[Federal Register Volume 59, Number 210 (Tuesday, November 1, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-27036]


[[Page Unknown]]

[Federal Register: November 1, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34893; File No. SR-Phlx-92-09]

 

Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.; 
Order Granting Approval to Proposed Rule Change Prohibiting Trading the 
Quote Spread on PACE

October 25, 1994.
    On April 10, 1992, the Philadelphia Stock Exchange, Inc. (``Phlx'' 
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 prohibit the use of the Phlx 
Automated Communication and Execution System (``PACE'') volume 
execution guarantees with offsetting orders in low-volatility, high 
volume stocks in order to ``trade the quote spread.'' On April 14, 
1994, and June 6, 1994, the Phlx submitted Amendment Nos. 1 and 2, 
respectively.\3\
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    \1\15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1991).
    \3\See letters from Gerald D. O'Connell, Vice President, Market 
Surveillance, Phlx, to Sharon Lawson, Assistant Director, 
Commission, dated April 14, 1994, and June 1, 1994. In Amendment No. 
1 the Phlx amended the language of the rule to clarify that three 
occurrences of trading the quote spread within one month may 
constitute a violation of the rule. In Amendment No. 2 the Phlx (a) 
clarified that the three occurrences are meant to be in the same 
stock, and (b) changed the word ``may'' to ``will'' constitute a 
violation.
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    The proposed rule change, as amended, was published for comment in 
Securities Exchange Act Release No. 34259 (June 27, 1994), 59 FR 34000 
(July 1, 1994). No comments were received on the proposal.
    The proposed rule change adopts Commentary .18 to Phlx Rule 229,\4\ 
which details the execution guarantees due a PACE order. Commentary .18 
generally prohibits members from engaging in any established pattern of 
trading via PACE to generate short-term trading profits by exploiting 
PACE volume execution guarantees.
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    \4\See Philadelphia Stock Exchange Rules, Rule 229.
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    PACE is the Exchange's automated order routing, delivery and 
execution system for equity securities. Pursuant to Phlx Rule 229, 
customer orders entered through PACE are entitled to certain execution 
guarantees. For example, limit orders for less than 600 shares become 
due an execution once an accumulative volume of 1,000 shares of that 
security prints at the limit price or better on the New York Stock 
Exchange (``primary market guarantee'').\5\
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    \5\See Phlx Rule 229, Supplementary Material .10(a).
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    As used in the proposed rule change, unjustly exploiting the PACE 
volume execution guarantees by trading the quote spread refers to the 
practice of placing an order to buy at the primary market's bid price 
and simultaneously or shortly thereafter placing an order to sell for a 
related account at the primary market's offer price, or vice versa. 
This creates the expectation that each of the orders will be elected at 
their respective limit prices when the required volume trades on the 
primary market. When both orders are filled due to volume guarantees, a 
profit is locked-in, equal to the amount of shares multiplied by the 
quote spread less commissions. This profit can be made within minutes 
after the orders are placed and without any quote change in the stock. 
This practice usually is most successfully undertaken with respect to 
low-volatility, high-volume stocks, because the bid-ask spread for 
these stocks is often narrow and static.
    For the reasons described below, the Commission believes that the 
proposed rule change is consistent with the Act, and the rules and 
regulations thereunder applicable to a national securities exchange, 
and in particular Section 6(b).\6\ Specifically, the Commission 
believes the proposal is consistent with the Section 6(b)(5) 
requirements that the rules of an exchange be designed to promote just 
and equitable principles of trade, to prevent fraudulent and 
manipulative acts, and, in general, to protect investors and the public 
in that it prevents the misuse of the Exchange's execution guarantees 
available through PACE.\7\
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    \6\15 U.S.C. Sec. 78f(b) (1988).
    \7\See generally Securities Exchange Act Release No. 33678, 59 
FR 10192 (March 3, 1994), in which the Commission approved a NYSE 
proposed rule change prohibiting certain abusive uses of that 
Exchange's odd-lot order execution system. The prohibited uses were 
not consistent with the traditional odd-lot investing practices of 
smaller investors for which the odd-lot order execution system was 
developed.
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    The Commission believes the use of the PACE system as proscribed in 
the proposal is inappropriate and inconsistent with PACE's functioning 
as a small order execution system. Automated order routing and 
execution systems were described in general in the Report of the 
October 1987 Market Break.\8\ The Report stated that these systems 
provide the primary means of executing the vast majority of small-sized 
trades both for listed and OTC stocks, and that, with the exception of 
program trades, most of these trades are for retail customers. 
According to the Report, small order routing and execution systems are 
designed to receive smaller sized orders electronically from broker-
dealers and route them to the appropriate stock exchange floor for 
automatic execution or for manual handling by the specialist. The 
Exchange's PACE system is one of these systems. The Commission 
believes, therefore, that PACE was intended to facilitate execution of 
small orders, and not to force Phlx specialists to trade at the inside 
primary market quote with traders trying to get the advantage of the 
spread without taking any risk.
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    \8\Division of Market Regulation of the Securities and Exchange 
Commission, Report of the October 1987 Market Break (February 1988) 
(``Report'').
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    The Commission also believes that trading the quote spread as 
proscribed in the proposal potentially can result in misleading market 
information with respect to the level of bona fide investment interest 
in the subject stocks. Using PACE to trade the quote spread could 
potentially disadvantage other market participants by ultimately 
reducing liquidity. Moreover, this type of trading is unfair to the 
PACE specialists, who are not obligated to trade at the same prices as 
the primary market, but who have agreed that for small, retail orders, 
they will provide primary market price guarantees.
    The Commission further believes the Exchange has adequately 
identified in the proposal the violative trading activity and what 
constitutes an established pattern of violative trading. The proposal 
makes clear that three occurrences of proscribed trading in the same 
security within a one-month period constitute an established pattern in 
violation of Rule 229. Because the rule excludes from its coverage 
random or inadvertent violations, the Commission believes that the Phlx 
has reasonably tailored and defined its prohibition.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\9\ that the proposed rule change (SR-Phlx-92-09) is approved.

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    \9\15 U.S.C. Sec. 78s(b)(2) (1988).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\10\
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    \10\17 CFR 200.30-3(a)(12) (1991).
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Jonathan G. Katz,
Secretary.
[FR Doc. 94-27036 Filed 10-31-94; 8:45 am]
BILLING CODE 8010-01-M