brokers, dealers or investors on a real-time basis, bids and
offers made available pursuant to this section, whether
distributed through an electronic communications network or
displayed on a terminal or other display device.
(20) The term reported security shall mean any security or
==========================================START OF PAGE 203======
class of securities for which transaction reports are collected,
processed and made available pursuant to an effective transaction
reporting plan.
(21) The term responsible broker or dealer shall mean:
(i) When used with respect to bids or offers communicated on
an exchange, any member of such exchange who communicates to
another member on such exchange, at the location (or locations)
designated by such exchange for trading in a covered security, a
bid or offer for such covered security, as either principal or
agent; provided, however, That, in the event two or more members
of an exchange have communicated on such exchange bids or offers
for a covered security at the same price, each such member shall
be considered a "responsible broker or dealer" for that bid or
offer, subject to the rules of priority and precedence then in
effect on that exchange; and further provided, That for a bid or
offer which is transmitted from one member of an exchange to
another member who undertakes to represent such bid or offer on
such exchange as agent, only the last member who undertakes to
represent such bid or offer as agent shall be considered the
"responsible broker or dealer" for that bid or offer; and
(ii) When used with respect to bids and offers communicated
by a member of an association to another broker or dealer or to a
customer otherwise than on an exchange, the member communicating
the bid or offer (regardless of whether such bid or offer is for
its own account or on behalf of another person).
(22) The term revised bid or offer shall mean a market
==========================================START OF PAGE 204======
maker's bid or offer which supersedes its published bid or
published offer.
(23) The term revised quotation size shall mean a market
maker's quotation size which supersedes its published quotation
size.
(24) The term specified persons, when used in connection
with any notification required to be provided pursuant to
paragraph (b)(3) of this section and any election (or withdrawal
thereof) permitted under paragraph (b)(5) of this section, shall
mean:
(i) Each quotation vendor;
(ii) Each plan processor; and
(iii) The processor for the Options Price Reporting
Authority (in the case of a notification for a subject security
which is a class of securities underlying options admitted to
trading on any exchange).
(25) The term subject security shall mean:
(i) With respect to an exchange:
(A) Any exchange-traded security other than a security for
which the executed volume of such exchange, during the most
recent calendar quarter, comprised one percent or less of the
aggregate trading volume for such security as reported in the
consolidated system; and
(B) Any other covered security for which such exchange has
in effect an election, pursuant to paragraph (b)(5)(i) of this
section, to collect, process, and make available to quotation
==========================================START OF PAGE 205======
vendors, bids, offers, quotation sizes, and aggregate quotation
sizes communicated on such exchange; and
(ii) With respect to a member of an association:
(A) Any exchange-traded security for which such member acts
in the capacity of an OTC market maker unless the executed volume
of such member, during the most recent calendar quarter,
comprised one percent or less of the aggregate trading volume for
such security as reported in the consolidated system; and
(B) Any other covered security for which such member acts in
the capacity of an OTC market maker and has in effect an
election, pursuant to paragraph (b)(5)(ii) of this section, to
communicate to its association bids, offers and quotation sizes
for the purpose of making such bids, offers and quotation sizes
available to quotation vendors.
(b) Dissemination requirements for exchanges and
associations.
(1) Every exchange and association shall establish and
maintain procedures and mechanisms for collecting bids, offers,
quotation sizes and aggregate quotation sizes from responsible
brokers or dealers who are members of such exchange or
association, processing such bids, offers and sizes, and making
such bids, offers and sizes available to quotation vendors, as
follows:
(i) Each exchange shall at all times such exchange is open
for trading, collect, process and make available to quotation
vendors the best bid, the best offer, and aggregate quotation
==========================================START OF PAGE 206======
sizes for each subject security listed or admitted to unlisted
trading privileges which is communicated on any exchange by any
responsible broker or dealer, but shall not include:
(A) Any bid or offer executed immediately after
communication and any bid or offer communicated by a responsible
broker or dealer other than an exchange market maker which is
cancelled or withdrawn if not executed immediately after
communication; and
(B) Any bid or offer communicated during a period when
trading in that security has been suspended or halted, or prior
to the commencement of trading in that security on any trading
day, on that exchange.
(ii) Each association shall, at all times that last sale
information with respect to reported securities is reported
pursuant to an effective transaction reporting plan, collect,
process and make available to quotation vendors the best bid,
best offer, and quotation sizes communicated otherwise than on an
exchange by each member of such association acting in the
capacity of an OTC market maker for each subject security and the
identity of that member (excluding any bid or offer executed
immediately after communication), except during any period when
over-the-counter trading in that security has been suspended.
(2) Each exchange shall, with respect to each published bid
and published offer representing a bid or offer of a member for a
subject security, establish and maintain procedures for
ascertaining and disclosing to other members of that exchange,
==========================================START OF PAGE 207======
upon presentation of orders sought to be executed by them in
reliance upon paragraph (c)(2) of this section, the identity of
the responsible broker or dealer who made such bid or offer and
the quotation size associated with it.
(3)(i) If, at any time an exchange is open for trading, such
exchange determines, pursuant to rules approved by the Securities
and Exchange Commission pursuant to section 19(b)(2) of the Act
(15 U.S.C. 78s(b)(2)), that the level of trading activities or
the existence of unusual market conditions is such that the
exchange is incapable of collecting, processing, and making
available to quotation vendors the data for a subject security
required to be made available pursuant to paragraph (b)(1) of
this section in a manner that accurately reflects the current
state of the market on such exchange, such exchange shall
immediately notify all specified persons of that determination.
Upon such notification, responsible brokers or dealers that are
members of that exchange shall be relieved of their obligation
under paragraph (c)(2) of this section and such exchange shall be
relieved of its obligations under paragraphs (b)(1) and (2) of
this section for that security: provided, however, That such
exchange will continue, to the maximum extent practicable under
the circumstances, to collect, process, and make available to
quotation vendors data for that security in accordance with
paragraph (b)(1) of this section.
(ii) During any period an exchange, or any responsible
broker or dealer that is a member of that exchange, is relieved
==========================================START OF PAGE 208======
of any obligation imposed by this section for any subject
security by virtue of a notification made pursuant to paragraph
(b)(3)(i) of this section, such exchange shall monitor the
activity or conditions which formed the basis for such
notification and shall immediately renotify all specified persons
when that exchange is once again capable of collecting,
processing, and making available to quotation vendors the data
for that security required to be made available pursuant to
paragraph (b)(1) of this section in a manner that accurately
reflects the current state of the market on such exchange. Upon
such renotification, any exchange or responsible broker or dealer
which had been relieved of any obligation imposed by this section
as a consequence of the prior notification shall again be subject
to such obligation.
(4) Nothing in this section shall preclude any exchange or
association from making available to quotation vendors
indications of interest or bids and offers for a subject security
at any time such exchange or association is not required to do so
pursuant to paragraph (b)(1) of this section.
(5)(i) Any exchange may make an election for purposes of
paragraph (a)(25)(i)(B) of this section for any covered security,
by collecting, processing, and making available bids, offers,
quotation sizes, and aggregate quotation sizes in that security;
except that for any covered security previously listed or
admitted to unlisted trading privileges on only one exchange and
not traded by any OTC market maker, such election shall be made
==========================================START OF PAGE 209======
by notifying all specified persons, and shall be effective at the
opening of trading on the business day following notification.
(ii) Any member of an association acting in the capacity of
an OTC market maker may make an election for purposes of
paragraph (a)(25)(ii)(B) of this section for any covered
security, by communicating to its association bids, offers, and
quotation sizes in that security; except that for any other
covered security listed or admitted to unlisted trading
privileges on only one exchange and not traded by any other OTC
market maker, such election shall be made by notifying its
association and all specified persons, and shall be effective at
the opening of trading on the business day following
notification.
(iii) The election of an exchange or member of an
association for any covered security pursuant to this paragraph
(b)(5) shall cease to be in effect if such exchange or member
ceases to make available or communicate bids, offers, and
quotation sizes in such security.
(c) Obligations of responsible brokers and dealers.
(1) Each responsible broker or dealer shall promptly
communicate to its exchange or association, pursuant to the
procedures established by that exchange or association, its best
bids, best offers, and quotation sizes for any subject security.
(2) Subject to the provisions of paragraph (c)(3) of this
section, each responsible broker or dealer shall be obligated to
execute any order to buy or sell a subject security, other than
==========================================START OF PAGE 210======
an odd-lot order, presented to it by another broker or dealer, or
any other person belonging to a category of persons with whom
such responsible broker or dealer customarily deals, at a price
at least as favorable to such buyer or seller as the responsible
broker's or dealer's published bid or published offer (exclusive
of any commission, commission equivalent or differential
customarily charged by such responsible broker or dealer in
connection with execution of any such order) in any amount up to
its published quotation size.
(3)(i) No responsible broker or dealer shall be obligated to
execute a transaction for any subject security as provided in
paragraph (c)(2) of this section to purchase or sell that subject
security in an amount greater than such revised quotation if:
(A) Prior to the presentation of an order for the purchase
or sale of a subject security, a responsible broker or dealer has
communicated to its exchange or association, pursuant to
paragraph (c)(1) of this section, a revised quotation size; or
(B) At the time an order for the purchase or sale of a
subject security is presented, a responsible broker or dealer is
in the process of effecting a transaction in such subject
security, and immediately after the completion of such
transaction, it communicates to its exchange or association a
revised quotation size, such responsible broker or dealer shall
not be obligated by paragraph (c)(2) of this section to purchase
or sell that subject security in an amount greater than such
revised quotation size.
==========================================START OF PAGE 211======
(ii) No responsible broker or dealer shall be obligated to
execute a transaction for any subject security as provided in
paragraph (c)(2) of this section if:
(A) Before the order sought to be executed is presented,
such responsible broker or dealer has communicated to its
exchange or association pursuant to paragraph (c)(1) of this
section, a revised bid or offer; or
(B) At the time the order sought to be executed is
presented, such responsible broker or dealer is in the process of
effecting a transaction in such subject security, and,
immediately after the completion of such transaction, such
responsible broker or dealer communicates to its exchange or
association pursuant to paragraph (c)(1) of this section, a
revised bid or offer; provided, however, That such responsible
broker or dealer shall nonetheless be obligated to execute any
such order in such subject security as provided in paragraph
(c)(2) of this section at its revised bid or offer in any amount
up to its published quotation size or revised quotation size.
(4) Subject to the provisions of paragraph (b)(4) of this
section:
(i) No exchange or OTC market maker may make available,
disseminate or otherwise communicate to any quotation vendor,
directly or indirectly, for display on a terminal or other
display device any bid, offer, quotation size, or aggregate
quotation size for any covered security which is not a subject
security with respect to such exchange or OTC market maker; and
==========================================START OF PAGE 212======
(ii) No quotation vendor may disseminate or display on a
terminal or other display device any bid, offer, quotation size,
or aggregate quotation size from any exchange or OTC market maker
for any covered security which is not a subject security with
respect to such exchange or OTC market maker.
(5)(i) Entry of any priced order for a covered security by
an exchange market maker or OTC market maker in that security
into an electronic communications network that widely
disseminates such order shall be deemed to be:
(A) A bid or offer under this section, to be communicated to
the market maker's exchange or association pursuant to paragraph
(c) of this section for at least the minimum quotation size that
is required by the rules of the market maker's exchange or
association if the priced order is for the account of a market
maker, or the actual size of the order up to the minimum
quotation size required if the priced order is for the account of
a customer; and
(B) A communication of a bid or offer to a quotation vendor
for display on a display device for purposes of paragraph (c)(4)
of this section.
(ii) An exchange market maker or OTC market maker that has
entered a priced order for a covered security into an electronic
communications network that widely disseminates such order shall
be deemed to be in compliance with paragraph (c)(5)(i)(A) of this
section if the electronic communications network:
(A) Provides to an exchange or association (or an exclusive
==========================================START OF PAGE 213======
processor acting on behalf of one or more exchanges or
associations) the prices and sizes of the orders at the highest
buy price and the lowest sell price for such security entered in,
and widely disseminated by, the electronic communications network
by exchange market makers and OTC market makers for the covered
security, and such prices and sizes are included in the quotation
data made available by the exchange, association, or exclusive
processor to quotation vendors pursuant to this section; and
(B) Provides, to any broker or dealer, the ability to effect
a transaction with a priced order widely disseminated by the
electronic communications network entered therein by an exchange
market maker or OTC market maker that is:
(1) Equivalent to the ability of any broker or dealer to
effect a transaction with an exchange market maker or OTC market
maker pursuant to the rules of the exchange or association to
which the electronic communications network supplies such bids
and offers; and
(2) At the price of the highest priced buy order or lowest
priced sell order, or better, for the lesser of the cumulative
size of such priced orders entered therein by exchange market
makers or OTC market makers at such price, or the size of the
execution sought by the broker or dealer, for the covered
security.
(d) Exemptions. The Commission may exempt from the
provisions of this section, either unconditionally or on
specified terms and conditions, any responsible broker or dealer,
==========================================START OF PAGE 214======
electronic communications network, exchange, or association if
the Commission determines that such exemption is consistent with
the public interest, the protection of investors and the removal
of impediments to and perfection of the mechanism of a national
market system.
4. Section 240.11Ac1-4 is added to read as follows:
240.11Ac1-4 Display of customer limit orders.
(a) Definitions. For purposes of this section:
(1) The term association shall mean any association of
brokers and dealers registered pursuant to Section 15A of the Act
(15 U.S.C. 78o-3).
(2) The terms best bid and best offer shall have the
meaning provided in 240.11Ac1-1(a)(3).
(3) The terms bid and offer shall have the meaning provided
in 240.11Ac1-1(a)(4).
(4) The term block size shall mean any order:
(i) Of at least 10,000 shares; or
(ii) For a quantity of stock having a market value of at
least $200,000.
(5) The term covered security shall mean any "reported
security" and any other security for which a transaction report,
last sale data or quotation information is disseminated through
an automated quotation system as described in Section
3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)).
(6) The term customer limit order shall mean an order to
buy or sell a covered security at a specified price that is not
==========================================START OF PAGE 215======
for the account of either a broker or dealer; provided, however,
That the term customer limit order shall include an order
transmitted by a broker or dealer on behalf of a customer.
(7) The term electronic communications network shall have
the meaning provided in 240.11Ac1-1(a)(8).
(8) The term exchange-traded security shall have the
meaning provided in 240.11Ac1-1(a)(10).
(9) The term OTC market maker shall mean any dealer who
holds itself out as being willing to buy from and sell to its
customers, or otherwise, a covered security for its own account
on a regular or continuous basis otherwise than on a national
securities exchange in amounts of less than block size.
(10) The term reported security shall have the meaning
provided in 240.11Ac1-1(a)(20).
(b) Specialists and OTC market makers. For all covered
securities:
(1) Each member of an exchange that is registered by that
exchange as a specialist, or is authorized by that exchange to
perform functions substantially similar to that of a specialist,
shall publish immediately a bid or offer that reflects:
(i) The price and the full size of each customer limit
order held by the specialist that is at a price that would
improve the bid or offer of such specialist in such security; and
(ii) The full size of each customer limit order held by the
specialist that:
(A) Is priced equal to the bid or offer of such specialist
==========================================START OF PAGE 216======
for such security;
(B) Is priced equal to the national best bid or offer; and
(C) Represents more than a de minimis change in relation to
the size associated with the specialist's bid or offer.
(2) Each registered broker or dealer that acts as an OTC
market maker shall publish immediately a bid or offer that
reflects:
(i) The price and the full size of each customer limit
order held by the OTC market maker that is at a price that would
improve the bid or offer of such OTC market maker in such
security; and
(ii) The full size of each customer limit order held by the
OTC market maker that:
(A) Is priced equal to the bid or offer of such OTC market
maker for such security;
(B) Is priced equal to the national best bid or offer; and
(C) Represents more than a de minimis change in relation to
the size associated with the OTC market maker's bid or offer.
(c) Exceptions. The requirements in paragraph (b) of this
section shall not apply to any customer limit order:
(1) That is executed upon receipt of the order.
(2) That is placed by a customer who expressly requests,
either at the time that the order is placed or prior thereto
pursuant to an individually negotiated agreement with respect to
such customer's orders, that the order not be displayed.
(3) That is an odd-lot order.
==========================================START OF PAGE 217======
(4) That is a block size order, unless a customer placing
such order requests that the order be displayed.
(5) That is delivered immediately upon receipt to an
exchange or association-sponsored system, or an electronic
communications network that complies with the requirements of
240.11Ac1-1(c)(5)(ii) with respect to that order.
(6) That is delivered immediately upon receipt to another
exchange member or OTC market maker that complies with the
requirements of this section with respect to that order.
(7) That is an "all or none" order.
(d) Exemptions.
The Commission may exempt from the provisions of this
section, either unconditionally or on specified terms and
conditions, any responsible broker or dealer, electronic
communications network, exchange, or association if the
Commission determines that such exemption is consistent with the
public interest, the protection of investors and the removal of
impediments to and perfection of the mechanism of a national
market system.
By the Commission.
Jonathan G. Katz
Secretary
Date: September 6, 1996