[Federal Register Volume 59, Number 100 (Wednesday, May 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-12739]
[[Page Unknown]]
[Federal Register: May 25, 1994]
=======================================================================
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34078; File No. SR-BSE-93-12]
Self-Regulatory Organizations; Boston Stock Exchange, Inc.; Order
Granting Temporary Approval for One Year to Proposed Rule Change
Permitting Competing Specialists on the Floor of the Exchange
May 18, 1994.
On June 4, 1993, the Boston Stock Exchange, Inc. (``BSE'' or
``Exchange'') submitted to the Securities and Exchange Commission
(``SEC'' or ``Commission''), pursuant to section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to permit competing specialists
(``CSs'') on the floor of the Exchange and to adopt guidelines
governing their registration and activity. The proposed rule change was
published for comment in Securities Exchange Act Release No. 32549
(June 29, 1993), 58 FR 36229 (July 6, 1993).
---------------------------------------------------------------------------
\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1993).
---------------------------------------------------------------------------
In addition, on July 7, 1993, September 24, 1993, and October 12,
1993, the Exchange filed with the Commission Amendment Nos. 1, 2, and
3, respectively. The amendments were published for comment in
Securities Exchange Act Release No. 33089 (October 22, 1993), 58 FR
58205 (October 29, 1993). Amendment Nos. 1 and 3 were largely
technical, and resulted in deletions from the final text of the
rule.\3\ Amendment No. 2 adds to the procedures for CSs an index
arbitrage provision\4\ and a restriction on cash payment for order flow
by CSs in those stocks in which the specialist becomes registered as a
CS.\5\
---------------------------------------------------------------------------
\3\The substance of Amendment No. 1 concerned a requirement that
appropriate Chinese Wall procedures be in place. In Amendment No. 2,
the Exchange deleted the substance of Amendment No. 1. The Exchange,
however submitted a separate proposed rule change (File No. SR-BSE-
93-17) establishing Chinese Wall procedures. See Securities Exchange
Act Release No. 33090 (October 22, 1993) 58 FR 58206. That proposal
is being separately approved today in conjunction with approval of
this rule proposal. Amendment No. 3 deleted a footnote that had been
added in Amendment No. 2.
\4\The index arbitrage provision mirrors that portion of the
NYSE's Rule 80A restriction on index arbitrage in situations where
the Dow Jones Industrial Average has declined by 50 points or more
from the previous day's closing value.
\5\The Commission notes that the current registered specialist
(the ``regular'' specialist) in a particular stock is not considered
a ``competing specialist'' in that stock under the proposal, and
therefore is not affected by this prohibition. If, however, it
applies to compete in a different stock, it is a ``competing
specialist'' in that stock and, pursuant to this rule change, may
not pay for any order flow in that stock.
---------------------------------------------------------------------------
II. Description of the Proposal
The purpose of the proposed rule change is to permit competing
specialists on the floor of the BSE. Currently, each stock traded on
the BSE is assigned to one particular specialist. This contrasts with a
multiple market maker system where competing market makers compete for
order flow in the same securities. The BSE competing specialist
proposal will permit up to three specialists\6\ in each stock, who
would compete with each other for order flow.\7\ Each specialist will
have the same affirmative and negative obligations as are imposed
currently upon BSE specialists.
---------------------------------------------------------------------------
\6\The proposal provides for both a ``regular'' specialist (the
current specialist) and up to two ``competing'' specialists. The
regular specialist would remain responsible for (1) updating
quotations, (2) coordinating all openings and reopenings to ensure
that they are unitary, (3) inputing quotations on ITS to reflect the
best BSE quote among all the specialists, and (4) coordinating
trading halts. The BSE will display only one consolidated quotation
to other markets in the National Market System.
\7\The scope of the pilot is further limited in that each
competitor may specialize in a maximum of 10 stocks unless the
Market Performance Committee (``MPC'') approves an increase of up to
20 stocks per applicant firm. The MPC may approve such an increase
on a case-by-case basis. The BSE has represented that, during the
pilot program, the total number of stocks subject to competition
will not exceed 360. See Securities Exchange Act Release No. 32549
(June 29, 1993), 58 FR 36229 (July 6, 1993).
---------------------------------------------------------------------------
Moreover, the BSE rules governing the auction market principles of
priority, parity, and precedence remain unchanged.\8\ Thus, if the
specialists are quoting the same price (i.e., they are on price
parity), the earliest bid/offer at that price has time priority and
will be filled first up to its specified size; and if the specialists
are on both price and time parity, then all bids/offers equal to or
greater than the size of the contra-side order are on parity and
entitled to precedence over smaller ones (if it is possible to
determine the order of time such orders were made, they shall be filled
in that order).
---------------------------------------------------------------------------
\8\See BSE Rules Ch. II Sec. 6.
---------------------------------------------------------------------------
In addition to facilitating competition among the specialists, the
proposal permits preferenced order routing. Orders may be directed to
any specialist based on the request of the firm submitting the order,
or, if a particular specialist is not specified, then the orders will
be directed to the regular specialist.\9\ If an order is entered into
BSE's automated order routing system (``BEACON'') by a member firm
affiliated with a specialist, that order automatically will be routed
to that member firm's affiliated specialist, thereby preventing member
firms affiliated with a specialist from routing non-profitable orders
through BEACON to the other specialist when market conditions are
unfavorable.\10\
---------------------------------------------------------------------------
\9\As noted below, however, if the CS is quoting the ITS/BBO and
clearly has established priority on the BSE floor, then the CS will
fill the order despite the default routing to the regular
specialist.
\10\Conversation between Karen Aluise, Assistant Vice President,
Boston Stock Exchange, and N. Amy Bilbija, Commission, on December
14, 1993.
---------------------------------------------------------------------------
All limit orders in a pilot stock, regardless as to which
specialist they are sent, will be represented and executed strictly
according to time priority in BEACON. Once all limit orders at the
Intermarket Trading System best bid or offer (``ITS/BBO'') or better
are depleted, each specialist will be responsible for the market orders
directed specifically to it. BEACON (which handles approximately 95% of
all order flow on the BSE) will execute automatically\11\ an incoming
order against an order on the book, and only if there is no contra-side
agency order on the limit order book at the price will the incoming
order be routed to the designated specialist for execution.
---------------------------------------------------------------------------
\11\BEACON will continue to expose all market and marketable
limit orders (on the designated specialist's BEACON terminal) for 15
seconds, prior to automatic execution at the ITS/BBO, for possible
price betterment.
---------------------------------------------------------------------------
In addition to the rules discussed above, the proposal outlines
registration procedures and daily responsibilities for CSs. All
competing specialists will be responsible for:
a. Cooperating with the regular specialist regarding openings
and reopenings to ensure that they are unitary;
b. Keeping each other informed and communicating to inquiring
floor brokers the full size of any executable ``all or none'' orders
in their possession and representing such orders on a best efforts
basis to ensure the execution of the entire order at a single price
or prices, or not at all;
c. Communicating their markets to the regular specialist and
being responsible for their portion of the published bid and/or
offer; and
d. Conforming generally to all of the rules and policies
applicable to a regular specialist.
To register as a CS the applicant must submit a written application to
the Market Performance Committee (``MPC''), listing in order of
preference the stock(s) in which the applicant requests to compete. The
MPC will then review the application\12\ considering the following
factors:
---------------------------------------------------------------------------
\12\The decision of the MPC may be appealed to the Executive
Committee.
Overall performance evaluation results of the
applicant;
Financial capability;
Adequacy of manpower on the floor;
Existence of an adequate information barrier policy in
the applicant firm;\13\ and
---------------------------------------------------------------------------
\13\If the MPC finds that an applicant firm does not have
adequate information barrier procedures in place, it will deny that
firm status as a CS. Conversation between Karen Aluise, Assistant
Vice President, and N. Amy Bilbija, Commission, on March 7, 1994. As
noted above, the specific requirements for adequate information
barrier procedures are set forth in a separate proposal that is also
being approved in conjunction with this approval order.
---------------------------------------------------------------------------
Objection by the regular specialist in a stock, with or
without cause.\14\
\14\Any objection by the regular specialists to permit
comptition in one or more of such specialist's stocks must be in
writing and filed with the Exchange within 48 hours (unless the
specialist is unavailable, in which case within 48 hours of becoming
available) of notice of filing of the competing specialist
application. Such an objection is not an automatic veto, but rather
is merely a factor to be considered by the MPC in reviewing the
---------------------------------------------------------------------------
application.
In addition, all applicants must be registered with the Exchange as
specialists and must meet the current minimum requirements set forth in
chapter XV of the BSE rules, the minimum capital and equity
requirements as set forth in Chapters VIII and XII of the BSE rules,
and conform to all other performance requirements and standards set
forth in the Rules of the Exchange.
Any specialist seeking to terminate its status must so notify the
MPC at least three business days prior to the desired effective date of
such withdrawal from competition. Withdrawal from registration by a CS
will bar that CS from applying to compete in that same stock for 90
days following the effective date of withdrawal. When the regular
specialist requests to be relieved of a stock, the stock will be posted
for reallocation by the Stock Allocation Committee. In the interim, if
the MPC is satisfied that the CS can continue to maintain a fair and
orderly market in such stock, the CS will serve as the regular
specialist until the stock has been reallocated.\15\ Where there is
more than one CS in the stock, Exchange staff will place the stock with
a caretaker\16\ until reallocation.
---------------------------------------------------------------------------
\15\Once the stock has been reallocted to a regular specialist,
that specialist will not have the right to object to competition in
such stock.
\16\A ``caretaker'' is a specialist from another specialist unit
who is chosen by the Exchange to temporarily act as the regular
specialist.
---------------------------------------------------------------------------
The registration of any CS may be suspended or terminated by the
MPC upon a determination of any substantial or continued failure by
such CS to engage in dealings in accordance with the Constitution and
Rules of the Exchange.
Finally, the proposal amends the BSE Rule governing the
specialist's book, the contents of which are otherwise confidential, to
add a provision permitting specialists to disclose information in their
books to other specialists competing in the same stocks on a summary
basis as provided for in the procedures for CSs.
III. Summary of Comments
The Commission has received comment letters on the proposal from
the American Stock Exchange (``Amex),\17\ Chicago Stock Exchange
(``CHX''),\18\ Cincinnati Stock Exchange (``CSE''),\19\ and New York
Stock Exchange (``NYSE''),\20\ as well as BSE's responses thereto.\21\
The letters (with the exception of the CSE) raise similar concerns with
the BSE proposal about the preferencing feature, internalization of
order flow, payment for order flow, adequate information barrier
procedures, and the overall effect on auction market principles.\22\
These comments are discussed in more detail below.
---------------------------------------------------------------------------
\17\See letters from Jules L. Winters, Chief Operating Officer,
Amercian Stock Exchange, to Jonathan G. Katz, Secretary, Commission,
dated August 26, 1993 (``Amex letter 1'') and March 18, 1994 (``Amex
letter 2'').
\18\See letter from Homer J. Livingston, President and Chief
Executive Officer, Chicago Stock Exchange, to Jonathan G. Katz,
Secretary, Commission, dated December 10, 1993 (``CHX letter'').
\19\See letter from Robert P. Ackermann, Vice President,
Regulation, Cincinnati Stock Exchange, to Jonathan G. Katz,
Secretary, Commission, dated July 29, 1993 (``CSE letter''). In sum,
the CSE argues that because their current Dealer Preferencing System
is analogous to the BSE proposal, the same restrictions should be
applied to both pilots, or, in the alternative, the Commission
should remove the restrictions from the CSE pilot. The restrictions
include prohibitions on direct cash payments for preferenced order
flow, prohibitions on use of short-sale arbitrage programs, and
limitations on the scope of the program. All of these restrictions
have been incorporated into the BSE proposal. See Amendments Nos. 1,
2, and 3.
\20\See letters from James E. Buck, Senior Vice President and
Secretary, New York Stock Exchange, to Jonathan G. Katz, Secretary,
Commission, dated August 25, 1993 (``NYSE letter 1''); and Daniel
Parker Odell, Assistant Secretary, New York Stock Exchange, to
Jonathan G. Katz, Secretary, Commission, dated October 29, 1993
(``NYSE letter 2'').
\21\See letters from Karen A. Aluise, Assistant Vice President,
Boston Stock Exchange, to Jonathan G. Katz, Secretary, Commission,
dated July 30, 1993 (``BSE letter 1''); John I. Fitzgerald,
Executive Vice President, Legal Affairs and Trading Services, Boston
Stock Exchange, to Jonathan G. Katz, Secretary, Commission, dated
September 16, 1993 (``BSE letter 2'') and November 10, 1993 (``BSE
letter 3'').
\22\The CSE, Amex, and NYSE also recommended that the issue of
competing specialist should be made part of the Market 2000 Study
along with the Amex competing dealer proposal. Division of Market
Regulation, U.S. Securities and Exchange Commission, Market 2000: An
Examination of Current Equity Market Developments (1994). The Amex's
competing dealer proposal seeks to alter the current rules of
priority in regard to the orders of regional exchange specialists
and third market makers that are directed to the Amex. The issues
raised in Amex's competing dealer proposal are fundamentally
different from the concerns raised by the competing specialist
proposal which seeks to alter the current rules to accomodate
competitors on the floor of the BSE. Specifically, the Amex's
proposal is intended to alter the treatment of incoming orders from
competing dealers, while the BSE proposal creates the ability for
competing specialists to compete on the floor of the Exchange.
---------------------------------------------------------------------------
A. Preferencing
All four commentators attempted to draw an analogy between the
Cincinnati Dealer Preferencing Program (``CSE pilot'')\23\ and the BSE
proposal by alleging that the latter is in fact a preferencing system
despite the lack of a reference to the term ``preferencing'' in the
proposal.\24\ The NYSE also alleges that although the BSE rules
currently provide for the same auction market procedures as NYSE Rule
72, the competing specialist proposal effectively would change those
procedures by always giving priority to the designated specialist when
no other contra-side agency orders are present.\25\ The BSE, in
response, asserts that their priority, parity, and precedence rules
work the same way as the NYSE rules did, when competing specialists
were permitted on their floor, in that a BSE specialist quoting the
ITS/BBO would have priority over the other specialist who is quoting an
inferior market.\26\
---------------------------------------------------------------------------
\23\The CSE pilot originally was approved as a six month pilot
for 60 issues per preferencing dealer. See Securities Exchange Act
Release No. 28866 (February 13, 1991), 56 FR 5854 (February 7,
1991). It was subsequently extended several times and is currently
approved through August 7, 1994. The number of CSE issues which a
dealer may preference has been increased periodically to 350. See
Securities Exchange Act Release Nos. 29885 (October 30, 1991), 56 FR
56676; 30353 (February 7, 1992) 57 FR 5918; 30809 (June 15, 1992) 57
FR 27990; 31011 (August 7, 1992), 57 FR 38704; 32280 (May 7, 1993)
58 FR 28422; 33975 (April 28, 1994).
\24\See NYSE letter 1; NYSE letter 2; CSE letter; CHX letter;
Amex letter 2.
\25\See NYSE letter 2.
\26\See BSE letter 2.
---------------------------------------------------------------------------
B. Internalization
Internalization of order flow is the ability of diversified firms
to retain incoming customer orders by routing them to their affiliated
specialist for execution, thereby participating on both sides of the
transaction. The NYSE asserts that the BSE proposal could lessen
auction market depth and efficiency because the preferenced order flow
is internalized by specialists, does not participate in the auction
market, and is executed outside of it.\27\ The NYSE and Amex further
maintain that by allowing internalization of order flow, the BSE
proposal will diminish the efficiencies of auction market pricing by
denying preferenced orders any exposure to the primary market and
opportunity for price betterment thereon, and ultimately will lead to
market fragmentation.\28\
---------------------------------------------------------------------------
\27\See NYSE letter 1.
\28\See Amex letter 1; Amex letter 2; NYSE letter 1.
---------------------------------------------------------------------------
The NYSE believes the Commission should weigh possible positive
effects of competing specialists, such as fostering competition,
against the potential negative effects, such as distortion of the
auction market, and encourages the Commission to undertake a more
comprehensive study of preferencing in order to determine whether or
not it works to the benefit of the investing public.\29\ In response,
the BSE suggests that competition will heighten as the competing
specialists strive to establish priority on the BSE floor.\30\
Moreover, according to the BSE, liquidity in the national market will
increase at the ITS/BBO because (1) the competing specialists will be
forced to quote at the ITS/BBO to retain priority, and (2) the BSE
quote disseminated when two or more specialists are simultaneously
bidding at the same price will reflect their aggregated size.\31\
---------------------------------------------------------------------------
\29\See NYSE letter 1; See also Amex letter 2.
\30\Consistent with traditional auction market principles, the
only instance where preferencing would force a competitor with
clearly established priority on the BASE floor to step aside to a
preferenced order is when the ITS/BBO is greater than the BSE BBO.
In such a circumstance, the BSE specialist does not have priority at
the ITS/BBO and therefore BEACON will route the order to whomever is
the designated specialist. Conversation between Karen Aluise,
Assistant Vice President, Boston Stock Exchange, and N. Amy Bilbija,
Commission, on December 16, 1993.
\31\The Commission notes that the BSE is aware that it may not
aggregate auto-quotes for dissemination in ITS because auto-quoting
in size is not permitted under the ITS Plan. An auto-quote is a
systemic pricing change mechanism that generally tracks on the
primary market.
---------------------------------------------------------------------------
The NYSE and Amex also note that the BSE system in theory requires
marketable customer limit orders to be cleared before a preferenced
specialist can trade with its own order flow.\32\ The NYSE and Amex
maintain, however, that there is nothing to prevent BSE member firms
from withholding their limit orders from the market, and sending them
down to the exchange floor only when they have become marketable, at
which time they are paired off against the affiliated specialist for
execution.\33\ The NYSE and Amex further assert that BSE firms with
affiliated specialists would be motivated to act in such a fashion
because they would be providing each organization an ongoing
opportunity to trade as principal with its customers' market
orders.\34\ The BSE, however, maintains that BEACON will not
accommodate such a practice because the system does not accept paired
orders (where one side is an agency order and one side is a BSE market
maker as principal).\35\
---------------------------------------------------------------------------
\32\See NYSE letter 1; Amex letter 2.
\33\See NYSE letter 2; Amex letter 2.
\34\See NYSE letter 2; Amex letter 2.
\35\Conversation between Karen Aluise, Assistant Vice President,
Boston Stock Exchange, and N. Amy Bilbija, Commission, on February
14, 1994. The Commission notes that the practice of withholding
limit orders may be inconsistent with achieving best execution of
customer orders and may unnecessarily interpose a dealer into an
agency transaction. See 15 U.S.C. 78k-1(a)(1)(C)(v) (1988).
---------------------------------------------------------------------------
The BSE states, and the NYSE notes, that all BSE market and
marketable limit orders routed to a designated specialist will still
continue to be exposed for 15 seconds to allow the specialist to
execute the order at a price better than the ITS/BBO before automatic
execution at the ITS/BBO.\36\
---------------------------------------------------------------------------
\36\In contrast, the NYSE asserts that in the CSE pilot agency
at-the-market and marketable limit orders are executed immediately
and automatically at the ITS/BBO without exposure for price
betterment. See NYSE letter 1.
---------------------------------------------------------------------------
Finally, the Amex further asserts that increased internalization
resulting from the BSE proposal will lead to more order flow to the
BSE, which will in turn increase the amount of risk incurred by BSE
specialists. As a result, the Amex alleges, BSE specialists will ``lay
off'' their risk on the primary market specialist by means of
offsetting executions following a BSE transaction,\37\ thus increasing
the risk factor to the Amex specialists. The Amex concludes that this
potential increased risk, and the desire to foster protection of
customer orders, is the basis for its pending competing dealer
proposal.
---------------------------------------------------------------------------
\37\See Amex letter 2.
---------------------------------------------------------------------------
C. Effect on Auction Market Principles
The NYSE and Amex assert that the proposal represents a departure
from agency/auction principles and a movement toward ``dealerization''
of regional exchange markets by encouraging firms to set up CSs in
order to internalize preferenced order flow which is thereby denied the
chief benefits of auction market trading.\38\ The Amex further asserts
that:
---------------------------------------------------------------------------
\38\See Amex letter 1.
This development can only increase concerns * * * regarding
regional exchange market making in primary exchange listed
securities--namely, increased market fragmentation, passive
quotations and autoquoting, failure to enhance price discovery and
provide price betterment, and failure to reflect full bid/offer
size.\39\
---------------------------------------------------------------------------
\39\See Amex letter 1 (citing the Amex Market 2000 comment
letter, pp. 14-17).
The Amex also does not believe the BSE proposal will benefit the
investing public, asserting that for most securities there is little
evidence to support the proposition that increasing the number of
market making participants increases competition and provides price
betterment.\40\
---------------------------------------------------------------------------
\40\See Amex Letter.
---------------------------------------------------------------------------
The CHX letter, although more of a commentary on the CSE pilot than
on the BSE proposal, reaches the conclusion that it would be
inconsistent for the Commission to permit the CSE pilot to operate
without permitting the more traditional exchanges to compete by
providing similar systems of their own.\41\ In addition, the CHX takes
the position that the BSE proposal is a type of preferencing system,
but contains fewer negative aspects than does CSE's pilot. Therefore,
the CHX believes it would be illogical to permit the CSE pilot to
continue while disapproving the BSE proposal.\42\
---------------------------------------------------------------------------
\41\See CHX letter.
\42\See CHX letter.
---------------------------------------------------------------------------
D. Payment for Order Flow
Both the CSE pilot and the BSE proposal include a prohibition
against cash payments, by preferencing market makers and CSs
respectively, for preferenced order flow.\43\ The NYSE suggest that the
BSE's restriction may be broader than the CSE's because it appears to
apply to regular specialists as well as CSs.\44\ The BSE response,
however, emphasized that its restriction only applies to a CS in those
stocks in which he becomes registered as a CS. The NYSE, Amex, and BSE,
however, concur that the Commission should address the payment for
order flow issue on a national level. The NYSE suggests that the
Commission prohibit all dealers and specialists in all markets from
paying for order flow.\45\ The BSE response advocated a clear standard
for all industry participants, suggesting that the Commission either
prohibit all dealers and specialists in all markets from paying for
order flow or allow all such market participants to decide the issue
for themselves.\46\ The Amex agreed with the BSE in so far as the issue
should be addressed in a conceptually consistent manner rather than a
piecemeal approach.\47\
---------------------------------------------------------------------------
\43\See Securities Exchange Act Release No. 28866 (February 7,
1991), 56 FR 5854 (February 13, 1991); and Securities Exchange Act
Release No. 33089 (October 22, 1993), 58 FR 58205 (October 29,
1993).
\44\See NYSE letter 2, FN 2.
\45\See NYSE letter 1; NYSE letter 2.
\46\See BSE letter 2; BSE letter 1; BSE letter 3.
\47\See Amex letter 1.
---------------------------------------------------------------------------
E. Information Barriers
The NYSE and Amex commented on the BSE's original requirement that
competing specialists affiliated with upstairs firms must have and
maintain appropriate information barrier procedures as approved by any
SRO, noting that the BSE had no actual rules in place on the
establishment or enforcement of such procedures.\48\ In response, the
BSE separately filed information barrier procedures with the
Commission.\49\
---------------------------------------------------------------------------
\48\See NYSE letter 1; Amex letter 1. The NYSE's Rule 98 and the
Amex's Rule 193 are those exchanges' procedures that deal with
integrated, or diversified, number firms acting as specialists on
the primary markets.
\49\See Securities Exchange Act Release No. 33090 (October 22,
1993), 58 FR 58206 (October 29, 1993). That proposal is being
approved concurrently with the instant proposed rule change.
---------------------------------------------------------------------------
IV. Discussion
For the reasons discussed below, the Commission is approving the
BSE competing specialist proposal on a one-year pilot basis. During the
pilot the BSE will be required to monitor the pilot, collect data, and
submit reports as outlined below.
As a preliminary matter, the Commission supports efforts by
exchanges to provide increased market making and competition on their
trading floors or trading systems. Such efforts should increase the
provision of liquidity services by an exchange and enable it to compete
more effectively with other markets. The addition of specialist
competition on the BSE floor could help in this regard. At the same
time, the Commission is sensitive to the concerns of many of the
commentators about the structural implications of the preferencing
feature of the BSE proposal. The Commission believes that it is
important that the competing specialist program provide real quote
competition for the benefit of investors, and not simply a means for
firms to internalize their customer order flow while receiving
specialist designation and treatment. Accordingly, as discussed in more
detail below, the Commission only is approving the BSE proposal on a
one-year pilot basis. During that time, the BSE is expected to monitor
its pilot and provide the Commission with a report on its operation
detailing how the proposal has affected the quality of BSE's market,
including its effect on quote competition. The Commission expects the
BSE to adequately demonstrate, through the periodic reporting
requirements outlined below and other such data as the Exchange may
wish to generate, that there are in fact beneficial competitive effects
from the CS program. Specifically, the Commission expects the Exchange
to analyze the effects of the program on the quality of the market
making by BSE specialists as a result of competition. For the reasons
outlined below, if the BSE cannot provide such an analysis, the
Commission would have serious reservations about continuing the
preferencing feature of the program.
As discussed above, many of the commentators discussed their views
on CSE's preferencing pilot in commenting on the BSE proposal and made
certain conclusions about the effects of the BSE's proposal based on
the experience with the CSE preferencing pilot. Although the Commission
believes the discussion is useful, we note that the CSE differs in
market structure and in the details of the preferencing system. Under
the CSE's pilot, preferenced dealers have priority over same-priced
market maker or professional agency interest entered prior in time when
the preferenced dealer is interacting with the public agency market and
marketable limit orders that he or she represents as agent.50
Further, the CSE system does not currently provide for exposure for
orders that would allow for potential price improvement on incoming
orders. Instead, price improvement on the CSE is only possible if the
CSE dealer either (1) unilaterally improves the price before sending
the cross to the CSE for execution, or (2) voluntarily exposes the
improved order to the national consolidated quote system for possible
improvement before filling it at the ITS/BBO.
---------------------------------------------------------------------------
\5\0See Securities Exchange Act Release No. 28866 (February 7,
1991), 56 FR 5854 (February 13, 1991).
---------------------------------------------------------------------------
The BSE has attempted to design its proposal to enable customers to
receive best execution of their orders while stimulating competition
among specialists. As previously stated, the proposal does not alter
the auction market principles of priority, parity, and precedence. In
addition, limit orders will continue to be executed in accordance with
traditional auction market principles. Under the BSE proposal, all
limit orders will be represented and executed strictly according to
time priority according to the order of their receipt in Beacon,
irrespective of which specialist they are sent to. Further, all market
and marketable limit orders will continue to receive a 15 second
exposure for possible price improvement.51 Before an incoming
preferenced order is executed against the specialist, Beacon scans its
limit order book. If there is a contra-side order on the book, Beacon
will match up the two orders and execute without the specialist's
participation (unless the specialist opts to improve the price).
---------------------------------------------------------------------------
\5\1See Division of Market Regulation, U.S. Securities and
Exchange Commission, Market 2000: An Examination of Current Equity
Market Developments, Study V (1994) (``Market 2000 Study'').
---------------------------------------------------------------------------
The BSE proposal also is designed to provide for potential quote
competition. The only time the BSE's proposed preferencing feature can
force a non-designated specialist with clearly established priority on
the BSE floor to yield priority to a preferenced competitor, so that it
may trade as principal with the incoming preferenced order, is when (1)
the ITS/BBO is greater than the BSE BBO, and (2) there is no contra-
side agency order priced equal to or better than the ITS/BBO (i.e., all
limit orders at the price have been depleted). The BSE asserts that
this will enhance quote competition and, at a minimum, add liquidity at
the ITS/BBO.
The Commission recognizes that BSE specialists currently quote at
the best ITS price only 5% of the time.52 The proposal, however,
allegedly provides an incentive for specialists desiring to attract
order flow to quote more often at the ITS/BBO. If the BSE's assertion
is correct in that the specialists will be motivated to compete for
priority on the floor, then liquidity could be enhanced at the ITS/BBO.
In addition, if the specialists are simultaneously bidding at the same
price, the sizes will be aggregated for purposes of disseminating the
BSE quote.53 In sum, the proposal potentially could add depth at
the ITS/BBO if the BSE specialists begin to quote at the best ITS price
more frequently than is the practice today, and thereby improve the
overall quality of the BSE market place. Although it is unclear whether
the BSE proposal will have this result, the Commission intends to
carefully evaluate the effects on the quality of the BSE market from
this potential ``quote competition'' and whether the majority of
preferenced orders are executed by the affiliated specialist when
quoting at less than the ITS/BBO. As indicated above, the Commission
expects the BSE to provide sufficient evidence confirming the existence
of enhanced quote competition.
---------------------------------------------------------------------------
\5\2Conversation between Jack Fitzgerald, Executive Vice
President, Bill Lee, Senior Vice President, Karen Aluise, Assistant
Vice President, and Ken Meaden, Assistant Vice President, Boston
Stock Exchange, and N. Amy Bilbija, Commission, on December 29,
1993.
53But see note 32, supra.
---------------------------------------------------------------------------
With respect to the BSE proposal's effect on internalization of
order flow, and the potential for market fragmentation as a result, the
Commission's Division of Market Regulation (``Division'') recently
examined the extent of market fragmentation in its Market 2000 Study.
The Division found that multiple, varied market centers and competitors
for listed stocks has provided many benefits to the users of the
markets without impairing market quality or price discovery. The
Division concluded that concerns about fragmentation have been
overstated. However, the Commission is concerned that the
implementation of a preferencing system at one or more exchanges may
alter the analysis.
The potential effects of internalization by BSE specialists,
however, are difficult to analyze without some experience about the
effects of the pilot. The Commission does note that if the program of
competing specialists is used merely to expand the number of
specialists internalizing order flow rather than as a means of
improving the quality of BSE markets, then the proposal would raise
additional questions as to whether the competing specialists are acting
as active market makers and deserve specialist designation and the
benefits accruing thereto. Accordingly, although the BSE proposal may
result in more internalization of order flow, the Commission is not
willing at this time to conclude that it will be detrimental to the
quality of the equity markets, but instead intends to revisit this
issue at the expiration of the pilot. In reaching this conclusion, the
Commission emphasizes that the BSE proposal is limited in scope, and
best execution of customer orders in the context of fair competition is
still a primary objective. Under the proposal, customer orders will
continue to be able to interact, and the opportunity for price
improvement exists.
The preferencing feature of the competing specialist program also
raises questions about the use of payment for order flow by BSE
specialists. As discussed previously, during the pilot program a CS
will be prohibited from making cash payments for order flow in those
stocks in which it is registered as a CS. Such a prohibition is
important to assess the effects of the proposal and incentives for
market participants to take part in it and to benefit therefrom. The
Commission is still considering the concerns regarding the issue of
payment for order flow on the national level. On October 7, 1993, the
Commission published for comment Rule 11Ac1-3 and amendments to Rule
10b-10 under the Act relating to enhanced disclosure of payment for
order flow practices. The Commission also sought comments on various
alternative approaches to payment for order flow, such as banning the
practice outright, pass-through the payment to customers, and
decimalization.\54\ Accordingly, any final outcome in that rule making
procedure may ultimately effect the payment for order flow issue in the
BSE's pilot.
---------------------------------------------------------------------------
\54\See Securities Exchange Act Release No. 33026 (October 6,
1993). The comment period on the proposal ended December 3, 1993,
and the Commission is still reviewing the comments and issues
presented.
---------------------------------------------------------------------------
Finally, as discussed above, the Commission also is approving today
information barrier procedures for BSE specialists. These procedures
ensure that upstairs firms affiliated with BSE specialists will not
receive information advantages due to the relationship between the
entities.\55\
---------------------------------------------------------------------------
\55\See Securities Exchange Act Release No. 34-34076 (May 18,
1994) approving BSE's information barrier proposal.
---------------------------------------------------------------------------
Based on the above, the Commission believes it is appropriate to
allow the BSE to implement its competing specialist proposal on a one-
year pilot basis. In making this determination, the Commission has
carefully analyzed the potential benefits from competition, such as
better quotes, with the potential for increased internalization of
order flow. The Commission believes that the BSE has incorporated
features in its proposal to allow it to implement, for a one-year
period, a competing specialist system that will allow firms to
designate order flow to an affiliated specialist.
The Commission, nevertheless, believes that before the BSE proposal
will be extended beyond the one-year pilot period or approved on a
permanent basis, the BSE will have the burden to prove that its
proposal resulted in added depth and liquidity to its market and
improved quotations. The Commission emphasizes that if the Commission
is dissatisfied with the data or the market effects of the pilot, it
would not be inclined to extend the competing specialist program.
Accordingly, the Commission requests that the BSE provide, on a
quarterly basis, the following information:
1. A list indicating how many competing specialists are on the
Exchange.
2. A list identifying, for each competing specialist, the issues
in which they are competing.
3. The volume of ``preferenced'' trades in each issue; and the
percentage of total volume of trades sent to the BSE for execution
in each issue represented by ``preferenced'' volume.
4. The volume of ``preferenced'' share and transaction volume;
and the percentage of total BSE share and transaction volume the
``preferenced'' volume represents.
5. BSE's volume attributable to ITS commitments sent by other
ITS participant markets; and the percentage of such commitments
attributable to ``preferenced'' issues.
6. The number of ``preferenced'' orders executed by the non-
designated specialist(s).
7. The number of ``preferenced'' orders effected against the
limit order book, both in total and separately for each
``preferenced'' issue.
8. The number of limit orders placed on the book, as compared to
before the commencement of this pilot, both for the BSE as a whole
and separately for the stocks for which there are competing
specialists.
9. BSE's share of Tape trade reports, as compared to before the
commencement of this pilot.
Further, we request the Exchange to submit a report to the
Commission, discussing the data outlined above, eight months from the
date of commencement of the competing specialist pilot. The report
should discuss such data in terms of the effects of the competing
specialist pilot on the quality of the BSE market with respect to
depth, liquidity, and quote improvement.\56\
---------------------------------------------------------------------------
\56\Should any other exchange attempt to implement a similar
system that is acceptable to the Commission, it should be noted that
the pilot period would be limited to the same one year period
afforded the BSE. At the end of such period, all such systems will
be subject to the same rigorous scrutiny regardless of how long they
may have been in operation.
---------------------------------------------------------------------------
V. Conclusion
The Commission finds preliminarily that the proposed rule change is
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities exchange,
and, in particular, with the requirements of section 6(b).\57\ In
particular, the Commission preliminarily believes the proposal is
consistent with section 6(b)(5) because it is designed to promote just
and equitable principles of trade, to foster cooperation and
coordination with persons engaged in regulating, clearing, settling,
processing information with respect to, and facilitating transactions
in securities, to remove impediments to and perfect the mechanism of
free and open market and a national market system.
---------------------------------------------------------------------------
\57\15 U.S.C. 78f(b) (1988).
---------------------------------------------------------------------------
It is Therefore Ordered, pursuant to section 19(b)(2) of the
Act,\58\ that the proposed rule change (SR-BSE-93-12) is approved for a
period of one year through May 18, 1995.
---------------------------------------------------------------------------
\58\15 U.S.C. 78s(b)92) (1988).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\59\
---------------------------------------------------------------------------
\59\17 CFR 200.30-3(a)(12) (1993).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-12739 Filed 5-24-94; 8:45 am]
BILLING CODE 8010-01-M