[Federal Register Volume 61, Number 67 (Friday, April 5, 1996)]
[Notices]
[Pages 15322-15330]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-8397]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37046; File No. SR-CSE-95-03]


Self-Regulatory Organizations; The Cincinnati Stock Exchange; 
Order Granting Approval to Proposed Rule Change to Adopt Permanently 
Rules Regarding the Preferencing of Public Agency Orders

March 29, 1996.

I. Introduction

    On March 1, 1995, The Cincinnati Stock Exchange (``CSE'' 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 adopt permanently the Exchange 
rules governing preferenced trading. On August 11, 1995, the Exchange 
submitted Amendment No. 1 to the proposed rule change to adopt order 
handling policies for preferencing dealers.

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in Securities 
Exchange Act Release No. 35448 (March 7, 1995), 60 FR 13493 (March 13, 
1995). Amendment No. 1 was published for comment in Securities Exchange 
Act Release No. 36092 (August 11, 1995), 60 FR 42209 (August 15, 1995). 
The Commission received 18 comment letters on the proposed rule change, 
which are discussed below.\3\ For the reasons discussed below, the 
Commission has determined to approve the proposed rule change, as 
amended.

    \3\ See infra notes 29 to 33, and note 69.
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II. Background

    In February 1991, the Commission approved a six month pilot 
program, referred to as the CSE's Dealer Preferencing Program 
(``DPP''), to modify the Exchange's priority rules to give CSE 
Designated Dealers \4\ priority over same-priced professional interest 
when interacting with public agency market and marketable limit 
orders.\5\ Originally, the DPP contained limitations on preferencing 
dealers, including restricting to 60 the number of stocks each 
preferencing dealer could trade. Since the inception of the program in 
1991, the Commission has approved several extensions of the pilot and 
increases in the number of stocks each preferencing dealer could 
trade.\6\ Currently, the DPP is approved through March 29, 1996, and 
each preferencing dealer is permitted to trade up to 350 issues.

    \4\ The term ``Designated Dealer'' is defined by the Exchange as 
a member who maintains a minimum net capital amount and who has been 
approved by the CSE's Securities Committee to perform market making 
functions by entering bids and offers into the Exchange's trading 
system. See CSE Rule 11.9(a)(3). In addition, the Designated Dealer 
status obligates the dealer to guarantee execution of all public 
agency market and marketable limit orders up to 2099 shares. For 
issues in which there are more than one Designated Dealer, this 
execution guarantee obligation rotates on a daily basis. See CSE 
Rule 11.9(c)(iv) and (v).
    \5\ See Securities Exchange Act Release No. 28866 (February 7, 
1991), 56 FR 5854 (February 13, 1991).
    \6\ See Securities Exchange Act Release No. 29524 (August 5, 
1991), 56 FR 38160 (August 12, 1991) (extending pilot through 
February 7, 1992); Securities Exchange Act Release No. 30353 
(February 7, 1992), 57 FR 5918 (February 18, 1992) (increasing 
number of stocks to 125 and extending pilot through August 7, 1992); 
Securities Exchange Act Release No. 30809 (June 15, 1992), 57 FR 
27990 (June 7, 1992) (increasing number of stocks to 250); 
Securities Exchange Act Release No. 31011 (August 7, 1992), 57 FR 
38704 (August 26, 1992) (extending pilot through May 7, 1993 and 
increasing number of stocks to 350); Securities Exchange Act Release 
No. 32280 (May 7, 1993), 58 FR 28424 (May 13, 1993) (extending pilot 
through May 7, 1994); Securities Exchange Act Release No. 33975 
(April 28, 1994), 59 FR 23242 (May 5, 1994) (extending pilot through 
August 6, 1994); Securities Exchange Act Release No. 34493 (August 
5, 1994), 59 FR 41531 (August 12, 1994) (extending pilot through May 
18, 1995); Securities Exchange Act Release No. 35717 (May 15, 1995), 
60 FR 26909 (May 19, 1995) (extending pilot through October 2, 
1995); and Securities Exchange Act Release No. 36324 (September 29, 
1995), 60 FR 52436 (October 6, 1995) (extending pilot through March 
29, 1996).
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    The CSE initiated the DPP to provide dealers with the ability to 
retain and execute their internal order flow at the national best bid 
or offer, provided that public limit orders at the same price on the 
CSE book were executed first.\7\ In proposing the preferencing program, 
the Exchange noted that it had attempted to increase business and 
liquidity by developing the National Securities Trading System 
(``NSTS''), which electronically interfaces with retail order-delivery 
systems of CSE members, and had attempted to increase the number of 
issues traded on the Exchange through the creation of the Designated 
Dealer category of market makers, which are obligated to guarantee 
execution of all public agency orders up to 2,099 shares.\8\ According 
to the CSE, however, these efforts had not overcome the lack of 
incentive in CSE's multiple market maker environment for firms 
affiliated with CSE dealers to direct their retail order flow to the 
Exchange. Unlike the specialists affiliated with order flow firms on 
the other regional exchanges, who generally faced little or no market 
making competition on their floors, the multiple CSE dealers were 
subject to losing all or a portion of their public orders to other

[[Page 15323]]
market makers on the Exchange.\9\ Thus, the CSE believed that altering 
the priority rules between professional trading interests was necessary 
to bring the CSE dealers on par with other regional specialists and 
consequently attract retail order flow and enhance liquidity and 
efficiency on the Exchange. At the same time, the CSE continued to 
protect customer orders on the Exchange's central limit order book by 
requiring that such limit orders be satisfied before a dealer could 
internalize same-priced customer orders and by ensuring that 
internalized orders be executed at no worse than the national best bid 
or offer.\10\

    \7\ See Securities Exchange Act Release No. 28866, supra note 5.
    \8\ T3Id.
    \9\ Id.
    \10\ Id.
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    In approving the initial pilot program, the Commission stated that 
the proposal addressed the CSE's legitimate desire to attract 
additional business to the Exchange, while at the same time providing 
adequate protection for public agency orders placed on the Exchange's 
central limit order book.\11\ The Commission noted that the CSE 
combines features of both exchange and over-the-counter markets.\12\

    \11\ Id.
    \12\ Id. To this end, the Commission described the CSE as 
``unique among U.S. stock exchanges in that it is totally automated 
and utilizes a competing market maker system.''
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    During the course of the DPP pilot the Commission has been 
considering whether preferencing and the increasing internalization of 
order flow, and practices such as payment for order flow, are 
consistent with a broker-dealer's duty to seek best execution for 
customer orders. Consistent with its consideration of payment for order 
flow and best execution, the Commission requested that the CSE start 
providing data to show the effects of preferencing on the quality of 
order execution and market making on the CSE.\13\ At the same time, the 
Commission approved, on a pilot basis, a competing specialist program 
on the Boston Stock Exchange (``BSE''), which also raised issues 
regarding internalization of order flow.\14\

    \13\ See Securities Exchange Act Release No. 34493, supra note 
6. Specifically, the Commission requested that the CSE demonstrate 
that preferencing added depth and liquidity to the CSE market, and 
improved quotations. The Commission stated that if the CSE could not 
make such a showing, the Commission would not be inclined to extend 
the preferencing program. Accordingly, the CSE submitted several 
reports and letters containing data that it believes makes the 
required showing. See infra note 36.
    \14\ See Securities Exchange Act Release No. 34078 (May 18, 
1994), 59 FR 27082 (May 25, 1994). Unlike the CSE program, the BSE 
competing specialist program does not alter time priority among 
competing specialists quoting at the intermarket best bid or offer.
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    In addition, in October 1994, the Commission adopted rules 
concerning the disclosure of payment for order flow practices and the 
order routing arrangements of broker-dealers receiving payment for 
order flow.\15\ The Commission noted that not all market centers expose 
market orders to other order flow or provide an opportunity for price 
improvement for market orders. While price improvement was not the 
exclusive factor for determining whether a broker-dealer was fulfilling 
its duty to seek best execution, the Commission believed it important 
to the inquiry, particularly when payment was received by the broker-
dealer, or when the broker-dealer internalized orders or routed orders 
to affiliates.\16\

    \15\ See Securities Exchange Act Release No. 34902 (October 27, 
1994), 59 FR 55006 (November 2, 1994).
    \16\ The Commission also is currently considering comment 
received regarding a series of order handling rules it proposed last 
September. See Securities Exchange Act Release No. 36310 (September 
29, 1995), 60 FR 52792 (October 10, 1995).
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III. Description

    The Exchange requests permanent approval of its DPP. In conjunction 
with its permanent approval request, the CSE also seeks approval of 
rule changes implementing new order handling policies for the purpose 
of increasing order exposure and ensuring the timely execution and 
display of limit orders on the CSE.

A. Dealer Preferencing

    The preferencing program permits CSE dealers to retain and execute 
their internal order flow at the prevailing ITS best bid or offer 
(``ITS/BBO''), provided that there are no public agency limit orders on 
the Exchange's central limit order book at that price or better. To 
this end, the preferencing program permits CSE dealers to internalize 
order flow by eliminating time priority between CSE dealers, thereby 
enabling preferencing dealers to interact with public market and 
marketable limit orders they represent as agent. Specifically, the 
preferencing program gives preferencing dealers priority over 
professional agency or principal orders entered prior in time when 
interacting with a public order it represents as agent.\17\ The dealer 
may interact with such orders either by (1) taking the contra-side of 
the trade as principal (``paired order trade''), or (2) crossing the 
order with another customer order it represents as agent (``agency 
cross'').\18\

    \17\ See CSE Rule 11.9(u).
    \18\ The majority of agency crosses are the result of a limit 
order resident in the dealer's proprietary system at the ITS/BBO, 
which is matched with an incoming contra-side market order. For 
example, if the ITS/BBO is 20 bid--20\1/8\ asked, and a dealer has a 
limit order to buy at 20, an incoming market sell order will be 
matched with that limit order because the dealer may not trade for 
its own account ahead of its own customer limit order. See CSE Rule 
12.6(b).
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    For example, if dealer A on the CSE is quoting at the ITS/BBO, 
dealer B can still internalize its order flow (even if it is not 
quoting at the ITS/BBO) so long as dealer B executes the order at the 
ITS/BBO (or better) and there is no contra-side public agency order on 
the CSE's central limit order book at that price. If there is a public 
agency limit order on the CSE's book with priority, however, NSTS will 
automatically break the paired order trade and match the incoming 
public agency order with the public limit order on the CSE's book.\19\

    \19\ If there is a public agency order on the CSE's book, the 
system rejects the dealer's principal side of the attempted cross 
or, in the case of an attempted public agency cross, rejects the 
agency order that is on the same side of the market as the pre-
existing order on the book.
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    As noted above, in approving the initial DPP pilot, and subsequent 
extensions and expansions, the Commission imposed certain limitations 
and requirements on its operation. These conditions currently limit the 
number of issues in which a preferencing dealer may be registered to 
350; prohibit preferenced trading for index arbitrage purposes when 
certain ``circuit breakers'' are in effect; \20\ and prohibit a dealer 
from making cash payments for preferenced order flow. In connection 
with its request for permanent approval of the DPP, the Exchange 
requests that the Commission remove the limitation on the number of 
stocks preferencing dealers may trade and the prohibition on cash 
payments for order flow.

    \20\ Specifically, the index arbitrage restriction permits 
preferencing dealers to preference their customer order flow that is 
related to index arbitrage only on plus or zero plus ticks when the 
Dow Jones Industrial Average (``DJIA'') declines by fifty points or 
more from the previous day's closing value. See Securities Exchange 
Act Release No. 28866, supra note 5.
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B. Order Handling Policies for Preferencing Dealers

    The CSE also seeks approval for three rule changes related to the 
handling of customer orders on the Exchange. Generally, these 
requirements are designed to increase order exposure and ensure the 
timely execution and display of limit orders held by CSE dealers.
    First, the Exchange proposes to adopt Interpretation and Policy .01 
to CSE Rule 11.9(u) regarding price improvement of certain market 
orders. This policy would require that, in greater than minimum 
variation markets, a preferencing dealer

[[Page 15324]]
immediately execute market orders routed to him or her for execution on 
the CSE at an improved price or expose the orders on the Exchange for a 
minimum of thirty seconds to give other market participants an 
opportunity to provide an improved price.\21\ A preferencing dealer may 
expose a market order by representing the orders at an improved price 
in his or her CSE quote, or by placing the order on the CSE's central 
limit order book at an improved price.\22\ This requirement, however, 
will not be imposed upon members during unusual market conditions or if 
such action would not be in the best interest of the customer.\23\

    \21\ When exposing a market order on the Exchange for price 
improvement, a dealer stops the order to guarantee that the customer 
receives the then current best market price in the event that the 
order does not receive price improvement. The Commission has 
proposed a rule requiring that all market orders receive an 
opportunity for price improvement. See Securities Exchange Act 
Release No. 36310, supra note 16. The CSE order exposure policy 
would be superseded by any final rule adopted by the Commission to 
the extent that the Commission's rule imposed greater obligations on 
market participants.
    \22\ A dealer that represents an order in its CSE quote does not 
enter a public agency order into NSTS. Thus, representing an order 
in the dealer's quote would not result in the order being 
automatically matched with other orders in NSTS, such as with paired 
order trades entered by CSE preferencing dealers. However, if the 
customer limit order is at a price that is better than the ITS/BBO, 
inclusion in the CSE dealer's quote will narrow the market in that 
security.
    \23\ This provision is intended to apply to unusual market 
conditions (e.g., fast moving markets) and situations where it would 
be inconsistent with a preferencing dealer's best execution duty to 
expose the order. Conversation between David Colker, Executive Vice 
President and Chief Operating Officer, CSE, and N. Amy Bilbija, SEC, 
on August 14, 1995.
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    Second, the Exchange proposes to adopt Interpretation and Policy 
.02 to CSE Rule 11.9(u) regarding public agency limit order protection. 
Under this policy, a public agency limit order routed to a CSE dealer 
for execution on the CSE would be filled if (i) the bid or offer at the 
limit price has been exhausted in the primary market; (ii) there has 
been a price penetration of the limit order in the primary market; or 
(iii) the issue is trading at the limit price on the primary market 
unless it can be demonstrated that such order would not have been 
executed if it had been transmitteed to the primary market or the 
customer and the Designated Dealer agree to a specific volume related 
or other criteria for requiring execution of limit orders.\24\ This 
policy is designed to ensure that limit orders routed to CSE dealers 
for execution on the CSE receive timely executions relative to same-
priced limits orders on the primary markets, and is therefore referred 
to as ``primary market print protection.'' \25\

    \24\ In unusual trading situations, a Designed Dealer may seek 
relief from these requirements from two Trading Practices Committee 
members or a designated member of the Exchange staff who would have 
the authority to set execution parameters.
    \25\ The Commission notes that the Chicago Stock Exchange and 
Boston Stock Exchange currently have nearly identical primary market 
print protection policies. See CHX Rules, Article XX, Rule 37(a); 
and BSE Rules, Chapter II, Section 33, Interpretations and Policies 
.01.
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    Finally, the Exchange proposes to amend Interpretation and Policy 
.01 to CSE Rule 12.10 regarding the handling of public agency limit 
orders priced either at or between the ITS/BBO. The policy currently 
requires that a CSE dealer display all or a representative portion of 
such orders in the national market system unless the order is executed 
immediately or the customer requests that it not be displayed.\26\ 
Under the amended rule, a CSE dealer must display on the CSE all or a 
representative portion of public limit orders that he or she represents 
as agent for execution on the CSE, unless the order is executed 
immediately or the customer requests that it not be displayed.\27\ A 
dealer may satisfy this requirement by representing limit orders in his 
or her CSE quote, or by placing the agency orders (or a representative 
portion) on the CSE's central limit order book.\28\ In addition, if a 
representative portion of an order is executed, the CSE dealer must 
display all or a representative portion of the remainder of the order 
until the order is filled in its entirety.

    \26\ The Commission also has proposed a similar limit order 
display rule for all markets. Accordingly, the CSE limit order 
display policy would be superseded by any final rule adopted by the 
Commission to the extent that the Commission's rule imposed greater 
obligations on market participants. See Securities Exchange Act 
Release No. 36310, supra note 16.
    \27\ If the limit order is for 500 shares or fewer, a dealer 
must display the entire order. If the limit order is for more than 
500 shares, a dealer must display at least 500 shares, but is not 
required to display the entire order. Conversation between David 
Colker, Executive Vice President and Chief Operating Officer, CSE, 
and N. Amy Bilbija, SEC, on August 14, 1995. The Commission notes 
that the rule applies to all CSE dealers, not only preferencing 
dealers.
    \28\ See supra note 22.
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IV. Summary of Comments

    The Commission received 18 comment letters from a total of 13 
commenters. Eleven of the commenters opposed the DPP and requested that 
the Commission disapprove the CSE's request for permanent approval of 
the program. The Commission received comment letters from the New York 
Stock Exchange (``NYSE''),\29\ Boston Stock Exchange (``BSE''),\30\ 
American Stock Exchange (``Amex''),\31\ and The Specialist 
Association,\32\ as well as from other interested parties.\33\ The 
commenters that opposed the continuation of preferencing generally 
raised similar concerns regarding the practice of preferencing. As 
discussed below, these commenters asserted that preferencing, and the 
resulting internalization of order flow (1) decreases order interaction 
on the CSE, which negatively affects order execution quality, and (2) 
detrimentally affects the quality of the CSE market and the broader 
market.\34\ In addition, the NYSE

[[Page 15325]]
commented on the CSE's proposed order handling policies.\35\ The CSE 
submitted several letters in response to the comments and provided data 
requested by the Commission.\36\

    \29\ See letters from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Jonathan Katz, Secretary, SEC, dated March 16, 
1995 (``NYSE Letter No. 1''); Daniel Park Odell, Assistant 
Secretary, NYSE, to Jonathan Katz, Secretary, SEC, dated April 5, 
1995 (``NYSE Letter No. 2''); and James E. Buck, Senior Vice 
President and Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC, 
dated September 5, 1995 (``NYSE Letter No. 3''). In addition, the 
NYSE submitted several comment letters regarding prior extensions of 
the CSE's preferencing program.
    \30\ See letter from John Fitzgerald, Executive Vice President, 
BSE, to Howard Kramer, Associate Director, Division of Market 
Regulation, SEC, dated March 24, 1995 (``BSE Letter'').
    \31\ See letter from James Duffy, Executive Vice President and 
General Counsel, Amex, to Jonathan Katz, Secretary, SEC, dated April 
20, 1995 (``Amex Letter'')
    \32\ See letters from David Humphreville, Executive Director, 
The Specialist Association, to Jonathan Katz, Secretary, SEC, dated 
April 3, 1995 (``Specialist Association Letter No. 1''); and July 
27, 1995 (``Specialist Association Letter No. 2'').
    \33\ See letter from The Honorable Thomas J. Bliley, Jr., 
Chairman, Committee on Commerce, U.S. House of Representatives, and 
The Honorable Jack Fields, Chairman, Subcommittee on 
Telecommunications and Finance, U.S. House of Representatives, to 
Arthur Levitt, Jr., Chairman, SEC, dated July 6, 1995 (supporting a 
disclosure approach to regulation of broker order routing 
practices); letter from The Honorable Alfonse M. D'Amato, Chairman, 
Committee on Banking Housing and Urban Affairs, United States 
Senate, to Arthur Levitt, Jr., Chairman, SEC, dated July 17, 1995 
(opposing preferencing); letter from The Honorable John D. Dingell, 
Ranking Member, Committee on Commerce, U.S. House of 
Representatives, to Arthur Levitt, Jr., Chairman, SEC, dated June 
28, 1995 (``Dingell Letter'') (opposing preferencing); letter from 
The Honorable Dan Frisa, U.S. House of Representatives, to Arthur 
Levitt, Jr., Chairman, SEC, dated August 9, 1995 (opposing 
preferncing); letters from Paula Gavin, Chair, NYSE Individual 
Investors Advisory Council, to Arthur Levitt, Jr., Chairman, SEC, 
dated July 17, 1995, and October 2, 1995 (opposing preferencing); 
letter from Thomas E. O'Hara, Chairman, Board of Trustees, National 
Association of Investors Corporation, to Arthur Levitt, Jr., 
Chairman, SEC, dated September 20, 1995 (opposing preferencing); 
letter from Wayne F. Haefer, to Arthur Levitt, Jr., Chairman, SEC, 
dated September 20, 1995 (opposing preferencing); and letter from 
Bruce B. Johnson, for Otten, Johnson, Robinson, Neff & Ragonetti, 
P.C., to Arthur Levitt, Jr., Chairman, SEC, dated October 5, 1995 
(opposing preferencing).
    \34\ The NYSE attempted to evaluate preferencing by constructing 
a program, using data from the Consolidated Tape (``CT''), 
Consolidated Quotation System (``CQS''), and ITS, to identify paired 
order trades (``POTs'') occurring on the CSE. A POT was defined as a 
trade printed on the CSE that was not the result of interaction with 
the existing CSE quote, e.g., not a trade between two distinct CSE 
members. The NYSE included analysis for five consecutive trading 
days in March 1995. See NYSE Letter No. 2, supra note 29.
    \35\ See NYSE Letter No. 3, supra note 29.
    \36\ See letters from David Colker, Executive Vice President and 
Chief Operating Officer, CSE, to Arthur Levitt, Jr., Chairman, SEC, 
dated January 18, 1995 (``CSE Letter No. 1''); Jonathan Katz, 
Secretary, SEC, dated April 26, 1995 (``CSE Letter No. 2''), and 
June 14, 1995 (``CSE Letter No. 3''); Brandon Becker, Director, 
Division of Market Regulation, SEC, dated June 19, 1995 (``CSE 
Letter No. 4''); Richard Lindsey, Director, Division of Market 
Regulation, SEC, dated January 31, 1996 (``CSE Letter No. 5'').
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A. Order Execution Quality

    Several commenters asserted that the alteration of priority rules 
to facilitate internalization discourages interaction between dealers 
and among customer orders in the CSE market.\37\ Specifically, 
commenters stated that preferencing discourages interdealer competition 
on the CSE and, as a result, the CSE functions as a mere facility by 
which its members can receive a print for an exchange execution for 
internalized trades.\38\ The NYSE asserted that, as a result of 
preferencing, there are multiple proprietary trading systems within the 
CSE market wherein CSE members can internalize order flow with minimal 
probability of that order flow interacting with the orders of other CSE 
members.\39\ In response, the CSE indicated that an average of 8,000 
trades per month result from interaction between CSE dealers.\40\ In 
addition, the CSE believes interdealer activity has been increasing due 
to efforts by the Exchange to encourage quote competition among its 
dealers.\41\

    \37\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra 
note 30; Amex Letter, supra note 31; and Specialist Association 
Letters Nos. 1 and 2, supra note 32.
    \38\ See NYSE Letters Nos. 2 and 3, supra note 29; and 
Specialist Association Letter No. 2, supra note 31. The NYSE claimed 
that a total of 87.7% of CSE executions were POTs. Further, the NYSE 
asserted that in a subset of securities in which there were only 
preferencing dealers, 94.2% of all trades were POTs. The NYSE 
asserted that only 4.8% of CSE trades could be characterized as 
trades between CSE dealers.
    \39\ See NYSE Letter No. 2, supra note 29.
    \40\ See CSE Letter No. 1, supra note 36.
    \41\ Id. In January 1994, the Exchange proposed quoting 
parameters that would require dealers to maintain quotation spreads 
that are no wider than 125% of the three narrowest ITS quotations. 
As a result, in some circumstances, dealers would be required to 
maintain quotes that match at least one side of the ITS/BBO. In 
addition, the Exchange proposed to prohibit the use of computer-
generated quotations that track the primary market quotation. 
Although the rule proposal has not yet been approved by the 
Commission, the CSE maintains that many of its dealers began to 
comply with these quoting policies voluntarily in January 1994. See 
File No. SR-CSE-95-01.
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    Commenters asserted that because preferencing provides a 
disincentive for interdealer competition, customer orders are denied 
the opportunity to interact with other trading interest in the 
market.\42\ Several commenters further stated that preferencing 
undermines the proper price discovery and market transparency functions 
of the agency auction market and makes best execution of customer 
orders less likely.\43\ In this regard, commenters asserted that 
preferencing makes it more profitable for dealers to internalize orders 
by maintaining limit orders on their internal proprietary systems until 
they become marketable, rather than placing them on the Exchange's 
central limit order book where they would be displayed and have an 
opportunity to interact with other customer orders.\44\ In addition, 
commenters charged that because orders on the CSE's central limit order 
book must be satisfied before a dealer can internalize orders at the 
same price, it is to the advantage of dealers that seek to internalize 
customer order flow to discourage the placing of limit orders on the 
CSE's book.\45\ As a result, the commenters maintained that there are 
relatively few, if any, limit orders sent to the CSE's book.\46\

    \42\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra 
note 30; Amex Letter, supra note 31; and Specialist Association 
Letters Nos. 1 and 2, supra note 32. See also comment letters cited 
supra note 33 that opposed preferencing
    \43\ See Amex Letter, supra note 31; and Specialist Association 
Letters No. 1, supra note 32. See also comment letters cited supra 
note 33 that oppose preferencing.
    \44\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra 
note 30; Amex Letter, supra note 31; and Specialist Association 
Letters Nos. 1 and 2, supra note 32.
    \45\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra 
note 30; Amex Letter, supra note 31.
    \46\ Id.
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    The CSE stated that is has encouraged dealers to place limit orders 
on the NSTS book, but that no exchange has the authority to dictate 
firm order handling practices by requiring that firms place their limit 
orders in the exchange's book.\47\ The NYSE believes, however, that 
while the CSE lacks the authority to dictate that its preferencing 
dealers enter limit orders on the CSE, the CSE could require firms to 
route a mix of order types to CSE preferencing dealers.\48\

    \47\ The CSE reported that in the first quarter of 1995, 2104 
preferenced orders interacted with pre-existing public agency limit 
orders on the CSE's book. See CSE Letter No. 4, supra note 36. The 
CSE reported that in the fourth quarter of 1995, 4802 preferenced 
orders interacted with agency limit orders on the CSE's book. See 
CSE Letter No. 5, supra note 36. As described above, the CSE is 
proposing to require dealers to display their limit orders by either 
placing the orders on the Exchange's central limit order book, or 
representing the orders in their CSE quote.
    \48\ The NYSE states as an example that the CSE could require 
dealers to route the same ratio of market orders and limit orders to 
the CSE. See NYSE Letter No. 2, supra note 29.
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    With respect to market order exposure, the CSE maintained that the 
rate of price improvement on the Exchange compares favorably to other 
exchanges. The CSE asserted that 59% of CSE executions in greater than 
minimum variation markets were printed between the ITS/BBO in the 
fourth quarter of 1995, and that an additional 4% of the orders 
received price improvement after being exposed at prices that narrowed 
the ITS/BBO.\49\ The NYSE asserted that the CSE does not compare 
favorably to the other exchanges and reported that only approximately 
45% of the executions on CSE occur between the ITS/BBO.\50\ Finally, 
the NYSE noted that the CSE is the only exchange that does not have 
rules requiring members, when trading as principal with an agency 
order, to publicly cross the order in the market and quote the agency 
order 1/8 better so as to permit other members to improve the 
price.\51\

    \49\ See CSE Letter No. 5, supra note 36. In addition, the CSE 
reported that for the first quarter of 1995, 57% of CSE executions 
in greater than minimum variation markets were executed between the 
ITS/BBO, and that an additional 3% of the orders received price 
improvement after being exposed at prices that narrowed the ITS/BBO. 
See CSE Letter No. 4, supra note 36.
    \50\ See NYSE Letter No. 2, supra note 29. Based on its own 
analysis, the NYSE asserted that during the month of December 1994, 
CSE's rate of price improvement was 48.7% in 1/4 point markets, 48% 
in 3/8 point markets, and 37.7% in 1/2 point markets. The NYSE also 
stated that, contrary to the CSE's contention, price improvement is 
possible in minimum variation markets and that 17.6% of NYSE 
SuperDot market orders receive price improvement in 1/8 point 
markets. Id. The BSE also measures price improvement in minimum 
variation markets, and maintains that it provides price improvement 
approximately 4% of the time when the ITS/BBO spread is 1/8 point. 
See BSE Letter, supra note 30.
    \51\ See NYSE Letter No. 2, supra note 29. As described above, 
the CSE is proposing to require dealers to either execute market 
orders in greater than minimum variation markets between the spread, 
or expose the orders for 30 seconds to give other market 
participants an opportunity to provide price improvement.
---------------------------------------------------------------------------

B. Market Quality

    Several commenters asserted that the Commission should not 
permanently approve the DPP because the CSE has not demonstrated that 
preferencing results in added depth and liquidity to its market, nor 
improved quotations.\52\

[[Page 15326]]
The NYSE and BSE asserted that the existence of preferencing dealers in 
an issue actually diminishes the quality of the CSE quotes.\53\ In 
evaluating whether preferencing dealers add to the quality of the CSE 
market, the NYSE believes that preferenced trade activity should not be 
considered.\54\ Rather, the NYSE believes that the measure of a 
preferencing dealer's contribution to the market is whether it 
maintains quotations and handles order flow that interacts with other 
CSE members and market participants.\55\ As discussed above, the NYSE 
estimated that approximately 88% of CSE trades are executed without 
interaction between CSE members.\56\ In addition, the NYSE believes 
that ITS inbound activity is an indication of competitive quoting, in 
that quotes at the ITS/BBO draw orders to trade on the CSE from other 
markets. In this regard, the NYSE asserted that the percentage of CSE 
trades in a stock involving orders from other market participants 
(i.e., ITS inbound activity) decreased as the number of preferencing 
dealers in an issue increased.\57\ Similarly, the BSE argued that the 
percentage of ITS inbound activity attributable to preferencing dealers 
should be higher in proportion to the number of trades and shares they 
execute on the CSE.\58\

    \52\ See NYSE Letters Nos. 2 and 3, supra note 29; BSE Letter, 
supra note 30; Amex Letter, supra note 31; Specialist Association 
Letters Nos. 1 and 2, supra note 32; and Dingell Letter, supra note 
33. The commenters note that the Commission requested that the CSE 
demonstrate that preferencing added depth and liquidity to its 
market, improved quotations, and generally had a beneficial 
competitive effect on the national market system. See Securities 
Exchange Act Release No. 34493, supra note 6.
    \53\ See NYSE Letter No. 2, supra note 29; and BSE Letter, supra 
note 30.
    \54\ The CSE maintains, however, that the preferencing program 
has provided additional depth and liquidity for a substantial amount 
of public order flow, and that it is therefore appropriate for the 
Commission to include preferenced trade activity in its analysis. 
See CSE Letter No. 3, supra note 36.
    \55\ See NYSE Letter No. 2, supra note 29. See also BSE Letter, 
supra note 30 (asserting that CSE dealers do not trade at their 
displayed quotes); and infra note 60.
    \56\ See NYSE Letter No. 2, supra note 29. The NYSE maintained 
that for stocks in which there were only preferencing dealers, 94% 
of the trades were POTs. The NYSE asserted that this data evidenced 
that the CSE is being used by its members as a printing mechanism 
for their own pre-arranged trades.
    \57\ The NYSE reported that, as a percentage of total trades, 
ITS inbound trades were 5.8% for stocks with one preferencing 
dealer, 3.8% for stocks with two preferencing dealers, and 2.5% for 
stocks with three preferencing dealers. In contrast, the NYSE 
reported that in stocks with both preferencing and non-preferencing 
dealers ITS inbound trades were 7.7% of total trades. The NYSE also 
asserted that a single non-preferencing CSE dealer had more ITS 
inbound activity than the combined total of the 9 preferencing 
dealers during the week studied. See NYSE Letter No. 2, supra note 
29.
    \58\ See BSE Letter, supra note 30.
---------------------------------------------------------------------------

    The CSE maintained that preferencing dealers add depth and 
liquidity to the market through quotes at the ITS/BBO. In its initial 
report, the CSE analyzed its average quote spread, average quote size, 
the relation of CSE quotes to the ITS/BBO, total trade activity, ITS 
inbound trade activity, and customer order price improvement.\59\ In 
every category the CSE reported that its performance either equaled or 
exceeded the other regional exchanges.\60\ Several commenters noted 
that the CSE's data included all dealers on the CSE and asserted that 
inclusion of non-preferencing dealers improved the overall results.\61\ 
In response, the CSE submitted an analysis that isolated the trading 
activity of preferencing dealers in the above categories, and reported 
that their performance also equaled or exceeded the other regional 
exchanges.\62\ Most recently, the CSE reported that 71% of the CSE's 
quotations match at least one side of the ITS/BBO,\63\ and that the CSE 
was responsible for generating 6% of all quotes that established a new 
ITS/BBO.\64\

    \59\ See CSE Letter No. 1, supra note 36.
    \60\ See id. The BSE noted that the CSE's data showed that the 
BSE's average size for quotes at the ITS/BBO (1,325 shares) far 
exceeded that of the CSE (700 shares). While the CSE data also 
indicated that the BSE only quotes at the ITS/BBO 5% of the time 
compared to approximately 71% for the CSE, the BSE asserts that CSE 
dealers do not trade at their quotes and that the size of CSE quotes 
is therefore meaningless. See BSE Letter, supra note 30.
    \61\ See NYSE Letter No. 2, supra note 29; and BSE Letter, supra 
note 30.
    \62\ See CSE Letter No. 3, supra note 36. The CSE reported that 
for a subset of 237 stocks in which there were only preferencing 
dealers (1) the average quotation spread was \1/4\ point, which the 
CSE reported was narrower than any other regional exchange, (2) 60% 
of their quotes matched one or both sides of the ITS/BBO, while none 
of the other exchanges exceeded 30%; and (3) the CSE generated 4% of 
all quotes that established a new ITS/BBO, which exceeded the 
performance of all other regional exchanges. The CSE also asserted 
that it had the highest average quote size (700 shares) of any 
regional stock exchange in the 237 stocks. The CSE asserted that the 
depth provided by preferencing specialists when their quotes 
establish or match the ITS/BBO actually contributed more depth to 
the national market than all the other regional exchanges when 
viewed in conjunction with the lower rates at which the regional 
exchanges quote at the ITS/BBO. The CSE also maintained that 
preferencing dealers executed almost half of all ITS inbound 
activity in those issues that have at least one preferencing dealer, 
and that preferencing dealers' ITS/total trade ratio of 3.5% 
compared favorably to the NYSE's ITS/total trade ratio of 2.8%.
    \63\ See CSE Letter No. 5, supra note 36 (data from fourth 
quarter 1995). The CSE reported that in the first quarter of 1995 
73% of the CSE quotes matched at least one side of the ITS/BBO. See 
CSE Letter No. 4, supra note 36.
    \64\ See CSE Letters No. 4 and 5, supra note 36.
---------------------------------------------------------------------------

    Several commenters asserted, however, that any liquidity that may 
be provided by the CSE is artificial due to the inaccessibility of the 
CSE's quotes.\65\ Commenters charged that CSE quotes change too quickly 
for other market participants to have a meaningful opportunity to send 
ITS orders to the CSE.\66\ Commenters believe that the rapid quote 
changes are caused by a combination of multiple dealers in the single 
market and the use by some CSE dealers of automated systems that 
generate quotations.\67\ The CSE maintained, however, that its 
cancellation rate is not increased by computer-generated quotations, 
and that 87% of quote changes that result in cancellations are 
displayed to other market participants for over one minute.\68\

    \65\ See NYSE Letter No. 1, supra note 29; BSE Letter, supra 
note 30; Amex Letter, supra note 31; and Specialist Association 
Letter No. 1, supra note 32.
    \66\ See NYSE Letter Nos. 1 and 2, supra note 29; BSE Letter, 
supra note 26 (incorporating by reference letter from John I. 
Fitzgerald, Executive Vice President, BSE, to Jonathan G. Katz, 
Secretary, SEC, dated April 29, 1994); and Amex Letter, supra note 
31.
    \67\ Id.
    \68\ The CSE analyzed 2,626 CSE ITS cancellations that occurred 
on eight randomly chosen trading days between August 4, 1994, and 
January 13, 1995. The CSE concluded that, of the total cancellations 
analyzed, 4% were caused by erroneous pricing, 9% were the result of 
``fishing,'' and 22% were the result of stock having traded prior to 
receipt of the ITS commitment. The remaining cancellations were due 
to the CSE's quote changing before the commitment to trade was 
received by the CSE system. In this regard, the CSE asserts that 87% 
of the quotes that changed prior to receipt of ITS commitments to 
trade had been displayed for more than one minute, and more than 50% 
of these quotes had been displayed for over five minutes. See CSE 
Letter No. 2, supra note 36.
---------------------------------------------------------------------------

    Finally, the Commission received two preliminary drafts of an 
academic paper from Indiana University that studies the short term 
effects of preferencing on market quality (``IU Study'').\69\ The IU 
Study looked for potential shifts in market share, bid/ask spreads, and 
liquidity premiums \70\ for 256 securities that the authors believed 
were preferenced during the entire pilot (1991-1995). The IU Study's 
preliminary results indicated that, while internalization results in 
significant volume redistribution, the preferencing program does not 
appear to have had an adverse effect on the measures of market 
quality.\71\ The IU study noted, however,

[[Page 15327]]
that to the extent that retail brokers internalizing trades reduce (or 
even eliminate) commissions, investor welfare is improved.

    \69\ See letter from Robert Jennings, Faculty Fellow and 
Professor of Finance, Indiana University School of Business, to 
Jonathan Katz, Secretary, SEC, dated June 30, 1995; and letter from 
Robert Battalio, Assistant Professor, University of Notre Dame, to 
Jonathan G. Katz, Secretary, SEC, dated March 6, 1996.
    \70\ The liquidity premium measures the closeness of transaction 
prices to the mid-point of the quotation spread. Thus, a decrease in 
the liquidity premium indicates that transaction prices have moved 
closer to the mid-point of the spread.
    \71\ Although the IU Study found that spreads and liquidity 
premiums decreased, because of the long time intervals involved, the 
study noted that it could not rule out a general decreasing trend in 
these measures.
---------------------------------------------------------------------------

    In this regard, the CSE asserted that its efficient electronic 
environment, coupled with the ability of member firms to become 
specialists in a larger number of desirable stocks than is feasible on 
other exchanges, results in cost efficiencies that flow through to 
customers.\72\ Some commenters, however, maintained that there is no 
evidence to indicate that the purported efficiencies from 
internalization are passed along to the CSE dealers' customers.\73\

    \72\ See CSE Letter No. 1, supra note 36.
    \73\ See NYSE Letter No. 2, supra note 29; and BSE Letter, supra 
note 30. The Specialist Association cites to a draft article by 
professors Huang and Stoll of the Owen Graduate School of Management 
that concludes that internalization and preferencing in the over-
the-counter market limit the incentive of market participants to 
narrow spreads, with the result that Nasdaq execution costs are 
twice NYSE costs. The Specialist Association concludes that the same 
result occurs on the CSE. See Specialist Association Letter 2, supra 
note 32 (citing Huang and Stoll, Dealer Auction Markets: A Pencil 
Comparison of Execution Costs on NASDAQ and the NYSE (June 6, 1995) 
(draft article)).
---------------------------------------------------------------------------

C. Order Handling Policies for Preferencing Dealers

    As described above, the CSE also proposed policies regarding order 
exposure and limit order protection for preferencing dealers. The NYSE 
criticized the order exposure portion of the proposed order handling 
policies, and stated that these policies will not provide meaningful 
benefits to investors or to the market in general. Specifically, the 
NYSE maintained that the proposed order exposure requirement will 
affect as few as 8% of preferenced orders.\74\ The NYSE further 
asserted that, while some customer orders may receive price improvement 
as a result of the policy, preferencing dealers will continue to have 
an opportunity to trade against the order at the improved price, 
negating the opportunity for two customer orders to meet without dealer 
intervention. The NYSE also asserted that even if CSE dealers expose 
orders for 30 seconds, the short duration of the exposure is unlikely 
to provide other market participants sufficient time to trade with 
those orders.\75\

    \74\ The NYSE states that only approximately 15% of preferenced 
trades occur in markets with a quotation spread that is greater than 
the minimum variation, and that according to the CSE, dealers 
already trade between the ITS/BBO 55% of the time. Thus, NYSE 
concludes that the order exposure rule would apply to only 8% of the 
order handled by preferencing dealers. See NYSE Letter No. 3, Supra 
note 29.
    \75\ The NYSE believes that the 30 seconds mandated for order 
exposure could lead to an increase in the CSE's ITS cancellation 
rate. Id.
---------------------------------------------------------------------------

V. Commission Data

    As discussed above, the Commission received substantial data from 
commenters and the CSE. The various studies result in differing 
conclusions regarding the quality of executions achieved on the CSE by 
preferencing dealers, as well as the quality of the CSE market. In 
response to the differing assertions made by the commenters and the 
CSE, the Commission's Office of Economic Analysis (``OEA'') evaluated 
CSE quotations and transactions. In considering the CSE trade and 
quotation data, the OEA distinguished between the trading activity of 
preferencing versus non-preferencing dealers.
    During the period considered, preferencing dealers accounted for 
more than 90% of trades and two-thirds of share volume on the CSE. The 
281 stocks where preferencing dealers accounted for 80% to 99% of total 
CSE trades were the most actively traded stocks on the CSE.
    The data analyzed by the OEA also showed that CSE preferencing 
dealers often matched the NYSE BBO, and that the percentage of time 
that the CSE quotes matched those on the NYSE was greatest for those 
stocks in which preferencing takes place. Specifically, for the 281 
stocks in which preferencing dealers accounted for 80% to 99% of total 
CSE trades, the CSE quote on average matched the NYSE best bid 
approximately 54% of the time and the NYSE best offer nearly 61% of the 
time. When matching at least one side of the ITS/BBO, the CSE's 
quotation depth in these 281 stocks averaged over 720 shares. For all 
quotes in the 281 stocks, the CSE quotation depth averaged close to 900 
shares.

VI. Discussion

    The Commission has considered carefully the issues presented by the 
CSE's preferencing program, including its potential effects on the 
execution of customer orders, competition between markets, and CSE 
market quality. In particular, the Commission considered carefully the 
commenters' concerns regarding the alteration of time priority, the 
lack of order interaction on the CSE, and the impact on public 
customers and the quality of the CSE market. Similarly, the Commission 
has reviewed the CSE's findings that the DPP has increased the CSE's 
market share without affecting the quality of its markets or execution 
of customer orders.
    The DPP has proven to be a competitive benefit to the CSE. In 
addition, after analyzing substantial data provided by the CSE and 
commenters, as well as conducting its own data collection and 
examination, the Commission believes that the DPP also has improved CSE 
quotations, and has added to the depth and liquidity of the CSE market. 
In addition, the Commission believes that the DPP, as supplemented by 
the adoption of policies related to the handling of customer orders, is 
not necessarily inconsistent with best execution of customer orders. 
For these reasons, discussed more fully below, the Commission believes 
that the proposed rule change, as amended, is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange. In particular, the 
Commission believes that the proposal is consistent with Section 
6(b)(5) of the Act,\76\ which requires, among other things, that the 
rules of an exchange be designed to promote just and equitable 
principles of trade and to perfect the mechanism of a free and open 
market and a national market system and to protect investors and the 
public interest. The DPP, as amended, also is consistent with Section 
11A of the Act,\77\ which generally promotes, among other things, the 
development of a national market system for securities to assure 
economically efficient execution of securities transactions and fair 
competition among brokers and dealers, among exchange markets and 
markets other than exchange markets.

    \76\ 15 U.S.C. Sec. 78f(b).
    \77\ 15 U.S.C. Sec. 78k-1.
---------------------------------------------------------------------------

    The Commission supports efforts by exchanges to provide increased 
liquidity and competition on their trading floors or trading systems. 
Such efforts can enhance market quality and enable exchanges to compete 
more effectively for order flow. The CSE's preferencing program was 
designed to attract more market making and order flow to the Exchange, 
and it is apparent from the data that the DPP has led to a substantial 
increase in the CSE's trading volume.\78\ At the same time, the 
Commission has been very concerned about the market structure issues 
presented by internalization of order flow and its potential effect on 
the handling of customer orders and the ability of broker-dealers to 
fulfil their duty to seek best execution of customer orders. 
Accordingly, in scrutinizing the CSE's preferencing pilot, including 
the numerous comment letters, the Commission has considered, among 
other things, preferencing's effect on achievement of economically 
efficient execution of securities transactions, fair competition among 
brokers and dealers

[[Page 15328]]
and among exchange markets, as well as the practicability of brokers 
executing investors' orders in the best market.

    \78\ See CSE Letters, supra note 36.
---------------------------------------------------------------------------

    Although preferencing enables CSE dealers to internalize order 
flow, the CSE's unique system is not necessarily inconsistent with a 
broker-dealer's duty to seek best execution of customer orders.\79\ 
Dealers preference their customer order flow on the CSE by matching 
themselves with a customer order and sending a paired trade priced at 
or between the ITS/BBO to NSTS for execution. Upon receiving the paired 
order, NSTS replaces the preferencing dealer's side of the trade if 
there are any public agency orders at the same price on the CSE's 
central limit order book. If there are no such public agency orders, 
the paired trade is executed, regardless of dealer quotes resident in 
the system. In this manner, the preferencing program protects customer 
limit orders entered into NSTS while permitting broker-dealers to 
retain their own customer order flow where those orders would have 
otherwise been executed by another broker-dealer. Accordingly, 
preferencing alters the pre-existing CSE time priority rule that 
determines which broker-dealer is entitled to execute a customer order 
in favor of the broker-dealer that brought the order flow to the CSE.

    \79\ See Securities Exchange Act Release No. 28866, supra note 
5. The CSE's NSTS system was designed to centralize the trading 
interest of geographically dispersed dealers by consolidating and 
disseminating the dealers' quotations, and providing a central limit 
order book for orders entered by the multiple dealers. Thus, the 
NSTS system provides a central location for CSE dealers to interact 
in a manner similar to a traditional exchange trading floor. 
Preferencing, however, suspends time priority between professional 
trading interest so that the multiple CSE dealers can execute their 
own customer orders without interruption by other dealers and is 
more akin to trading in the over-the-counter markets.
---------------------------------------------------------------------------

    Several commenters express concern, however, that the ability of 
dealers to maintain and execute their order flow without interruption 
from other professionals trading on the CSE provides an incentive for 
dealers to delay sending limit orders to the Exchange until they are 
marketable,\80\ and that all orders on the CSE are thereby deprived of 
the benefits accruing from order interaction. In this regard, the 
Exchange is adopting policies for the display and timely execution of 
limit orders held by preferencing dealers. Under the policies, a 
preferencing dealer will be required to display limit orders he or she 
represents as agent priced at or better than the ITS/BBO on the CSE 
\81\ and to execute such limit orders in a timely manner relative to 
executions on the primary market.\82\

    \80\ See supra note 44.
    \81\ As described above, see id., CSE dealers may display limit 
orders by either representing the orders in their CSE quotes or 
placing the orders on the CSE's central limit order book.
    \82\ Any preferencing dealer that failed to display limit orders 
or provide timely executions as required by these policies would 
violate CSE rules and would violate CSE rules and would be subject 
to disciplinary action by the Exchange.
---------------------------------------------------------------------------

    The Commission believes that these limit order policies should 
promote order interaction on the CSE through improved quotations and 
increased volume on the Exchange's central limit order book, as well as 
add to the quality of information displayed to the national market 
system. The Commission notes, however, that the limit order display 
policy permits a CSE dealer to display orders in his or her quotes, 
rather than placing a customer limit order in NSTS where it would have 
the opportunity to interact with customer orders from other CSE 
dealers. The holding of customer limit orders that are routed to a CSE 
dealer for execution on the Exchange outside of the NSTS system raises 
concerns regarding whether such order handling practices are consistent 
with a CSE dealer's best execution obligations. A CSE dealer that 
chooses to represent a customer limit order in his or her dealer quote 
instead of on the CSE's central limit order book must ensure that the 
customer is not disadvantaged as a result of that decision. 
Representing a limit order in his or her quote, rather than placing a 
limit order in the NSTS system where it can be matched with customer 
orders from other CSE dealers, places an obligation on the CSE dealer 
to monitor executions on the CSE to ensure that the limit order 
receives an appropriate execution.
    While preferencing, and the resulting internalization of order flow 
by broker-dealers, may reduce order interaction on the CSE, 
preferencing does not inhibit dealers from executing customer orders 
between the ITS/BBO spread, nor from executing customer buy orders at 
the ITS best bid and sell orders at the ITS best offer. In this regard, 
the CSE reported that CSE executions in greater than minimum variation 
markets receive price improvement at a rate that is comparable to that 
of the NYSE.\83\ Moreover, the CSE is adopting an order handling policy 
designed to give market orders an opportunity for price improvement 
through exposure on the CSE and to the national market system.\84\ 
Under this policy, in greater than minimum variation markets, 
preferencing dealers will be required to immediately execute market 
orders at an improved price, or expose the orders to other market 
participants for an opportunity for price improvement.\85\ Accordingly, 
these market orders cannot be internalized by a CSE dealer without 
first receiving an improved price or the opportunity for price 
improvement.

    \83\ See CSE Letters Nos. 3, 4, and 5, supra note 36.
    \84\ Market orders exposed on the CSE will also be exposed to 
the national market system through the CSE's consolidated quote.
    \85\ Any preferencing dealer that failed to expose market orders 
as required by the policy would violate CSE rules and would be 
subject to disciplinary action by the Exchange.
---------------------------------------------------------------------------

    Although the data indicates that the quality CSE preferencing 
dealers' market making is presently comparable to other markets, the 
Commission recognizes that this quality relative to other markets may 
change over time. The Commission will periodically review the practices 
of broker-dealers that internalize order flow through the CSE's 
preferencing program. If a deterioration in the performance of 
preferencing dealers were evident, the Commission would consider 
whether the CSE would need to reinstitute time priority between dealer 
quotes on the CSE, or take other actions to improve the quality of 
market making on the CSE.
    Furthermore, while the CSE's order handling policies and the data 
described in this order lead us to conclude that preferencing on the 
CSE is not necessarily inconsistent with a broker-dealer's duty to seek 
best execution, the Commission recognizes that CSE execution quality 
is, nevertheless, in large part dependent on the diligence of CSE 
members in handling customer orders. While this is true of all markets, 
it is of particular significance in markets where dealers execute 
customer orders as principal. It is therefore incumbent on the CSE, 
\86\ as well as the Commission in its oversight capacity, to ensure 
that CSE members provide best execution of customer orders.

    \86\ At a minimum, the Commission would expect the CSE, as with 
any self-regulatory organization, to conduct regular, comprehensive 
surveillance of the execution quality provided by its members.
---------------------------------------------------------------------------

    In this regard, the Commission's recent order routing disclosure 
requirements \87\ and its proposed order handling rules \88\ signal a 
renewed emphasis on the important of price improvement opportunities in 
connection with the duty to seek best execution. As the Commission has 
noted, while an automated order routing environment is not necessarily 
inconsistent with the achievement of best executive, broker-dealers 
choosing where to automatically route orders must assess periodically 
the quality of

[[Page 15329]]
competing markets to assure that order flow is directed to markets 
providing the most advantageous terms for their customers' orders.\89\ 
Consequently, a broker-dealer may not simply employ default order 
routing to an affiliated CSE dealer without undertaking such an 
evaluation on an ongoing basis. A broker-dealer sending orders to the 
CSE must satisfy itself that its routing decision is consistent with 
its best execution obligations, irrespective of the firm's desire to 
internalize order flow through an affiliated CSE preferecing dealer. To 
reach this conclusion, the broker-dealer must rigorously and regularly 
examine the executions likely to be obtained for customer orders in the 
different markets trading the security, in addition to any other 
relevant considerations in routing customer orders.

    \87\ See Securities Exchange Act Release No. 34902, supra note 
15.
    \88\ See Securities Exchange Act Release No. 36310, supra note 
16.
    \89\ Id. The Commission also noted that the availability of 
sophisticated order handling systems has made it possible for some 
broker-dealers and market centers to provide an opportunity for 
price improvement for their customer orders. The use of these 
efficient routing and execution facilities by firms and exchanges 
suggests that price improvement procedures and other best execution 
safeguards in an automated environment are increasingly practicable 
and are setting new standards for the industry. See also Division of 
Market Regulation, SEC, Market 2000: An Examination of Current 
Equity Market Developments, (January 1994), at Study V.
---------------------------------------------------------------------------

    The Commission also has considered carefully the commenters' 
concerns regarding the quality of the CSE's market, and whether 
preferencing has added depth and liquidity to the CSE market, and 
improved quotations.\90\ In this respect, the Commission first 
considered data provided by the CSE and commenters. In light of the 
conflicting results from the two groups of data, the Commission 
collected additional data on its own. Overall the data indicates that 
preferencing dealers have added depth and liquidity to the CSE market. 
Specifically, data indicated that, for the 281 stocks in which 
preferencing dealers accounted for 80% to 99% of total CSE quote on 
average matched the NYSE best bid approximately 54% of the time and the 
NYSE best offer nearly 61% of the time, with an average depth of over 
720 shares. This compares favorably to the data for other regional 
exchanges provided by the CSE.\91\ Finally, for the 114 stocks traded 
on the CSE for which there are only preferencing dealers, the depth of 
CSE quotes matching at least one side of the NYSE BBO nearly 500 
shares. This data indicates that preferencing dealers are providing 
competitive quotations that add liquidity to the national market.

    \90\ See supra note 52 and accompanying text.
    \91\ See CSE Letter No. 1, supra note 36.
---------------------------------------------------------------------------

    Several commenters asserted that CSE quotations at the ITS/BBO do 
not add depth and liquidity to the national market because they change 
too quickly for other market participants to react. The data regarding 
CSE quotations was analyzed by the OEA on a time-weighted basis, so 
that, unlike the figures provided by the commenters and the CSE, the 
results took into consideration whether the quotes at the NYSE BBO were 
short in duration relative to quotes outside of the NYSE BBO. The 
resulting figures that CSE dealers match at least one side of the NYSE 
BBO between 54% and 61% of the time in the 281 securities, therefore, 
indicate that CSE quotes are often maintained at the NYSE BBO.
    The Commission believes that the CSE's proposed limit order display 
policy could further add to the depth and liquidity of the CSE market. 
As discussed above, under the policy, CSE dealers will be required to 
display limit orders priced at or better than the ITS/BBO. Whether 
represented in the dealer's quote or placed on the Exchange's central 
limit order book, these orders will be included in the CSE consolidated 
quote and disseminated to the national market system. The Commission 
recently recognized that the display of limit orders could produce, 
among other benefits, spreads that more fully represent buying and 
selling interest in the market and enhance an investor's ability to 
monitor execution quality.\92\ This, in turn, should increase 
competition among dealers based on their respective quotations.

    \92\ See Securities Exchange Act Release No. 36310, supra note 
16.
---------------------------------------------------------------------------

    Finally, the Commission believes it is consistent with the Act for 
the CSE to remove the restriction placed on the DPP during the pilot 
prohibiting preferencing dealers from making cash payments for order 
flow. The Commission believed that a limitation on the inducements for 
preferencing order flow was necessary until the Commission had an 
opportunity to assess the effects of the DPP pilot. As discussed above, 
the Commission has assessed the preferencing pilot and determined that 
it is not inconsistent with the Act, nor necessarily, a broker-dealer's 
obligation to seek best execution. Moreover, lifting the payment for 
order flow restriction on CSE preferencing dealers will place them in 
the same position as the CSE's other members. Accordingly, the 
Commission believes it is appropriate at this time to remove this 
restriction.
    The Commission also is approving the DPP without the restriction on 
the number of stocks in which a single CSE dealer is permitted to 
register. These restrictions were necessary to limit the scope of the 
pilot program so that the CSE and Commission could evaluate the effects 
of preferencing. The Commission has completed such an evaluation and 
finds no reason to continue the restriction.

VII. Conclusion

    The Commission believes it is consistent with the Act to approve 
the CSE's dealer preferencing program, as amended, on a permanent 
basis. In making this determination, the Commission has carefully 
evaluated the data provided by the CSE and commenters, as well as data 
collected by the Commission. The Commission has concluded that 
preferencing, as supplemented by the order handling policies, is not 
necessarily inconsistent with the attainment of best execution of 
customer orders, the maintenance of fair and orderly markets, or the 
protection of investors and the public interest under Section 6(b)(5) 
of the Act. In addition, the Commission believes approval of the DPP, 
as amended, also is consistent with Section 11A of the Act, 
particularly considering the order handling policies being adopted 
herein. Moreover, to the extent that preferencing does not have the 
effect of increasing order interaction, it fulfills the other national 
market system goals of Section 11A(a)(1)(C) of the Act, such as 
furthering competition among brokers and dealers, among exchange 
markets and markets other than exchange markets.
    Nevertheless, Commission approval of the CSE's preferencing program 
is not a determination by the Commission that mere default routing by a 
firm to its affiliated preferencing dealer is consistent with a firm's 
best execution obligations. A broker-dealer associated with a 
preferencing dealer must still ensure that its order routing decisions 
and the preferencing dealer's order handling practices on the CSE (even 
if in technical compliance with the CSE's order handling requirements) 
are consistent with the firm's best execution obligations and assess 
periodically the quality of competing markets to assure that order flow 
is directed to markets providing the most advantageous terms for its 
customers' orders.

[[Page 15330]]

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\93\ that the proposed rule change (SR-CSE-95-03), as amended, is 
approved.

    \93\ 15 U.S.C. 78s(b)(2).
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    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-8397 Filed 4-4-96; 8:45 am]
BILLING CODE 8010-01-M