[Federal Register Volume 61, Number 178 (Thursday, September 12, 1996)]
[Rules and Regulations]
[Pages 48290-48332]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-23210]



[[Page 48289]]


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Part III





Securities and Exchange Commission





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17 CFR Part 240



Order Execution Obligations; Final Rule; Proposed Quote Rule Amendment

  Federal Register / Vol. 61, No. 178 / Thursday, September 12, 1996 / 
Rules and Regulations  

[[Page 48290]]



SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-37619A; File No. S7-30-95]
RIN 3235-AG66


Order Execution Obligations

AGENCY: Securities and Exchange Commission.

ACTION: Final Rules.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting a new rule requiring the display of customer limit orders and 
amending a current rule governing publication of quotations to enhance 
the quality of published quotations for securities and to enhance 
competition and pricing efficiency in our markets. These rules have 
been designed to address growing concerns about the handling of 
customer orders for securities.
    Specifically, the Commission is adopting new Rule 11Ac1-4 
(``Display Rule'') under the Securities Exchange Act of 1934 
(``Exchange Act'') to require the display of customer limit orders 
priced better than a specialist's or over-the-counter (``OTC'') market 
maker's quote or that add to the size associated with such quote. The 
Commission also is adopting amendments to Rule 11Ac1-1 (``Quote Rule'') 
under the Exchange Act to require a market maker to publish quotations 
for any listed security when it is responsible for more than 1% of the 
aggregate trading volume for that security and to make publicly 
available any superior prices that a market maker privately quotes 
through certain electronic communications networks (``ECNs'') (``ECN 
amendment''). Finally, the Commission is deferring action on proposed 
Rule 11Ac1-5 (``Price Improvement Rule'').

Effective Date: January 10, 1997. For specific phase-in dates for the 
Display Rule, see section III.A.3.d of this Release.

FOR FURTHER INFORMATION CONTACT: Elizabeth Prout Lefler or Gail A. 
Marshall regarding amendments to the Quote Rule and David Oestreicher 
regarding the Display Rule at (202) 942-0158, Division of Market 
Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., 
Mail Stop 5-1, Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction and Summary

    On September 29, 1995, the Commission issued a release 1 
proposing for comment new Rules 11Ac1-4 and 11Ac1-5 and amendments to 
Rule 11Ac1-1 2 under the Exchange Act.3 As proposed, new Rule 
11Ac1-4 would require the display of customer limit orders that improve 
certain OTC market makers' and specialists' quotes or add to the size 
associated with such quotes. The proposed amendments to the Quote Rule 
would require OTC market makers and specialists who place priced orders 
with ECNs to reflect those orders in their published quotes. The 
proposed Quote Rule amendments also would require OTC market makers and 
specialists that account for more than 1% of the volume in any listed 
security to publish their quotations for that security (``Mandatory 
Quote Rule''). The Price Improvement Rule would have required OTC 
market makers and specialists to provide their customer market orders 
an opportunity for price improvement; it also would have included a 
non-exclusive safe harbor to satisfy the price improvement obligation.
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    \1\ Securities Exchange Act Release No. 36310 (September 29, 
1995), 60 FR 52792 (October 10, 1995) (``Proposing Release'').
    \2\ 17 CFR 240.11Ac1-1.
    \3\ 15 U.S.C. 78a to 78ll (1988).
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    The Commission received 152 comment letters (from 145 commenters) 
in response to the Proposing Release.4 Commenters generally 
supported the Display Rule and the Mandatory Quote Rule, with some 
commenters suggesting specific modifications or alternatives to the 
proposed rules. Commenters also supported the objectives of the ECN 
amendment, but many expressed concerns that diminishing the anonymity 
of such systems would threaten their viability. Most commenters 
believed the Price Improvement Rule would be costly to implement and 
would not be necessary if the other proposals were adopted.
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    \4\ The comment letters and a summary of comments have been 
placed in Public File No. S7-30-95, which is available for 
inspection in the Commission's Public Reference Room. The Commission 
received comments on the proposals from 77 individual investors, ten 
industry associations, seven exchanges and the National Association 
of Securities Dealers (``NASD''), eight academics, 41 market 
participants and the United States Department of Justice. In 
addition, the Commission met with representatives of broker-dealers, 
self-regulatory organizations (``SROs''), industry associations, and 
the U.S. Department of Justice to discuss the proposals. The 
Commission has conducted its own economic analysis of the likely 
economic effects of the various proposals.
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    After considering the comments and relevant economic research, and 
based on the Commission's experience with the development of the 
national market system (``NMS'') and its knowledge of current market 
practices, the Commission is adopting the Display Rule and the proposed 
amendments to the Quote Rule, with certain modifications. The 
Commission believes that these modifications are consistent with the 
proposals and responsive to many of the concerns voiced by the 
commenters.
    The Display Rule adopted today requires OTC market makers and 
specialists to display the price and full size of customer limit orders 
when these orders represent buying and selling interest that is at a 
better price than a specialist's or OTC market maker's public quote. 
OTC market makers and specialists also must increase the size of the 
quote for a particular security to reflect a limit order of greater 
than de minimis size when the limit order is priced equal to the 
specialist's or OTC market maker's disseminated quote and that quote is 
equal to the national best bid or offer.
    The Commission has modified the proposed Display Rule in some 
respects in response to comments. The proposal included an exception to 
permit a specialist or OTC market maker to deliver a limit order to an 
exchange or registered national securities association 
(``association'') sponsored system that complies with the Display Rule. 
This exception has been expanded to permit delivery to ECNs that 
display and provide access to these orders. Additionally, with regard 
to implementation of the rule, the Commission has provided for a phase-
in over a one year period for non-exchange-traded securities covered by 
the Display Rule.
    Today, the Commission also is adopting two significant amendments 
to the Quote Rule. These amendments are designed to ensure that more 
comprehensive quotation information is made available to the public. 
The first amendment requires a specialist or OTC market maker to make 
publicly available the price of any order it places in an ECN if the 
ECN price is better than the specialist's or OTC market maker's public 
quotation. The Commission has adopted this amendment as proposed, with 
an alternative (``ECN display alternative'') that deems OTC market 
makers and specialists in compliance with the Quote Rule if prices 
these OTC market makers and specialists enter into an ECN are publicly 
disseminated and the ECN provides access to other broker-

[[Page 48291]]

dealers to trade at those prices.5 Thus, OTC market makers and 
specialists may comply directly with the ECN amendment by changing 
their public quote to reflect their ECN order, or by using an ECN that 
facilitates their compliance with the rule as described above.
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    \5\ This alternative means of compliance with the ECN amendment 
is referred to hereinafter as the ``ECN display alternative''.
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    Implementation of the ECN display alternative requires the 
cooperation of the SROs in order to include the ECN prices in the 
public quotation system and to provide equivalent access to these 
quotations. The Commission expects the SROs to work expeditiously with 
ECNs that wish to avail themselves of this alternative to develop rules 
or understandings of general applicability. The Commission is prepared 
to act if necessary to ensure implementation of the ECN display 
alternative prior to the effective date of the Quote Rule.
    The second amendment to the Quote Rule expands the categories of 
securities covered by the Mandatory Quote Rule. As amended, the Quote 
Rule will require that OTC market makers and specialists publish quotes 
in any listed security if their volume in that security exceeds 1% of 
the aggregate volume during the most recent calendar quarter. 
Previously, these requirements applied only to certain listed 
securities.6
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    \6\ Additional amendments to the Quote Rule adopted today 
provide that certain Quote Rule provisions that previously applied 
to market makers that elected to quote a Nasdaq National Market 
security now also will apply to market makers electing to quote a 
Nasdaq SmallCap security. See section III.B.d.iii.
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    The Commission is deferring final action on the Price Improvement 
Rule at this time. The Commission will consider the effect of the new 
Display Rule and the amendments to the Quote Rule adopted today before 
determining the appropriate course of action on that proposal.
    In a parallel action, the Commission today is proposing for comment 
an additional amendment to the Quote Rule. The proposed amendment would 
require OTC market makers and specialists that account for more than 1% 
of the volume in any Nasdaq security to publish their quotations for 
that security.7
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    \7\ See Securities Exchange Act Release No. 37620 (August 28, 
1996) (``Companion Release'').
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II. Basis and Purpose of the Display Rule and Quote Rule Amendments

    Twenty years ago, Congress directed the Commission--having due 
regard for the public interest, the protection of investors, and the 
maintenance of fair and orderly markets--to use the Commission's 
authority granted under the Exchange Act to facilitate the 
establishment of a national market system for securities.8 
Congress further determined that the public interest, investor 
protection and the maintenance of fair and orderly markets required the 
NMS to feature:
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    \8\ Pub. L. No. 94-29, 89 Stat. 97 (1975) (``1975 Amendments'').
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    (i) Economically efficient executions;
    (ii) Fair competition among brokers and dealers, among exchange 
markets, and between exchange markets and markets other than exchange 
markets;
    (iii) Public availability of quotation and transaction information;
    (iv) An opportunity to obtain best execution; and
    (v) An opportunity to obtain execution without dealer intervention 
to the extent consistent with economically efficient executions and the 
opportunity to obtain best execution.9
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    \9\ Exchange Act section 11A(a)(1), 15 U.S.C. 78k-1(a)(1). This 
Section also recites the Congressional findings that: The securities 
markets are an important national asset which must be preserved and 
strengthened; and new data processing and communications techniques 
create the opportunity for more efficient and effective market 
operations.
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    The years since the 1975 Amendments have witnessed dramatic 
developments in the U.S. securities markets. Last sale reporting, which 
enables investors to determine the current market for a security, has 
been extended to OTC-traded securities. The Consolidated Quotation 
System (``CQS''), which allows investors to view in a single source 
quotes disseminated from dispersed market centers, did not exist in 
1975. The Intermarket Trading System (``ITS''), which permits 
investors' orders in certain exchange-listed securities to be routed to 
the market center displaying the best quotation, has greatly 
facilitated quote competition. Moreover, technological developments not 
envisioned twenty years ago have enabled market centers to handle 
volume levels many times greater than those that led to the ``back 
office'' crisis of the late 1960s and early 1970s. Taken together, 
these and other developments have made it possible for investors' 
orders to be executed much more rapidly and at far lower cost.
    The Commission recognized that U.S. equity markets had undergone 
significant changes since passage of the 1975 Amendments and were 
likely to undergo further changes of equal magnitude.10 
Accordingly, the Commission announced in July 1992 that its Division of 
Market Regulation (``Division'') would undertake a study of the 
structure of the U.S. equity markets and of the regulatory environment 
in which those markets operate.11
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    \10\ See Securities Exchange Act Release No. 30920 (July 14, 
1992), 57 FR 32587 (July 22, 1992) (``Market 2000 Concept 
Release'').
    \11\ Id.
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    In January 1994, the Division published a study,12 which 
reviewed, among other things, market practices and structures that 
could affect the ability of customers to obtain opportunities for 
better prices. The Market 2000 Study noted that U.S. equity markets had 
evolved since 1975 to provide a much wider array of trading venues to 
meet the diverse needs of investors and made a series of 
recommendations intended to facilitate the further development of a 
national market system. As expected, U.S. equity markets have continued 
to evolve since the Market 2000 Study was published.
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    \12\ Division of Market Regulation, Market 2000: An Examination 
of Current Equity Market Developments (January 1994) (``Market 2000 
Study'' or ``Study'').
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    This evolution of the markets is reflected in part by comparing 
trading volumes and the venues in which orders are executed. In 1976, 
the New York Stock Exchange (``NYSE'') average daily trading volume was 
approximately 21.2 million shares.13 By 1995, average daily 
trading volume exceeded 346 million shares.14 Third market 
trading, i.e., OTC trading of listed securities, in NYSE-listed issues 
accounted for 4.57% of consolidated volume in 1976.15 By 1995, 
third market trading increased to 7.94% of consolidated volume.16 
In 1987, the NYSE handled almost 74% of trades of NYSE-listed issues 
reported on the consolidated tape; in 1995, it handled 70.22% of such 
trades.17
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    \13\ 1982 NYSE Fact Book.
    \14\ 1995 NYSE Annual Report.
    \15\ 1982 NYSE Fact Book.
    \16\ 1995 NYSE Fact Book.
    \17\ Regional exchanges, namely, the Boston Stock Exchange 
(``BSE''), the Philadelphia Stock Exchange (``Phlx''), the 
Cincinnati Stock Exchange (``CSE''), the Chicago Stock Exchange 
(``CHX''), and the Pacific Stock Exchange (``PSE''), have captured a 
significant share of volume in NYSE-listed issues, particularly with 
respect to smaller investor orders. In 1995, the regional exchanges 
accounted for 9.96% of consolidated volume in NYSE-listed issues but 
accounted for 19.01% of trades of NYSE-listed issues reported on the 
consolidated tape. Id. They also accounted for approximately 35% of 
share volume in trades of 100 to 2,099 shares. Shapiro, U.S. Equity 
Markets: Recent Equity Developments, in Global Equity Markets: 
Technological, Competitive, and Regulatory Challenges 21 (R. 
Schwartz ed. 1995). In January 1996, trades of 100-499 shares 
represented between 65-72% of all trades in NYSE-listed issues on 
regional exchanges; such trades represented only 37% of all trades 
on the NYSE. Ross, Shapiro and Smith, Price Improvement of SuperDOT 
Market Orders on the NYSE (NYSE Working Paper 96-01) (March 11, 1996 
draft) (prepared for the NYSE Conference for the Search for Best 
Price) (``Ross, Shapiro and Smith'').
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    Comparable figures for The Nasdaq Stock Market (``Nasdaq'') are 
even more

[[Page 48292]]

dramatic. In 1975, Nasdaq annual volume was approximately 1.39 billion 
shares.18 By 1995, Nasdaq annual volume increased to 101.2 billion 
shares,19 which means that more shares traded hands on three 
average trading days in 1995 than in all of 1975. In 1993, volume in 
all proprietary trading systems combined represented 13% of the total 
volume in Nasdaq/National Market securities; 20 by January 1996, 
volume on Instinet alone represented approximately 15% of total Nasdaq 
volume and 20% of total volume for the 250 Nasdaq stocks with the 
highest median dollar volume.21
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    \18\ 1992 Nasdaq Fact Book.
    \19\ 1995 NASD Annual Report.
    \20\ Market 2000 Study at Appendix IV-2.
    \21\ The Introduction of NAqcess into the Nasdaq Stock Market: 
Intent and Expectation, NASD Economic Research Staff, June 6, 1996 
(``NASD Study''), Exhibit D to Securities Exchange Act Release No. 
37302 (June 11, 1996), 61 FR 31574 (June 20, 1996) (Notice of Filing 
of Amendment No. 2 to Proposed Rule Change by National Association 
of Securities Dealers Relating to the NAqcess System and 
Accompanying Rules of Fair Practice)(``NAqcess Release 2'').
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    The Study addressed the development of certain practices, such as 
internalization,22 payment for order flow 23 and the non-
disclosure of certain customer trading interest to all market 
participants, that raise a variety of market structure and customer 
order handling concerns. For example, brokers today may quote one price 
publicly to retail customers, while showing a better price privately to 
other investors and dealers on an ECN. In addition, the quotes 
displayed to public investors may not accurately reflect the best price 
for a security because limit orders, which specify the price at which 
customers will buy or sell a security, are not uniformly required to be 
included in the quote.
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    \22\ Internalized orders are customer orders routed by a broker-
dealer to an affiliated specialist or executed by that broker-dealer 
as a market maker.
    \23\ The Commission now requires enhanced disclosure of payment 
for order flow practices on customer confirmations and account 
statements, as well as upon opening new accounts. Securities 
Exchange Act Release No. 34902 (October 27, 1994), 59 FR 55006 
(November 2, 1994) (adopting rules requiring enhanced disclosure of 
payment for order flow practices on customer confirmations, and 
account statements, as well as upon opening new accounts) (``Payment 
for Order Flow Release''). See also Securities Exchange Act Release 
No. 35473 (March 10, 1995), 60 FR 14366 (March 17, 1995).
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    The Study recommended that the exchanges and the NASD consider 
taking action to respond appropriately to certain of these 
developments. Since that time, Nasdaq market makers holding customer 
limit orders have been prohibited from trading ahead of those 
orders,24 and some market makers have begun to offer price 
improvement opportunities in OTC transactions to their retail 
customers.25 In addition, the NYSE now requires almost all limit 
orders transmitted through SuperDOT to be displayed to the 
market.26 Further, Commission rules require enhanced disclosure of 
payment for order flow practices on customer confirmations and account 
statements, as well as upon opening new accounts.27
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    \24\ Securities Exchange Act Release No. 34279 (June 29, 1994), 
59 FR 34883 (July 7, 1994) (``Manning I''); Securities Exchange Act 
Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 1995) 
(``Manning II'').
    \25\ See, e.g., Louis, Schwab Debuts New Trading System, San 
Francisco Chronicle, October 17, 1995, at D1.
    \26\ Securities Exchange Act Release No. 36231 (September 14, 
1995), 60 FR 48736 (September 20, 1995).
    \27\ See Payment for Order Flow Release supra note 23.
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    Notwithstanding the progress achieved in this period, the 
Commission believes that further regulatory initiatives are warranted 
at this time. These changes, as indicated in the Proposing Release, are 
intended to address current market practices that inhibit opportunities 
for order interaction and that are inconsistent with Congress's vision 
of the national market system. These changes also address certain 
problems in Nasdaq. The Commission recently reported that, among other 
things: (i) Nasdaq market makers widely followed a pricing convention 
concerning the increments they used to adjust their displayed quotes; 
(ii) adherence to the pricing convention was not the result of natural 
economic forces, often impacted the fairness and accuracy of public 
quotation information and interfered with the economically efficient 
execution of customer transactions; (iii) the pricing convention 
impaired the ability of investors to ascertain the best market for 
their trades, increased the costs of transactions, and resulted in 
unfair discrimination among classes of market participants; (iv) 
numerous market makers collaborated in ways that misled and 
disadvantaged their customers and other market participants and 
frequently failed to honor their price quotations; and (v) many market 
makers have not consistently reported their trades on time or 
appropriately designated them as late as required by NASD rules.28
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    \28\ Report Pursuant to Section 21(a) of the Securities Exchange 
Act of 1934 Regarding the NASD, the Nasdaq Market, and Nasdaq Market 
Makers, Securities Exchange Act Release No. 37542 (August 8, 1996) 
(``21(a) Report'').
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    The Commission has taken specific regulatory and enforcement 
actions to address these problems.29 The Display Rule and Quote 
Rule amendments adopted today should bring about other, significant 
changes in the operation of Nasdaq, by ensuring the disclosure of 
customer and market maker buying and selling interest that heretofore 
has been hidden from many market participants. At the same time, the 
new rules will benefit investors in the exchange markets by increasing 
transparency in those markets and improving opportunities for the best 
execution of customer orders.
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    \29\ See id.
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    The Commission firmly believes that the actions it is taking today 
are consistent with the regulatory framework for a national market 
system established by Congress in the 1975 Amendments. Congress 
envisioned a national market system supported by accurate and reliable 
public quotation and transaction information, and fair competition 
among market centers. Congress also believed that linking all markets 
for qualified securities through communication and data processing 
facilities would foster efficiency, enhance competition, increase 
information available to market participants and contribute to the best 
execution of customer orders.30
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    \30\ See Exchange Act section 11A(a)(1)(D), 15 U.S.C. 78k-
1(a)(1)(D).
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    The Commission recognizes that investors will lose confidence in 
the fairness of the markets unless market structures and practices 
treat all investors fairly. The regulatory initiatives adopted today 
address current market practices that hinder competition among markets 
and affect the prices at which customer orders are executed. The 
Display Rule and Quote Rule amendments enhance transparency and 
facilitate best execution of customer orders in a manner that preserves 
maximum flexibility for the markets to design and implement trading and 
communication systems that are consistent with the objectives of the 
national market system. These rules contribute to the achievement of 
the full potential of the national market system as envisioned by 
Congress. They represent one more step to facilitate the development of 
an efficient, competitive and transparent national market system in 
which all market participants can achieve best execution of their 
orders.

III. Discussion

A. Display of Customer Limit Orders

1. Introduction
    As discussed above, the 1975 Amendments contain an explicit 
statutory mandate for the establishment of a national market system. 
Congress considered mandating certain minimum

[[Page 48293]]

components of the national market system, but instead created a 
statutory scheme granting the Commission broad authority to oversee the 
implementation, operation and regulation of the national market 
system.31 At the same time, Congress charged the Commission with 
the responsibility to assure that the national market system develop 
and operate in accordance with specific goals and objectives.32 
The Commission believes that the adoption of a limit order display rule 
furthers these goals and objectives determined by Congress.
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    \31\ S. Rep. No. 75, 94th Cong., 1st Sess. 8-9 (1975) (``Senate 
Report'').
    \32\ Id. at 9. Among other things, Congress found it in the 
public interest and appropriate for the protection of investors and 
the maintenance of fair and orderly markets to assure an opportunity 
for investors' orders, in both dealer and auction markets, to be 
executed without the participation of a dealer, to the extent that 
this was consistent with economically efficient executions of such 
orders in the best market. Exchange Act Section 11A(a)(1(c), 15 
U.S.C. 78k-1(a)(1)(C).
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    Specifically, the display of customer limit orders advances the 
national market system goal of the public availability of quotation 
information, as well as fair competition, market efficiency, best 
execution and disintermediation. The enhanced transparency of such 
orders increases the likelihood that limit orders will be executed 
because contra-side market participants will have a more accurate 
picture of trading interest in a given security. Further, this 
increased visibility will enable market participants to interact 
directly with limit orders, rather than rely on the participation of a 
dealer for execution.
    Moreover, as noted in the Proposing Release, the display of limit 
orders that are priced better than current quotes addresses at least 
three regulatory concerns. First, displaying customer limit orders in 
the quotation can increase quote competition. If the quotes from a 
market or market maker represent only market maker buying and selling 
interest in a given security, the market or market maker faces less 
price competition than if customer buying and selling interest is made 
public. As a result, the price discovery process may be constrained. 
Second, the display of limit orders can narrow quotation spreads. 
Third, because many markets and market makers offer automatic 
executions of small orders at the best displayed quotes, the display of 
limit orders that improve the best displayed quotes can result in 
improved executions for these orders.
    Limit orders currently are handled differently in the various 
auction and dealer markets. Generally, the rules of most exchanges 
require that a limit order be displayed in the quotation for a security 
when it improves the best bid or offer. NYSE specialists, for example, 
must reflect a customer limit order in their quotations at the limit 
price when requested to do so.33 In addition, the NYSE's order 
handling procedures assume that all limit orders routed to a specialist 
through SuperDOT contain a display request.34 Therefore, except in 
the unusual and infrequent circumstance where a specialist believes 
market conditions suggest the likelihood of imminent price improvement, 
a limit order received by a specialist through SuperDOT should be 
reflected in the specialist's quote as soon as practicable following 
receipt of the order.35 According to the NYSE, 93% of all SuperDOT 
limit orders that improve the best bid or offer displayed are reflected 
in the specialist's quote within two minutes of receipt, while 98% of 
such limit orders are reflected within five minutes of receipt.36
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    \33\ See NYSE Rule 79A.10 (when a limit order is presented to 
the specialist by a floor broker, the floor broker must 
affirmatively request that the specialist display the limit order; 
failure to so request leaves the decision whether to display the 
limit order to the discretion of the specialist); see also NYSE Rule 
60 (requiring specialists to promptly report, inter alia, the best 
bid and offer in the trading crowd in each reported security in 
which the specialist is registered).
    \34\ NYSE Information Memo 93-12 (Mar. 30, 1993).
    \35\ Id.
    \36\ Telephone Conference between Edward A. Kwalwasser, 
Executive Vice President, NYSE, and Holly H. Smith, Associate 
Director, Division of Market Regulation, SEC, January 9, 1995.
    Other exchanges also have rules regarding dissemination of bids 
and offers. However, no uniform standard has been adopted among the 
exchanges. Generally, the rules either cite, in whole or in part, 
language from the Quote Rule, or are drafted in such a manner as to 
allow for broad interpretation with respect to the display of limit 
orders. See, e.g., BSE Guide, Rules of the Board of Governors, 
Chapter II, Sec. 7, (CCH) para. 2020; PSE Guide, Rules of the Board 
of Governors, Rule 5.6(f), (CCH) para. 3979; American Stock Exchange 
Guide, General and Floor Rules, Rule 115, (CCH) para. 9265; CHX 
Guide, Article XX, Rule 7, (CCH) para. 1688; Phlx Guide, Rules 105 
and 229 (CCH) para. 2105 and 2229; Cincinnati Stock Exchange Rules, 
Rule 11.9.
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    A recent NYSE policy statement requires specialists to display the 
full size of all orders received through SuperDOT as well as orders 
received by specialists manually that are subsequently entered into the 
electronic book.37 When a member requests that less than the full 
size of the order be shown, the specialist is obligated to show the 
size requested. Specialists must display as soon as practicable any 
order that, in relation to current market conditions in a particular 
security, represents a material change in the supply or demand for that 
security. This requirement includes increasing the size of a quotation 
for orders at the same price as the current bid or offer. If the 
quotation already reflects significant supply or demand, and the 
specialist receives an order that is de minimis in relation to such 
supply or demand, the specialist may take a reasonable time (generally 
not more than two minutes) before updating the size of the 
quotation.38
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    \37\ See supra note 26.
    \38\ The NYSE provides the following example of when a 
specialist may take a reasonable time to update the size of the 
quotation: If the market in XYZ security is 20 (5,000)--20\1/4\ 
(50,000), and the specialist receives an order to sell 200 shares at 
20\1/4\, such order would be considered de minimis and the 
specialist would be permitted to wait a reasonable period of time 
(but not more than two minutes) before changing the size of the 
offer to 50,200.
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    Currently in the OTC market, the quote for any security typically 
represents a dealer's own bid and offer. The rules of the NASD do not 
require market makers to display customer limit orders, whether or not 
they better the best bid or offer for the security.39 Generally, 
customer limit orders in OTC securities either will be routed to a 
broker-dealer's market making desk or to another market maker for 
execution if the customer's firm does not make a market in the 
security. In the past, market makers typically did not execute limit 
orders until the best bid (for sell orders) or offer (for buy orders) 
displayed on Nasdaq reached the limit price. This practice has changed, 
however, in recent years. In June 1994, the Commission approved a rule 
change filed by the NASD that prohibits broker-dealers from trading 
ahead of their customers' limit orders.40 This rule was expanded 
in May 1995, to prohibit broker-dealers from trading ahead of customer 
limit orders they accept from other brokers.41 The NASD also has 
filed a proposed rule change that would require, in certain 
circumstances, the display of customer limit orders for exchange-listed 
securities traded OTC.42
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    \39\ See NASD Manual, Rule 4613.
    \40\ See Manning I, supra note 24.
    \41\ See Manning II, supra note 24.
    \42\ See Securities Exchange Act Release No. 35471 (March 10, 
1995), 60 FR 14310 (March 16, 1995). The NASD proposal, applicable 
to exchange-listed securities traded OTC, generally would require a 
market maker either to execute immediately a limit order of less 
than the minimum quotation size priced better than the market 
maker's quotation, or display the order in its quotation for an 
amount equal to the minimum quotation size. Market makers would have 
to display a limit order greater than the minimum quotation size for 
that security but would not have to display the full size of the 
order. Any portion of the order not displayed, however, would have 
to be executed at a price at least as favorable as the displayed 
price if the displayed portion is executed in its entirety. At the 
NASD's request, the Commission has postponed final action on the 
NASD's proposal in order to permit the NASD to evaluate its proposal 
in light of the Commission's actions on the proposals it is adopting 
today.

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[[Page 48294]]

    The exchanges and the NASD use automated trading systems to route 
and, in some instances, execute orders up to a predetermined size. Some 
of these systems accept limit orders. Each system, however, may differ 
in its handling of limit orders that are not executed immediately upon 
receipt. For example, the NYSE's SuperDOT system routes limit orders to 
the specialists' posts where they are handled in accordance with NYSE 
rules governing specialist representation of such orders. The American 
Stock Exchange's (``Amex'') PER system routes limit orders in the same 
manner as SuperDOT and the orders are handled in accordance with Amex 
rules. The NASD's Small Order Execution System (``SOES'') treats limit 
orders priced at the current inside market as market orders that are 
immediately executed.43 All other limit orders reside in a limit 
order file that can be viewed only by market makers.44 SOES does 
not provide an opportunity for limit orders to interact with incoming 
market orders. The Commission has published for comment an NASD 
proposal to replace SOES with ``NAqcess,'' a system that would include 
a limit order file designed to display certain customer limit 
orders.45
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    \43\ Preferenced orders (i.e., orders routed to a specific 
market maker pursuant to a pre-existing agreement) are executed 
immediately at the inside quote. Unpreferenced orders are executed 
against market makers in a security in rotation. SOES, however, does 
not execute an unpreferenced order against a single market maker 
more than once every 15 seconds.
    \44\ The current SOES rules have been extended, with certain 
changes that do not affect the handling of limit orders, through 
January 31, 1997. Securities Exchange Act Release No. 37502 (July 
30, 1996), 61 FR 40869 (August 6, 1996).
    \45\ See Securities Exchange Act Release No. 36548 (December 1, 
1995), 60 FR 60392 (December 8, 1995) (``NAqcess Release 1''); 
NAqcess Release 2, supra note 21. As proposed, NAqcess would act as 
an order delivery system with a limited public limit order file.
    Limit orders up to 9,900 shares would be permitted in NAqcess 
for the top 250 Nasdaq National Market securities, defined by median 
daily dollar volume, and for 1,000 shares for all other Nasdaq 
securities. Market makers would be allowed to query the entire limit 
order file. All other market participants would be limited to 
viewing the top of the NAqcess limit order file (i.e., the best 
priced buy and sell limit orders, and the size associated with those 
orders--the NAqcess inside market). This inside market would be 
factored into the calculation for the inside quote for each Nasdaq 
security. Although use of NAqcess would be voluntary, limit orders 
not entered in NAqcess would be provided with market-wide price 
protection under the proposal.
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    The disparate treatment of limit orders across markets was raised 
as an issue in the Market 2000 Study. The Commission received numerous 
comments concerning whether the optimal degree of pre-trade disclosure 
of limit orders was being achieved within the U.S. equity markets. Some 
commentators alleged that specialists and third market dealers 
sometimes fail to display limit orders priced better than the displayed 
quotation.46 Questions also were raised about the lack of limit 
order exposure on Nasdaq. After considering these comments, the 
Division recommended in the Study that the securities exchanges 
consider whether to encourage the display of all limit orders in listed 
stocks priced better than the best intermarket quotes, unless the 
ultimate customer requests that the order not be displayed. The Market 
2000 Study also recommended the display of limit orders in Nasdaq 
stocks when the orders are at prices better than the best Nasdaq 
quotes, unless the customer requests that the order not be 
displayed.47
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    \46\ See generally Thomas H. McInish & Robert A. Wood, Hidden 
Limit Orders on the NYSE, 21 J. Portfolio Mgmt. 19 (No. 3, Spring 
1995) (``McInish & Wood Study''). The authors asserted that NYSE 
specialists only display about 50% of limit orders that better 
existing quotes. In their opinion, this practice represents a 
serious policy issue because it places both public investors and 
regional exchanges at a disadvantage. They asserted that hiding 
limit orders impedes strategic decisions on order placement; results 
in publicly submitted market orders receiving inferior prices; 
hampers the monitoring of order executions; reduces the probability 
of a limit order being executed; results in a delay in reporting 
limit order executions; interferes with the ability of the regional 
exchanges to execute public orders; and artificially improves NYSE 
performance relative to the regional exchanges using a common 
benchmark. The authors also claimed that NYSE Rule 60 is ambiguous 
in that the specialists may have some leeway in choosing what to 
disclose in their quotes.
    In its comment letter to the Market 2000 Study, however, the 
NYSE asserted that its publicly disseminated best bid or offer 
includes all firm trading interest announced on the floor as 
required by the exchange's rules. See Letter from William H. 
Donaldson, Chairman and Chief Executive Officer, NYSE, to Jonathan 
G. Katz, Secretary, SEC at 25-26 (November 24, 1992). In addition, 
the NYSE issued a policy statement that reiterates that specialists 
have an obligation to reflect in their quotes certain limit orders 
received manually or via SuperDOT that are not executed on receipt. 
See supra note 26.
    \47\ Market 2000 Study, at IV-6.
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2. Discussion
a. Basis for Adoption of the Rule
    After carefully considering all of the comments as well as economic 
research regarding the Display Rule, and based on the Commission's 
experience and knowledge of current market practices and conditions, 
the Commission believes that adoption of the Display Rule will promote 
transparency and enhance execution opportunities for customer orders, 
and encourage liquidity.48
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    \48\ See, e.g., Letter from Thomas F. Ryan, Jr., President and 
Chief Operating Officer, Amex, to Jonathan G. Katz, Secretary, SEC, 
dated February 1, 1996 (``Amex Letter''); Letter from David E. Shaw, 
Ph.D., Chairman, D.E. Shaw & Co., to Jonathan G. Katz, Secretary, 
SEC, dated January 9, 1996 (``D.E. Shaw Letter'') (rule will promote 
transparency); Letter from Paul A. Merolla, Vice President, 
Associate General Counsel, Goldman, Sachs & Co., to Jonathan G. 
Katz, Secretary, SEC, dated January 26, 1996 (``Goldman Sachs 
Letter'') (rule would benefit marketplace); Letter from Craig S. 
Tyle, Vice President and Senior Counsel, Securities and Financial 
Regulation, Investment Company Institute, to Jonathan G. Katz, 
Secretary, SEC, dated January 16, 1996 (``ICI Letter'') (increased 
transparency of customer limit orders in all markets could produce 
benefits to the markets and investors); Letter from Donald L. 
Crooks, Managing Director, Lehman Brothers, Inc., to Jonathan G. 
Katz, Secretary, SEC, dated February 26, 1996 (``Lehman Letter'') 
(rule promotes transparency and results in improved opportunities 
for execution of customer orders); Letter from Bernard L. Madoff and 
Peter B. Madoff, Bernard L. Madoff Investment Securities, to 
Jonathan G. Katz, Secretary, SEC, dated January 12, 1996 (``Madoff 
Letter'') (rule will help achieve true price discovery and fairness 
to investors); Letter from Andrew E. Feldman, Director and Associate 
General Counsel, Smith Barney Inc., to Jonathan G. Katz, Secretary, 
SEC, dated January 29, 1996 (``Smith Barney Letter'') (rule will 
promote transparency and assist in achieving best execution of 
orders). But see Letter from Charles R. Hood, Senior Vice President 
and General Counsel, Instinet, to Jonathan G. Katz, Secretary, SEC, 
dated January 16, 1996 (``Instinet Letter'') (exceptions to rule 
eliminate potential positive impact on transparency).
---------------------------------------------------------------------------

    The Commission stresses, however, that the rule is not meant to 
displace any SRO rules that provide additional order handling 
protections to customer limit orders. Instead, the Commission rule 
represents only a minimum display standard.
    The Commission believes that limit orders are a valuable component 
of price discovery. The uniform display of such orders will encourage 
tighter, deeper, and more efficient markets. Limit orders convey buying 
and selling interest at a given price. The display of limit orders can 
be expected to narrow the bid-ask spread when this buying and selling 
interest is priced better than publicly disclosed prices.49 Both 
large and small orders stand to benefit from the Display Rule's effect 
on price discovery.50 In fact, the importance of

[[Page 48295]]

limit orders in the trading process was documented in recent 
studies.51 The author quantified the impact of exposing limit 
orders on quoted spreads and effective transaction costs. Using NYSE 
data, he determined that the quote spreads resulting from participation 
of the limit order book were approximately 4 to 6 cents smaller than 
the spreads not set by the limit order book. Further, trading costs on 
the NYSE were approximately 3-4 cents less per share on a ``round 
trip'' transaction when both the purchase and the sale were executed 
against the limit order book.52
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    \49\ For example, limit order trading allows investors the 
opportunity to trade at prices superior to those represented by the 
prevailing inside bid and offer. See NASD Study, supra note 21.
    \50\ According to SuperDOT trade data analyzed by the 
Commission's Office of Economic Analysis (``OEA''), customer limit 
orders account for 50% of all NYSE customer trades originating from 
orders routed through SuperDOT (``customer trades'') of 100-500 
shares; 66% of all customer trades of 600-1,000 shares; 71% of all 
customer trades of 1,100-3,000 shares; and 74% of all customer 
trades of 3,100-9,900 shares. The Commission believes that these 
high percentages are based, at least in part, on the fact that limit 
orders routed through SuperDOT are required to be displayed in the 
specialist's quote. The Commission believes that these percentages 
help demonstrate the benefits associated with limit order display 
for both large and small order sizes. In addition, OEA data shows 
that NYSE customer limit orders routed through SuperDOT narrow the 
NYSE quote 22% of the time and match the quote 39% of the time for 
customer limit orders of 100-1,000 shares; narrow the quote 17% of 
the time and match the quote 43% of the time for customer limit 
orders of 1,100-3,000 shares; and narrow the quote 14% of the time 
and match the quote 46% of the time for customer limit orders of 
3,100-9,900. OEA data also shows that, when the NYSE bid-ask spread 
was \1/4\ point or more, customer limit orders routed through 
SuperDOT narrow the NYSE spread between 41% and 50% of the time, 
depending on the size of the customer order.
    \51\ See Jason T. Greene, The Impact of Limit Order Executions 
on Trading Costs in NYSE Stocks (An Empirical Examination), December 
1995 (``Greene Study''); see also Jason T. Greene, Limit Order 
Executions and Trading Costs for NYSE Stocks, June 1996 (``Greene 
Study II'').
    \52\ The Commission further believes that the display 
requirement will improve price transparency in securities with 
diverse trading characteristics. Based on SuperDOT trade data, the 
Commission's OEA has determined that for NYSE securities with an 
average daily trading value (``ADTV'') of under $100,000, customer 
limit orders account for 57% of all NYSE customer trades originating 
from orders routed through SuperDOT (``customer trades'') of 100-500 
shares; 69% of all customer trades of 600-1,000 shares; 76% of all 
customer trades of 1,100-3,000 shares; and 83% of all customer 
trades of 3,100-9,900 shares. Limit orders also are frequently used 
for securities with higher ADTVs. For example, for NYSE securities 
with an ADTV of over $5,000,000, customer limit orders account for 
48% of all NYSE customer trades of 100-500 shares; 68% of all 
customer trades of 600-1,000 shares; 72% of all customer trades of 
1,100-3,000 shares; and 73% of all customer trades of 3,100-9,900 
shares. Moreover, OEA data shows that for NYSE securities with an 
ADTV of under $100,000, customer limit orders routed through 
SuperDOT narrow the NYSE quote 30% of the time and match the quote 
32% of the time. For less liquid securities, therefore, the display 
of customer limit orders narrows spreads, improves price discovery, 
and increases market depth. For NYSE securities with an ADTV of 
$5,000,000 or more, customer limit orders routed through SuperDOT 
narrow the NYSE quote 18% of the time and match the quote 41% of the 
time.
    The NASD has suggested that the greater the size of the 
displayed spread, the greater the use of limit orders. See NASD 
Study, supra note 21.
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    The uniform display of limit orders also will lead to increased 
quote-based competition. Market makers will not only be competing 
amongst themselves, but also against customer limit orders represented 
in the quote. The Commission believes that this result will reduce the 
possibility of certain trading behavior on Nasdaq that was recently the 
subject of a Commission investigation.\53\ As reported in the 21(a) 
Report, Nasdaq market makers widely adhered to a ``pricing 
convention,'' whereby Nasdaq market makers maintained artificially 
inflexible quotations and as a result often traded with the public at 
prices unduly favorable to such market makers.\54\ In addition, the 
Commission determined that Nasdaq market makers adhered to a ``size 
convention'' that deterred Nasdaq market makers from narrowing their 
quotes to create a new inside market unless the market makers were 
willing to trade at least 2,000 to 5,000 shares at that price, rather 
than the minimum quotation size as determined by NASD rules.\55\ This 
practice prevented the dissemination of improved quotes when a trader 
sought to trade stock only at a size equal to the minimum quotation 
size. Thus, the true buying and selling interest in a given security 
was not reflected in the published quotes.
---------------------------------------------------------------------------

    \53\ See 21(a) Report, supra note 28. The investigation 
identified a number of practices in the Nasdaq market that are 
similar to practices identified in the 1963 Special Study. See SEC, 
Report of Special Study of Securities Markets (1963). For example, 
the 1963 Special Study discussed cooperation and information sharing 
between traders, as well as other non-competitive practices. Id. at 
pt. 2, 576-577.; See also Competitive Impact Statement of the U.S. 
Department of Justice Antitrust Division, United States v. Alex. 
Brown & Sons, et. al., (S.D.N.Y. 1996).
    \54\ As a result of this convention, most Nasdaq stocks were 
quoted only in increments of \1/4\. Under the convention, stocks 
with a dealer spread of \3/4\ or more would only be quoted in even-
eighths (i.e., \1/4\, \1/2\, \3/4\), thereby giving rise to a 
minimum inside spread of \1/4\. Stocks with dealer spreads less than 
\3/4\ would be quoted in both even and odd-eighths, thereby allowing 
a minimum inside spread of \1/8\. The pricing convention 
significantly limited the flexibility and competitiveness of price 
quotations in the Nasdaq market.
    \55\ See 21(a) Report, supra note 28.
---------------------------------------------------------------------------

    In addition to the Commission's actions, and those of the 
Department of Justice in connection with its investigation of the 
Nasdaq market, the Commission believes the requirement to display 
customer limit orders in market maker quotes would inhibit market 
makers from engaging in the conduct described above. Moreover, the 
display of limit orders reduces the potential for certain other conduct 
described in the 21(a) Report, including market maker collaboration and 
coordination of trade and quote activities. Market makers will be less 
able to improperly coordinate such behavior due to the display of 
competing customer order flow and the resulting transparency of 
ultimate buying and selling interest. The Commission believes that the 
display requirement will both foster renewed quote-based competition 
among market makers and introduce new competition from customer limit 
orders.
    The Commission also believes that overall market liquidity should 
be enhanced due to the increased trading volume that is expected to 
result from the display of limit orders.\56\ As noted previously, 
customer limit orders account for a significant percentage of total 
customer orders on the NYSE, where customer limit orders generally are 
required to be displayed when they represent a better price.\57\ 
Moreover, previous Commission initiatives designed to enhance 
transparency have resulted in increased competition and liquidity for 
the markets.\58\
---------------------------------------------------------------------------

    \56\ See Greene Study and Greene Study II, supra note 51 (limit 
orders affect the quoted spread, provide liquidity to traders that 
demand immediacy of execution, and may contribute to reduced trading 
costs); NASD Study, supra note 21 (the liquidity supplied by limit 
orders reduces trading costs of market participants); OEA Data, 
supra notes 50 and 52 (limit orders narrow spreads, improve price 
discovery, and increase market depth).
    \57\ See OEA Data, supra notes 50 and 52.
    \58\ See Market 2000 Study at Study IV. See also discussion at 
section III.A.b.iii., infra; Simon & Colby The National Market 
System For Over-The-Counter Stocks (``Simon and Colby''), 55 Geo. 
Wash. L. Rev. 17 (1986).
---------------------------------------------------------------------------

    Customers also will be better able to monitor the quality of their 
executions. Currently, the failure to display limit orders often 
results in inferior or missed executions for these orders. The 
Commission has received frequent complaints from customers whose limit 
orders have not been filled while other executions are reported at 
prices inferior to their limit order prices. Requiring the display of 
customer limit orders in specialist and market maker quotes, although 
not guaranteeing that such limit orders will be executed, will help 
ensure that other orders are not executed at inferior prices until 
better priced limit orders are executed. Similarly, customers entering 
market orders will be able to determine whether their orders are 
receiving the best price available. Customers also will be in a better 
position to compare the execution quality provided by different broker-
dealers.\59\
---------------------------------------------------------------------------

    \59\ The Commission notes that if the Display Rule leads some 
market makers to charge commissions for handling limit orders, 
Commission rules require disclosure of such charges. See 17 CFR 
240.10b-10.
---------------------------------------------------------------------------

    The absence of a uniform limit order display requirement across all 
markets has contributed to the controversy among market participants 
regarding the availability of true price improvement

[[Page 48296]]

opportunities. Many claim that ``hidden'' limit orders in exchange 
markets contribute to distorted price improvement figures for these 
markets.\60\ This potential distortion also hinders a customer's 
ability to monitor execution quality. Pursuant to the Display Rule, the 
vast majority of limit orders will be publicly disclosed, thus enabling 
a more accurate comparison of price improvement opportunities, and 
enabling customers and broker-dealers to make more informed order 
routing decisions.\61\
---------------------------------------------------------------------------

    \60\ See James J. Angel, Who Gets Price Improvement on the 
NYSE?, Working Paper, December 1994. In studying the availability of 
price improvement on the NYSE, the author noted that over 18% of the 
market orders that were price improved were filled by SuperDOT limit 
orders. Based on this percentage, the author estimated the 
percentage of orders price improved by ``hidden'' limit orders and 
determined that if such limit orders were represented in the 
specialist's quote rather than ``hidden,'' spreads would have been 
narrower and NYSE price improvement statistics would have declined. 
See also, McInish & Wood Study, supra note 46; Mitchell A. Petersen 
& David Fialkowski, Posted Versus Effective Spreads: Good Prices or 
Bad Quotes, 35 J. Fin. Econ. 269 (1994) (the fact that so many 
orders execute inside the posted spreads indicates that quotes do 
not represent the true supply and demand of a given security, and 
may be based, in part, on the failure to display public limit order 
interest in the quote). Cf. Ross, Shapiro and Smith, supra note 17 
(although the authors did not examine limit orders in detail, and 
discounted the effect of ``hidden'' limit orders on their 
statistics, the authors found that limit orders provide 27% of the 
price improvement afforded to SuperDOT market order volume).
    \61\ See, e.g., Amex Letter (rule would help eliminate hidden 
limit orders); Letter from Frederick Moss, Chairman of the Board, 
CSE, to Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 
(``CSE Letter'') (elimination of hidden limit orders will eliminate 
illusion of superior price improvement); Letter from Harold S. 
Bradley, Vice President and Director of Trading, Investors Research 
Corporation, to Jonathan G. Katz, Secretary, SEC, dated January 13, 
1996 (``Investors Research Letter'') (hidden limit orders are not 
justified).
---------------------------------------------------------------------------

    Moreover, the Commission believes that the display of limit orders 
will benefit orders routed to automated execution systems. To the 
extent these systems execute orders at prices based on the best 
displayed quotation for a particular security,\62\ customers whose 
orders are executed through these systems will receive the benefit of 
prices that more accurately reflect buying and selling interest in the 
market.
---------------------------------------------------------------------------

    \62\ Compare discussion of best execution at section III.C.2.
---------------------------------------------------------------------------

    In sum, the Commission believes the adoption of the Display Rule is 
an important step in furthering the goals expressed by Congress in the 
1975 Amendments. The Display Rule will provide enhanced opportunities 
for public orders to interact with other public orders, consistent with 
congressional goals.63 In addition, the display requirement will, 
among other things, narrow quotes, enhance market liquidity, and 
improve an investor's ability to monitor the quality of its 
executions.64 This will create a better environment for execution 
of both limit and market orders without the participation of a dealer. 
The increased order interaction will result in quicker and more 
frequent executions of customer limit orders. The Display Rule, 
therefore, will increase the likelihood that limit orders will be 
executed, a result that the Commission believes is consistent with the 
duty of best execution.
---------------------------------------------------------------------------

    \63\ See 15 U.S.C. 78k-1(a)(1)(C)(v).
    \64\ The Commission notes that a few commenters are concerned 
about the potential effects of the Commission's proposals on 
institutional customers. See Goldman Sachs Letter; Letter from 
Howard J. Schwartz, Chairman and Chief Executive Officer, and James 
Hanrahan, Managing Director--Trading, Lynch, Jones & Ryan, Inc., to 
Jonathan G. Katz, Secretary, SEC, dated February 9, 1996 (``LJR 
Letter''); Letter from A.B. Krongard, Chairman, SIA Board of 
Directors, and Bernard L. Madoff and Robert Murphy, Co-Chairmen, 
Order Execution Committee, Securities Industry Association, to 
Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 (``SIA 
Letter''). The Commission believes that the Display Rule will 
benefit both retail and institutional customers, while preserving 
the access to the markets that institutional customers have today. 
For example, an institutional customer's block size limit order 
would not be subject to the rule unless such customer requests that 
the order be displayed. Moreover, any customer, whether individual 
or institutional, can request that its non-block size limit order 
not be displayed. The Commission also notes that increased quote 
competition and enhanced transparency should improve the prices at 
which institutions and market makers begin their negotiations for 
the execution of institutional orders. See also 21(a) Report, supra 
note 28.
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b. Response to Comments 65
    The Commission proposed Rule 11Ac1-4 to establish minimum display 
requirements for customer limit orders that improve a specialist's or 
OTC market maker's best bid or offer for a particular security as well 
as the size of such orders. In addition, the rule requires the display 
of the size of certain limit orders priced at the national best bid or 
offer (``NBBO''). Although the rule generally would mandate the display 
of limit orders, market makers and specialists still would retain some 
flexibility in handling limit orders accepted for execution.
---------------------------------------------------------------------------

    \65\ For further discussion of the views of commenters, see the 
Summary of Comments, supra note 4.
---------------------------------------------------------------------------

    Specifically, the rule allows an OTC market maker or specialist, 
immediately upon receipt of a limit order, to: (1) Change its quote and 
the size associated with its quote to reflect the limit order; (2) 
execute the limit order; (3) deliver the limit order in an exchange- or 
association-sponsored system that complies with the requirements of the 
rule; or (4) send the limit order to another market maker or specialist 
who complies with the requirements of the rule. The rule would require 
a specialist or OTC market maker to display a customer limit order when 
the order was ``held'' by the specialist or OTC market maker. If the 
specialist or OTC market maker immediately sends the order to a system 
or to another specialist or OTC market maker that complies with the 
rule, the specialist or OTC market maker that routed the order would 
have satisfied its obligation to display the order. These alternatives 
are intended to allow market makers, specialists, and market centers an 
opportunity to continue to provide their valuable services while 
offering customers the best available execution opportunities.
    The Display Rule as adopted maintains these alternatives as 
proposed. Additionally, to better achieve its aims and to respond to 
comments, the Commission has made some modifications to the proposed 
rule. For example, the Commission has decided to permit a specialist or 
OTC market maker to deliver a limit order to certain ECNs as an 
alternative to representing the limit order in its quote. This change 
is an extension of the proposed exception that permits a specialist or 
OTC market maker to deliver a limit order to an exchange- or 
association-sponsored system that complies with the Display Rule. 
Moreover, with regard to implementation of the rule, the Commission is 
providing for a four-stage phase-in over a one year period for non-
exchange-traded securities.
    Of the commenters who specifically addressed the proposed Display 
Rule, an overwhelming majority strongly support the inclusion of 
customer limit orders in the quote.66 One commenter

[[Page 48297]]

notes that true price discovery and fairness for public investors can 
only be achieved when limit orders are reflected in the NBBO.67 
Other commenters, expressing strong support for the proposed rule, 
believe that market-wide limit order procedures will improve the 
markets by enhancing overall market transparency 68 and 
eliminating the advantages derived by some markets from hidden limit 
orders.69 The Department of Justice states that the proposed rule 
encourages quote competition, which is likely to reduce spreads,70 
and allows customer orders to interact with one another.71 In this 
regard, several commenters recognize that the proposed rule would 
assist in achieving best execution of customer orders 72 by 
increasing the opportunities for execution of limit orders, and 
improving the prices for market orders.73 Another commenter states 
that the proposed rule is consistent with investor expectations and 
will act to protect retail customer interests.74
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    \66\ See, e.g., Amex Letter; Letter from Marshall E. Blume, 
Director, Howard Butcher Professor of Financial Management, The 
Wharton School of the University of Pennsylvania, to Jonathan G. 
Katz, Secretary, SEC, dated January 11, 1996 (``Blume Letter''); 
Letter from George W. Mann, Jr., Senior Vice President and General 
Counsel, BSE, to Jonathan G. Katz, Secretary, SEC, dated January 26, 
1996 (``BSE Letter''); Letter from Robert H. Forney, CHX, to 
Jonathan G. Katz, Secretary, SEC, dated January 23, 1996 (``CHX 
Letter''); D.E. Shaw Letter; Letter from Antitrust Division, U.S. 
Department of Justice, to SEC, dated January 26, 1996 (``DOJ 
Letter''); Letter from Preston Estep, Estep Trading Partners L.P., 
to Jonathan Katz, Secretary, SEC, dated December 21, 1995 (``Estep 
Letter''); Goldman Sachs Letter; ICI Letter; Lehman Letter; Madoff 
Letter; Letter from William A. Lupien, Chairman and Chief Executive 
Officer, Mitchum, Jones & Templeton, Inc., to Jonathan G. Katz, 
Secretary, SEC, dated January 8, 1996 (``MJT Letter''); Letter from 
Joseph R. Hardiman, President, National Association of Securities 
Dealers, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 
26, 1996 (``NASD Letter''); Letter from James E. Buck, Senior Vice 
President and Secretary, NYSE, Inc., to Jonathan G. Katz, Secretary, 
SEC, dated January 15, 1996 (``NYSE Letter''); Letter from David S. 
Pottruck, President and Chief Operating Officer, The Charles Schwab 
Corporation, to Jonathan G. Katz, Secretary, SEC, dated May 7, 1996 
(``Schwab Letter II''); SIA Letter; Letter from William R. Rothe, 
Chairman, and John L. Watson III, President, Security Traders 
Association, to Jonathan G. Katz, Secretary, SEC, dated January 15, 
1996 (``STA Letter''); Letter from John F. Luikart, President and 
Chief Executive Officer, Sutro & Co., to Jonathan Katz, Secretary, 
SEC, dated January 16, 1996 (``Sutro Letter'').
    \67\ Madoff Letter.
    \68\ See, e.g., Amex Letter; CHX Letter; CSE Letter; D.E. Shaw 
Letter; ICI Letter; Investors Research Letter; Lehman Letter; Smith 
Barney Letter.
    \69\ See, e.g., Amex Letter (rule would help eliminate hidden 
limit orders); CSE Letter (elimination of hidden limit orders will 
eliminate illusion of superior price improvement); Investors 
Research Letter (hidden limit orders are not justified).
    \70\ DOJ Letter.
    \71\ Id; see also Amex Letter; Lehman Letter.
    \72\ See, e.g., Lehman Letter; Smith Barney Letter.
    \73\ Lehman Letter.
    \74\ D.E. Shaw Letter.
---------------------------------------------------------------------------

    Other commenters oppose the proposal. Several commenters in this 
group have raised the following general concerns regarding the proposed 
rule.
i. Distinction Between Markets
    Several commenters argue that the Display Rule does not take into 
account distinctions between auction and dealer markets. Some of these 
commenters, discussing the Proposing Release as a whole, argue that the 
Commission's proposals would ``auctionize'' the dealer market.75 
One commenter warns that, because auction and dealer markets are 
fundamentally different, a single set of rules for both auction and 
dealer markets would reduce quote quality and damage overall market 
integrity in dealer markets.76 Although the SIA reports that the 
consensus view of its Ad Hoc Committee on Order Execution is to require 
a market maker to reflect customer limit orders in the quote, the SIA 
argues that the adoption of the proposed rule, without suggested 
modifications, could adversely affect the dealer market so as to weaken 
competition between dealer and auction markets.77
---------------------------------------------------------------------------

    \75\ See, e.g., Letter from R. Steven Wunsch, President, AZX, 
Inc., to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 
(``AZX Letter''); Goldman Sachs Letter; Letter from David Rich, Vice 
President, Jefferies & Company, Inc., to Jonathan G. Katz, 
Secretary, SEC, dated January 25, 1996 (``Jefferies Letter''); 
Letter from Robert W. Murphy, President, RPM Specialist Corporation, 
to Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 (``RPM 
Letter''); Letter from Robert A. Schwartz, Professor of Finance and 
Economics, and Yamaichi Faculty Fellow, Leonard N. Stern School of 
Business, New York University, and Robert A. Wood, Distinguished 
Professor of Finance, Fogelman College of Business and Economics, 
University of Memphis, to Jonathan G. Katz, Secretary, SEC, dated 
January 23, 1996 (``Schwartz & Wood Letter''); SIA Letter.
    \76\ RPM Letter.
    \77\ SIA Letter. Cf. Letter from A.B. Krongard, Chairman, SIA 
Board of Directors, and Bernard L. Madoff, Chairman, Trading 
Committee, to Jonathan G. Katz, Secretary, SEC, dated August 1, 1996 
(``SIA NAqcess Letter'') (the SIA, in its letter to the Commission 
regarding the NASD's NAqcess proposal, states that the Commission's 
Order Execution Obligations proposal would narrow quotation spreads, 
improve transparency, and provide customers with best execution of 
their orders, consistent with the 1975 Amendments).
---------------------------------------------------------------------------

    The Commission believes that the application of the principles 
underlying the limit order display rule to the dealer market is neither 
a new nor radical concept. In 1975, Congress envisioned an NMS in which 
public limit orders in qualified securities would have a central 
role.78 Congress anticipated that the NMS would make all 
specialists and market makers aware of public customer limit orders 
held anywhere in the system, and provide enhanced protection and 
priority for limit orders in stocks qualified for trading in a national 
market system.79 The Commission has consistently recognized since 
1975 that, in order to satisfy this Congressional vision, multiple-
market display of limit orders was an important component for qualified 
securities.80 More recently, the Market 2000 Study recommended 
that the SROs, including the NASD, consider requiring the display of 
customer limit orders,81 and the NASD, in a proposed rule change 
filed with the Commission, proposed that CQS market makers display in 
their quotes certain customer limit orders for exchange-listed 
securities traded OTC.82 The NASD also has proposed a mechanism 
for the display and protection of customer limit orders in Nasdaq 
securities.83
---------------------------------------------------------------------------

    \78\ Senate Report, supra note 31.
    \79\ Id. The Senate Report stressed the need to establish a 
mechanism by which specialists and market makers could be made aware 
of customer orders within the NMS. The Senate Report was ``satisfied 
that [the legislation] grant[ed] the Commission complete and 
effective authority to implement a system for the satisfaction of 
public limit orders.'' Id. at 18.
    \80\ See Securities Exchange Act Release No. 15671 (March 22, 
1979), 44 FR 20360 (April 4, 1979) (Development of a National Market 
System Status Report). See also Securities Exchange Act Release No. 
18738 (May 13, 1982), 47 FR 22376 (May 24, 1982) (proposing limit 
order display requirement for Rule 19c-3 securities).
    \81\ Market 2000 Study, at IV-6.
    \82\ See supra note 42.
    \83\ See supra note 45.
---------------------------------------------------------------------------

    Although some commenters claim that the Commission is attempting to 
``auctionize'' the dealer market, the display requirement is based on 
transparency and agency concerns, including a broker-dealer's 
obligation to provide its customers with best execution.84 The 
display of customer limit orders will act to narrow spreads, improve 
price discovery, and increase market depth. The enhanced transparency 
resulting from the Display Rule will increase the likelihood that 
customer limit orders will be executed, improve the execution prices of 
market orders, and strengthen an investor's ability to monitor the 
quality of executions.85 These results further several 
Congressional goals.
---------------------------------------------------------------------------

    \84\ See NASD Study, supra note 21 (enhancements to limit order 
handling, within the dealer market structure, will create 
significant benefits for investors). See also Manning II, supra note 
24 (Commission's extension of limit order protection to Nasdaq does 
not suggest an intention to ``auctionize'' the dealer market).
    \85\ See Senate Report, supra note 31 at 16-18 (discussing 
desirability of incorporating certain auction market principles, 
such as limit order display and protection, for certain qualifying 
securities in dealer markets).
---------------------------------------------------------------------------

    In keeping with Congressional intent, the Commission believes the 
treatment of limit orders should reflect the very real changes in 
market structure that have taken place since the enactment of the 1975 
Amendments. These changes include the development of a robust, liquid 
OTC dealer market that attracts significant investor trading interest, 
that trades at many multiples of the volume extant in 1975, and that is 
characterized by the inclusion of thousands of securities that meet the 
NMS designation.86 In addition, the

[[Page 48298]]

Commission believes that application of the Display Rule should also 
benefit investors in those securities that do not yet meet the NMS 
designation.87 As noted earlier, the Commission believes that the 
increased use of limit orders in these securities will lead to a 
narrowing of spreads and ameliorate certain anti-competitive practices 
that have developed in the Nasdaq market.88 The Commission has 
determined that certain practices on Nasdaq have contributed to 
artificially wide spreads for OTC securities.89 The display of 
customer limit orders in all Nasdaq securities will promote accurate 
pricing and convey the true buying and selling interest in such 
securities.
---------------------------------------------------------------------------

    \86\ To date, approximately 4,000 Nasdaq securities have 
qualified for the NMS designation. In order to qualify as an NMS 
security, transaction reports are required to be reported on a real-
time basis pursuant to an effective transaction reporting plan 
approved by the Commission. See 17 CFR 240.11Aa2-1 and 11Aa3-1.
    \87\ As discussed below, the Display Rule will apply only to 
``covered securities.'' At the present time, the Commission does not 
believe the rule should be extended to securities for which market 
makers are not required to quote continuous firm two-sided markets, 
such as OTC Bulletin Board securities.
    \88\ See supra discussion at section III.A.2.a.
    \89\ 21(a) Report, supra note 28.
---------------------------------------------------------------------------

    A few commenters believe that the Display Rule was proposed solely 
to address problems in the OTC market, and accordingly there is no need 
for a uniform rule applicable to exchange markets.90 As noted 
previously, the Commission's intention is to create a minimum standard 
for the handling of limit orders across all markets, consistent with 
market transparency, competition, and best execution principles. 
Currently, the national securities exchanges do not handle limit orders 
uniformly, and in fact the non-display of retail-size limit orders is 
permitted under certain circumstances. The rule will ensure that 
investors benefit from the display of limit orders, no matter where an 
order is sent for execution.91 A minimum standard also addresses 
concerns regarding the prevalence of hidden limit orders.92 The 
Commission believes, therefore, that a market-wide limit order display 
requirement is most consistent with the duty of best execution and the 
expectations of investors.
---------------------------------------------------------------------------

    \90\ See, e.g., BSE Letter; NYSE Letter; RPM Letter; Letter from 
David E. Humphreville, Executive Director, The Specialist 
Association, to Jonathan G. Katz, Secretary, SEC, dated February 2, 
1996 (``Specialist Assoc. Letter'').
    \91\ See, e.g., Greene Study & Greene Study II, supra note 51.
    \92\ See generally McInish & Wood Study, supra note 46 (hidden 
limit orders result in, among other things, artificial price 
improvement statistics and inferior order executions); Traders 
Accuse Specialists of Holding Back Limit Orders, Investment Dealers' 
Digest, 8, (February 14, 1994) (some traders have continued to 
accuse NYSE specialists of hiding limit orders even after the NYSE 
issued an Information Memo reminding specialists of their duties); 
Greene Study and Greene Study II, supra note 51 (one explanation for 
the significantly lower bid-ask spreads in the 1994-95 sample than 
in the 1990 sample, and the increase in the percentage of 
transactions at the quoted prices from the 1990 sample to the 1994-
95 sample, may be that NYSE specialists were more diligent in 
reflecting the limit order book in their quotes as per Information 
Memo 93-12); Amex Letter (rule would help eliminate hidden limit 
orders); CSE Letter (elimination of hidden limit orders will 
eliminate illusion of superior price improvement); Investors 
Research Letter (hidden limit orders are not justified).
---------------------------------------------------------------------------

ii. Distinction Between Quotes and Orders
    Some commenters maintain that the rule blurs the distinction 
between quotations and orders.93 One commenter states that limit 
orders represent only a finite trading interest while quotes represent 
the ``actual'' market for a security; thus, displaying limit orders 
would not reflect the ``true'' state of the market and impair the 
quality of quotation information.94 The commenter suggests that a 
separate limit order file would be more appropriate in light of these 
distinctions.95 In this vein, several commenters mention the 
NASD's proposed NAqcess system,96 suggesting that the Commission 
postpone implementation of the Display Rule until the Commission has an 
opportunity to assess the effects of NAqcess.97 A few commenters 
suggest the implementation of an industry-wide consolidated limit order 
book as an alternative or a logical outgrowth of the Display 
Rule.98
---------------------------------------------------------------------------

    \93\ See, e.g., Letter from Raymond L. Aronson, Senior Managing 
Director, Bear, Stearns & Co. Inc., to Jonathan G. Katz, Secretary, 
SEC, dated February 1, 1996 (``Bear Stearns Letter''); Instinet 
Letter; Letter from Carol L. Cunniff, Executive Vice President, 
Ruane, Cunniff & Co., Inc., to Jonathan G. Katz, Secretary, SEC, 
dated February 23, 1996 (``Ruane Letter''); Letter from Charles R. 
Schwab, Chairman and Chief Executive Officer, The Charles Schwab 
Corporation, to Jonathan G. Katz, Secretary, SEC, dated January 25, 
1996 (``Schwab Letter''). But see Schwab II Letter (supporting the 
Display Rule).
    \94\ Ruane Letter.
    \95\ Id. See also Bear Stearns Letter (discussion of proposed 
central limit order file for The Nasdaq Stock Market so as to 
preserve distinction between dealer quotes and agency or proprietary 
orders).
    \96\ See supra note 45.
    \97\ See, e.g., Letter from A.B. Krongard, Chief Executive 
Officer, Alex. Brown & Sons, Inc., to Jonathan G. Katz, Secretary, 
SEC, dated February 29, 1996 (``Alex. Brown Letter''); Letter from 
Albert G. Lowenthal, Chairman of the Board, Fahnestock & Co., Inc., 
to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 
(``Fahnestock Letter''); Jefferies Letter; Letter from Gerard S. 
Citera, Deputy General Counsel, First Vice President, PaineWebber 
Incorporated, to Jonathan G. Katz, Secretary, SEC, dated February 9, 
1996 (``PaineWebber Letter''); Schwab Letter; STA Letter; Letter 
from Charles Snow, Counsel, Securities Traders Association of New 
York, to Jonathan G. Katz, Secretary, SEC, dated January 30, 1996 
(``STANY Letter''); see also Letter from C. Robert Paul, III, 
Associate General Counsel, Dean Witter Reynolds, Inc., to Jonathan 
G. Katz, Secretary, SEC, dated January 31, 1996 (``Dean Witter 
Letter''); Goldman Sachs Letter.
    \98\ See, e.g., DOJ Letter; MJT Letter; Schwab Letter; Letter 
from Junius W. Peake, Monfort Distinguished Professor of Finance, 
University of Northern Colorado, to Jonathan G. Katz, Secretary, 
SEC, dated January 15, 1996 (``Peake Letter''); Letter from Jeffrey 
P. Ricker, CFA, to Jonathan G. Katz, Secretary, SEC, dated January 
15, 1996 (``Ricker Letter''); Letter from Peter W. Jenkins, 
Chairman, and Holly A. Stark, Vice Chairman, Institutional 
Committee, Securities Traders Association, to Jonathan G. Katz, 
Secretary, SEC, dated January 19, 1996 (``STAIC Letter'').
---------------------------------------------------------------------------

    The Commission believes that the display of limit orders is an 
essential component of accurate price discovery. A quote provides 
market participants with information regarding a market maker's or 
specialist's trading interest at a given price. A market maker or 
specialist could be willing to purchase or sell additional shares above 
its quoted size.99 Entry of a customer limit order that improves 
the quote serves a similar purpose. A limit order accurately represents 
trading interest for a specific volume of a security at the limit 
price. There are few practical differences between customer limit 
orders and a market maker's quotation that is firm only for its quoted 
size. Nonetheless, the proposed rule was not intended to equate 
customer limit orders with market maker quotes. Instead, the proposed 
rule was designed to facilitate greater transparency of customer 
trading interest, with the expectation that orders would have an 
increased opportunity for best execution without the interaction of a 
dealer. In the Commission's opinion, these objectives are more 
difficult to achieve if customer trading interest is not routinely 
represented in publicly displayed quotes. The Commission notes that the 
Display Rule provides other means by which a market maker or specialist 
may comply with the requirements of the rule in the event a specialist 
or market maker elects not to display customer trading interest in its 
quote.100
---------------------------------------------------------------------------

    \99\ Under Commission rules, the market maker's quote is only 
required to be firm up to its published size. See 17 CFR 240.11Ac1-
1(c)(2).
    \100\ For example, a market maker or specialist may deliver a 
customer limit order immediately upon receipt to another market 
maker or specialist, or to an ECN or an exchange or association 
sponsored system pursuant to the rule. Section 240.11Ac1-4(c) (5) 
and (6).
---------------------------------------------------------------------------

    Further, the Commission does not agree with the suggestion that the 
Commission postpone the adoption of the Display Rule until the 
Commission has had an opportunity to evaluate the NASD's NAqcess 
proposal.101 Although

[[Page 48299]]

the NASD has argued that limit orders entered into NAqcess, as 
proposed, would result in greater display of OTC limit order prices, 
there is no assurance that market makers will enter such orders into 
NAqcess rather than hold the orders internally.102 Therefore, the 
Commission believes that the Display Rule is necessary to ensure 
display of these orders in the OTC market.103 If approved, NAqcess 
can assist in compliance with the Display Rule to the extent that the 
system incorporates customer limit orders in the consolidated quote 
stream, thereby allowing market makers to enter limit orders in NAqcess 
rather than displaying limit orders in their quotes.104 As noted 
earlier, the Commission has identified important benefits associated 
with limit order display. Accordingly, the Commission believes that it 
is not necessary to observe the effects of NAqcess in order to 
determine the benefits of the limit order display requirement.
---------------------------------------------------------------------------

    \101\ The Commission notes that the proposed NAqcess system is a 
significant and controversial proposal which has generated 
approximately 1,100 comment letters. The Commission is in the 
process of reviewing the comments and has yet to decide what action 
to take on the proposal.
    \102\ See NAqcess Releases, supra note 45. As noted above, limit 
orders not entered in NAqcess would be provided with market-wide 
price protection.
    \103\ In any event, NAqcess will not address at all the issues 
of disparate limit order handling practices or hidden limit orders 
in the exchange markets.
    \104\ See Section 240.11Ac1-4(c)(5).
---------------------------------------------------------------------------

iii. Liquidity
    Several commenters assert that application of the Display Rule to 
Nasdaq securities could reduce liquidity in the Nasdaq market.105 
These commenters believe that market maker profits may decline due to 
narrowed spreads or increased compliance costs, with the result that 
many firms will decide not to make the necessary capital commitment to 
continue their market making operations. The commenters conclude that 
as the number of market makers in a security declines, liquidity will 
be adversely affected, leading to wider spreads. Moreover, some 
commenters believe that the decrease in liquidity will impair the 
capital formation process, especially for securities that are not 
mature enough for auction trading.106
---------------------------------------------------------------------------

    \105\ See, e.g., Alex. Brown Letter; Bear Stearns Letter; Dean 
Witter Letter; Letter from Robert F. Mercandino, Senior Vice 
President, Dillon, Read & Co., Inc., to Jonathan G. Katz, Secretary, 
SEC, dated March 15, 1996 (``Dillon Letter''); Jefferies Letter; 
Lehman Letter; Letter from Robert J. McCann, Managing Director, Co-
Head, Global Equity Markets, Merrill Lynch, Pierce, Fenner & Smith 
Incorporated, to Jonathan G. Katz, Secretary, SEC, dated January 26, 
1996 (``Merrill Letter''); NASD Letter; PaineWebber Letter; Letter 
from David P. Semak, Vice President Regulation, PSE, to Jonathan G. 
Katz, Secretary, SEC, dated January 15, 1996 (``PSE Letter''); SIA 
Letter.
    \106\ See, e.g., NASD Letter; SIA Letter.
---------------------------------------------------------------------------

    At least one commenter states that the usefulness of limit orders 
could be diminished by the refusal of some market makers to accept such 
orders, or by the imposition of high commission costs charged to recoup 
lost profits on spreads.107 Other commenters believe, however, 
that it will be difficult for market makers to increase their 
commissions for limit orders.108 They believe commission charges 
would not compensate for lost trading profits or prevent the ebb of 
market liquidity.109
---------------------------------------------------------------------------

    \107\ Letter from David K. Whitcomb, Professor of Finance and 
Economics, Rutgers University Graduate School of Management, to 
Secretary, SEC, dated January 12, 1996 (``Whitcomb Letter'').
    \108\ See, e.g., Letter from Irving M. Pollack, Alan B. 
Levenson, and Robert H. Rosenblum, Fulbright & Jaworski L.L.P., on 
behalf of Herzog, Heine and Geduld, Inc., to Jonathan Katz, 
Secretary, SEC, dated January 16, 1996 (``HHG Letter''); STA Letter.
    \109\ Id.
---------------------------------------------------------------------------

    Other commenters believe the proposed rule will not have a negative 
impact on market liquidity. One commenter explicitly states that the 
benefits of the proposed rule would outweigh any potential adverse 
effects on liquidity.110 Another commenter says that the proposed 
rule would not result in any significant reduction in market making 
activity.111 The CSE notes that it has not noticed any negative 
effects on market liquidity as a result of the implementation of its 
own limit order display rule.112 Yet another commenter states that 
although it currently does not trade OTC securities, it expects that 
many market participants, including the commenter, would begin trading 
such securities if the proposed rule was adopted, thereby increasing 
market liquidity.113
---------------------------------------------------------------------------

    \110\ Lehman Letter.
    \111\ Letter from Daniel G. Weaver, Ph.D., Assistant Professor 
of Finance, Marquette University, to Jonathan G. Katz, Secretary, 
SEC, dated January 10, 1996 (``Weaver Letter'').
    \112\ CSE Letter.
    \113\ The commenter noted further that it does not currently 
trade OTC securities because it cannot be sure that its order will 
be represented to the whole market. Estep Letter.
---------------------------------------------------------------------------

    The display of limit orders is designed, among other objectives, to 
publicize accurate market interest and increase quote 
competition.114 The Commission understands that certain costs, 
including a diminution in market maker profits, are associated with 
this increased market transparency. For example, a market maker that 
holds a customer limit order has, in effect, a private ``option'' to 
execute the order as principal. The longer this ``option'' remains 
open, the more time the market maker has to determine whether it can 
profit from executing the order as principal.115 This private 
market maker ``option,'' however, is potentially detrimental to the 
execution opportunities for the limit order. The Display Rule will 
limit this ``option'' and expose the order to market-wide trading 
interest. Moreover, increased price competition from limit orders may 
reduce market maker profits through the narrowing of spreads.116 
As a result, the Display Rule may force less efficient competitors to 
stop making markets in some of the securities they now quote.
---------------------------------------------------------------------------

    \114\ See Market 2000 Study, at Study IV.
    \115\ The Commission recognizes that there is also a cost 
associated with holding that limit order, because a market maker is 
required to execute that limit order if it has engaged in a 
transaction for its own account that would have satisfied the limit 
order. See Manning I & II, supra note 24.
    \116\ See supra notes 53-55 and accompanying text (display of 
customer limit orders in market maker quotes will act to eliminate 
certain trading behavior on Nasdaq and foster quote competition).
---------------------------------------------------------------------------

    Although the rule could lead to a reevaluation by some market 
makers of the services they wish to provide, after considering the 
available evidence, and in light of its experience, the Commission does 
not believe that there will be a significant negative impact on the 
markets for covered securities. The Commission is not convinced that 
the loss of some market competitors in securities with many market 
makers would impair liquidity in these securities.117 The 
Commission believes that customer orders are the ultimate source of 
liquidity to the markets, and that adoption of a rule that improves the 
handling of such orders will have the effect of enhancing market 
liquidity.118 The Commission believes that a limit order display 
requirement will encourage new limit orders in securities to be 
entered, thus providing additional liquidity to the market from 
customers.119 The potential of limit orders to narrow quotes also 
may encourage the entry of additional market

[[Page 48300]]

orders.120 The Commission believes that the additional liquidity 
due to narrower spreads and increased customer orders will outweigh any 
potential loss of liquidity provided by market makers.
---------------------------------------------------------------------------

    \117\ See, e.g., STAIC Letter (limit orders are critical to 
market liquidity).
    \118\ The Commission does not thereby denigrate the contribution 
OTC market makers provide in a dealer market. The Commission notes, 
however, that most market makers provide primarily intra-day 
liquidity to customers, and generally seek to end the trading day 
with a limited inventory position in order to minimize inventory 
risk. Customer limit orders represent buying or selling interest at 
specified prices for their stated duration, which may be longer than 
intra-day. Market makers holding customer limit orders rely in part 
on these limit orders in quoting their own prices to buy and sell 
securities.
    \119\ See Greene Study & Greene Study II, supra note 51 (limit 
orders affect the quoted spread and provide liquidity); NASD Study, 
supra note 21 (limit orders, like market maker quotes, supply 
liquidity to the markets); OEA Data, supra notes 50 and 52.
    \120\ See NASD Study, supra note 21 (those investors that demand 
immediate execution, e.g. those entering market orders, will pay 
less for executions due to the augmented liquidity supplied by limit 
orders); Greene Study and Greene Study II, supra note 51 (limit 
orders provide liquidity to traders that demand immediacy of 
execution and may contribute to reduced trading costs); OEA Data, 
supra notes 50 and 52 (display of limit orders narrows spreads, 
improves price discovery, and increases market depth for a variety 
of securities, including those NYSE securities that are thinly 
traded).
---------------------------------------------------------------------------

    As noted above, some commenters expressed concern regarding the 
effect of the Display Rule on the availability of liquidity to small 
issuers.121 In response to these comments, the Commission's OEA 
examined market maker participation in 4,839 Nasdaq issuers over a one 
month period in 1996. The findings indicate that: (1) the median number 
of market makers in a security is not appreciably lower for initial 
public offering (``IPO'') issuers or for securities with the smallest 
market capitalization; (2) broker-dealers that participated in IPO 
underwriting syndicates were active participants in aftermarket 
trading, but were not alone in providing significant market maker 
liquidity; and (3) in Nasdaq securities with the smallest market 
capitalization ($2 million or less), the single most active market 
maker in an issue typically participated in one-third or fewer trades. 
Thus, there is no convincing evidence that Nasdaq issuers, including 
IPO issuers, are dependent for liquidity on any one market maker. The 
pattern of market making activity indicates that significant liquidity 
is provided by market makers who are not the ``most active'' market 
makers in a security. Because there does not appear to be high 
concentration in market making, and because of the Commission's belief 
that customer order flow is a critical source of market liquidity, the 
Commission believes that the proposals adopted today will not unduly 
impact liquidity for small or new issuers.
---------------------------------------------------------------------------

    \121\ This concern also was raised in the context of the ECN 
Amendment to the Quote Rule.
---------------------------------------------------------------------------

    Furthermore, Commission experience has been that enhancements to 
transparency result in improved liquidity.122 The Commission 
believes that these improvements are attributable, at least in part, to 
the impact of transparency on market integrity and investor confidence. 
In addition, while market maker profits per trade may be reduced as 
spreads are narrowed, increased volume over time may result in stable 
profit levels.123
---------------------------------------------------------------------------

    \122\ In several instances in the past, commenters have claimed 
that other Commission initiatives to increase transparency would act 
to reduce liquidity; others have warned that such initiatives would 
decrease the competitiveness of the U.S. markets in relation to 
foreign counterparts. These claims, however, have not been borne 
out. For example, many industry participants argued that the NASD's 
adoption of its ``Manning'' rules would severely impact market 
liquidity. See Market 2000 Study. However, there has been no 
evidence offered to the Commission of adverse liquidity consequences 
caused by these limit order protections, and the Commission is not 
aware of any significant diminution in liquidity. Further, as 
discussed in the Market 2000 Study, other transparency initiatives, 
such as the adoption of real-time transaction and quotation 
reporting, have resulted in increases in the competitiveness and 
liquidity of both listed and OTC equity markets despite market maker 
protestations to the contrary prior to adoption of these 
initiatives. See Id. at Study IV. See also Simon & Colby, supra note 
58. Even the creation of Nasdaq itself was met with much opposition. 
The result of this major structural change was far from the 
predicted ``death knell'' of the OTC market. Rather, OTC market 
strength and liquidity have flourished since Nasdaq's inception. 
Based on the Commission's experience with other market structure 
initiatives, therefore, the Commission believes that improvements in 
order handling, market transparency, and efficiency will likely 
improve market liquidity.
    \123\ Although the display requirement may decrease a market 
maker's per trade profit due to narrowed spreads, the Commission 
believes that this decrease will be made up for in part by expected 
increases in trading volume attributable to enhanced liquidity and 
pricing efficiency. See supra note 24. The Commission believes this 
potential impact on market maker profits is justified in light of 
the benefits that will accrue to investors and the markets as a 
whole. Moreover, even if market makers' profits from trading do 
decline, market makers may be able to obtain increased revenues from 
commissions or other fees charged directly to customers. Because 
these other revenue sources are more transparent to customers than 
are revenues from market maker trading with customers on a 
proprietary basis, increased reliance on these other revenue sources 
will enable customers to make more informed trading decisions.
---------------------------------------------------------------------------

    It also may become feasible for market makers to charge customers 
commissions for handling limit orders, even if that is not the current 
practice today. As noted earlier, some commenters claim that the 
Display Rule will have a disparate impact on wholesale Nasdaq market 
makers in that such market makers would not be able to offset the 
increased costs associated with limit order display through charges or 
commissions.124 The Commission believes, however, that the systems 
costs associated with the Display Rule should not be overly 
burdensome,125 nor should systems costs or any reduced market 
maker profitability from declining spreads be more extensive for 
wholesale market makers than for integrated market makers. Although 
exchange specialists and integrated firms may find it easier than 
wholesale firms to charge commissions initially, the Commission notes 
that wholesale firms are not prohibited from attempting to compensate 
for handling limit orders, either through negotiated fee arrangements, 
or reducing any payment made for order flow for limit orders.126
---------------------------------------------------------------------------

    \124\ See, e.g., HHG Letter.
    \125\ See Memorandum from Stephen L. Williams, S.L. Williams Co. 
to Richard R. Lindsey, Director, Division of Market Regulation, SEC 
(July 29, 1996) (``Williams Study'').
    \126\ The level of these fees, of course, would be determined by 
competitive forces in the marketplace. Any fees passed on to non-
broker-dealer customers would have to be disclosed in a clear 
fashion to the customer, and otherwise comply with applicable law. 
For example, NASD Rule 2440 states, in part, that if a member acts 
as agent for a customer in a transaction, the customer shall not be 
charged more than a fair commission or service charge, taking into 
consideration all relevant circumstances. See also NASD Regulatory & 
Compliance Alert Vol. 7, No. 4 (December 1993). At least one 
commenter argued that because spreads are ascertainable from public 
quotations and commissions are not, a rule that encourages charging 
commissions does not satisfy the goal of increased transparency. See 
Letter from Bruce C. Hackett, Managing Director, Salomon Brothers 
Inc., to Jonathan G. Katz, Secretary, SEC, dated January 25, 1996 
(``Salomon Letter''). The Commission notes, however, that Rule 10b-
10 under the Exchange Act requires customer confirmations to 
disclose commissions and, for listed and Nasdaq securities, the 
difference between the reported price and the price to the customer. 
Based on this disclosure, execution costs could actually become 
better known to customers if explicit fees are charged. Therefore, 
the Commission believes that the Display Rule will allow a customer 
to more easily monitor the execution quality of its limit orders, 
even if subject to fees for limit order executions. In addition, 
this situation should foster competition with respect to the amount, 
if any, firms will charge for the execution of a customer limit 
order.
---------------------------------------------------------------------------

iv. Discretion
    Several commenters are concerned that the Display Rule would 
eliminate their discretion to determine the best way in which to 
execute a customer's order. The commenters also claim that customers 
rely on the judgment of a market professional in choosing whether to 
display a limit order.127 For example, the NYSE believes that its 
current procedures allow broker-dealers to achieve the best prices for 
their customers.128 Other commenters suggest that if the rule were 
amended to require the display of representative size, a dealer would 
retain some discretion on

[[Page 48301]]

how best to execute the order.129 To preserve discretion, at least 
one commenter argues that the rule should apply only when the customer 
requests that its order be displayed.130
---------------------------------------------------------------------------

    \127\ See, e.g., NYSE Letter; RPM Letter; Specialist Assoc. 
Letter.
    \128\ See, e.g., NYSE Letter; Specialist Assoc. Letter. 
According to the NYSE, a customer can choose to benefit from the 
display of its order or to benefit from relying on the specialist's 
discretion, depending on whether the order is sent to the post via 
SuperDOT, or is manually submitted. The NYSE also notes that 
enabling a specialist to use discretion in the handling of limit 
orders is important in light of the fact that the NYSE defines a 
limit order as an order to buy or sell at a specified price, or at a 
better price, if obtainable after the order is represented in the 
trading crowd. See NYSE Rule 13.
    \129\ See, e.g., Madoff Letter; NASD Letter; SIA Letter.
    \130\ Jefferies Letter.
---------------------------------------------------------------------------

    The Commission believes that the rule appropriately establishes a 
presumption that limit orders should be displayed, unless such orders 
are of block size, the customer requests that its order not be 
displayed, or one of the exceptions to the rule applies. The exception 
allowing a customer to request that its limit order not be displayed 
gives the customer ultimate control in determining whether to trust the 
display of the limit order to the discretion of a market professional, 
or to display the order either in full, or in part, to other potential 
market interest.131
---------------------------------------------------------------------------

    \131\ See discussion of the exceptions to the Display Rule at 
section III.A.3.c., infra. See also Sec. 240.11Ac1-4(c)(2); 
Sec. 240.11Ac1-4(c)(4) (permitting a customer with a block size 
limit order to request that the order be displayed pursuant to the 
Display Rule). The Commission does not mean to imply that a 
specialist or OTC market maker that is not displaying a limit order 
pursuant to the request of its customer may not change its quotation 
in that security based on the specialist's or market maker's own 
trading interest.
---------------------------------------------------------------------------

v. Systems Burdens
    Based on their belief that compliance with the Display Rule would 
result in a large increase in quotation traffic, a number of commenters 
maintain that the rule would require major overhauls of the order 
handling systems used by brokers, market makers and markets. For 
example, one commenter believes that it would be impossible to comply 
with the rule without additional automated systems.132 The 
commenter concludes that the costs associated with new systems and 
additional staff necessary to monitor a more volatile market would 
contribute to wider spreads and higher commissions.133 In 
addition, one SRO claims that quotation traffic must be kept at 
manageable levels in order to allow entities to continue to manually 
process limit orders, thus eliminating the need for entities to bear 
the costs associated with automation of such orders.134 Other 
commenters also note their concern over the potential operational costs 
associated with the rule.135 The STA states that an in-depth 
review is needed to determine the costs for new equipment and 
technology necessary to comply with the rule.136
---------------------------------------------------------------------------

    \132\ PaineWebber Letter.
    \133\ Id.; see also Bear Stearns Letter (noting that the display 
rule would increase the volatility of quotes and, as a result, 
market makers would have a difficult time keeping up with the rapid 
changes in bids, offers, and quote sizes).
    \134\ PSE Letter.
    \135\ See, e.g., Alex. Brown Letter; Bear Stearns Letter; 
Jefferies Letter.
    \136\ STA Letter.
---------------------------------------------------------------------------

    A few commenters are concerned that the increased quotation traffic 
that may be associated with the rule could pose a threat to the 
integrity of the central quotation system.137 One commenter 
suggests that the rule be suspended for the first 30 minutes of 
trading.138 Another commenter argues that modifying the rule to 
require only the display of representative size could act to alleviate 
some of the traffic concerns.139
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    \137\ See, e.g., Letter from Thomas J. Jordan, Financial 
Information Forum, to Jonathan G. Katz, Secretary, SEC, dated 
January 12, 1996 (``FIF Letter''); PaineWebber Letter; PSE Letter. 
This concern was expressed with respect to the proposal that the 
Commission adopt both the Display Rule and Price Improvement Rule. 
The fact that the Commission has deferred action on the Price 
Improvement Rule, as discussed below, should substantially diminish 
any system capacity concerns. Moreover, the Commission's decision 
not to require display of de minimis orders also should minimize 
system capacity concerns.
    \138\ FIF Letter. According to FIF, the heaviest traffic volume 
usually occurs within the first 30 minutes of trading.
    \139\ PSE Letter. The PSE notes, however, that the rule, even if 
modified, still may result in an increase in staffing costs. Id.
---------------------------------------------------------------------------

    The Commission recognizes that achieving greater transparency for 
limit orders depends upon the existence of systems that are capable of 
the smooth and efficient display of trading interest. The Commission 
believes that the Display Rule will not substantially increase the 
quotation burden for exchange markets, where systems currently exist 
for the display of quotes.140 In the OTC market, the Display Rule 
will result in additional quotation entries for market makers that 
display customer limit orders in their quotes. The Commission believes, 
however, that current systems can handle the additional volume, or can 
be expanded at moderate cost to handle the additional volume.141 
Further, the Commission notes that the Display Rule contains an 
exception to the display requirement for limit orders of de minimis 
size priced at the NBBO when the market maker's or specialist's quote 
matches the NBBO.142 The Display Rule also allows a specialist or 
OTC market maker several ways to comply with the rule by routing the 
order elsewhere without displaying the limit order in its own quote by 
transmitting a customer limit order to an exchange-or association-
sponsored system or to a qualifying ECN.
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    \140\ For example, SuperDOT data indicates that 57% of all 
customer trades originating from orders routed through SuperDOT are 
limit orders. Of these limit orders, 20% narrowed the NYSE quote. 
See supra note 52. According to the NYSE, 93% of such orders are 
reflected in the NYSE quote within two minutes of receipt. See supra 
note 36 and accompanying text (teleconference). See also CSE Letter 
(costs associated with implementing such a system are minimal, 
especially in light of the benefits to the public); Paperwork 
Reduction Act discussion at section VII, infra.
    \141\ The Commission notes that many small to medium broker-
dealers utilize shared trading systems that enable such broker-
dealers to streamline their OTC market making and back office 
responsibilities. Subscribers to such systems benefit by sharing 
costs associated with the application of improved technologies, 
rather than creating and updating systems of their own. Therefore, 
it is assumed that any changes deemed necessary to these shared 
systems to facilitate efficient compliance with the Display Rule 
also would be shared by all subscribers.
    In addition, the Commission specifically evaluated the costs 
associated with implementation of the Display Rule. Based on this 
evaluation, the Commission concluded that most market makers will 
not be required to invest substantial amounts of money in systems 
development in order to comply with the Display Rule as adopted. See 
Williams Study, supra note 125. See also CSE Letter (costs of 
implementing a system for display of limit orders are minimal).
    \142\ See, Sec. 240.11Ac1-4(b)(1)(ii). See also Sec. 240.11Ac1-
4(b)(2)(ii).
---------------------------------------------------------------------------

    Additionally, a few commenters believe that the Commission should 
give more consideration to the Display Rule's impact on automatic 
execution systems.143 These commenters express concern that a 
market maker could be exposed to multiple transactions from its own 
customers in the firm's automatic execution system, which executes 
orders at the NBBO, even if the NBBO represents a customer limit order 
as opposed to the price at which a market maker is willing to trade. 
They claim this result is unfair, especially if the automatic system 
has a minimum share requirement that exceeds the customer limit order.
---------------------------------------------------------------------------

    \143\ See, e.g., Dillon Letter; HHG Letter; Merrill Letter; 
PaineWebber Letter; Schwab Letter.
---------------------------------------------------------------------------

    The Commission acknowledges the concern of some commenters 
regarding the rule's interaction with automated execution systems. 
However, because customer limit orders reflect actual trading interest, 
it has been the Commission's intention to enhance customer order 
executions throughout the markets by requiring the display of these 
customer limit orders.144 Where a limit order represents the best 
quote, a

[[Page 48302]]

market maker can respond by sending its customer order to the market 
maker displaying the limit order at the NBBO, thereby attempting to 
execute the limit order setting that price and removing it as the 
NBBO.145 Moreover, where the size of a limit order represented in 
the best quote is smaller than the size eligible for execution in an 
automated execution system, the Commission believes that it is not 
inconsistent with best execution principles for market makers and 
specialists using automated execution systems to take into account the 
size of the limit order quote in determining the price at which an 
order, or portions thereof, should be automatically executed. The 
Commission believes, however, that in such a case the market maker or 
specialist should provide the customer order an execution at the 
displayed price at least up to the displayed size of the limit 
order.146 For example, if customer limit orders compose the NBBO 
of 10 \1/4\-10 \1/2\ (100  x  300), and a market maker receives a 
market order to sell 1,000 shares via an automatic execution system, 
the market maker may automatically execute 100 shares of the order at 
10 \1/4\, and the remaining portion of the order at the next best bid.
---------------------------------------------------------------------------

    \144\ The Commission recognizes that SROs may have rules 
regarding the minimum quotation sizes associated with a specialist's 
or market maker's quote. The Commission believes that SROs should 
consider amending such rules and modifying certain systems to allow 
a specialist or market maker to quote in sizes smaller than the 
minimum quotation size when such quote represents a customer limit 
order. With these changes, a specialist or market maker that 
displays a customer limit order in its quote pursuant to the Display 
Rule would not be responsible for executing as principal any 
additional shares at the limit price where the size of the customer 
limit order is less than the minimum quotation size set by the SRO.
    \145\ The Commission notes that the NASD's NAqcess system, as 
proposed, would permit market makers to send orders, including 
proprietary orders, to other market makers through the system. See 
supra note 45. See also ITS Plan. Moreover, the Commission believes 
that the NASD should consider modifying its SOES system to allow OTC 
market makers to route customer orders for execution against limit 
orders displayed by another market maker in the same security.
    \146\ If the market maker or specialist attempted but was unable 
to execute the displayed limit order through a reasonable and 
efficient means, such as sending an order through an automated 
system for an OTC security, the market maker or specialist would not 
be expected to give that limit order price to its customer.
---------------------------------------------------------------------------

3. The Operation of the Rule as Adopted 147
    The rule as adopted applies to: (i) every member of an exchange 
that is registered by that exchange as a specialist or has been 
authorized by an exchange to perform functions substantially similar to 
that of a specialist (``specialist''); and (ii) OTC market 
makers.148 The rule as adopted applies to specialists that trade 
on the floor of an exchange; 149 third market makers; 150 
members of a national securities association that are OTC market 
makers; 151 and specialists that trade an OTC security pursuant to 
unlisted trading privileges (``UTP'').152 These market makers are 
required to reflect immediately in their bid or offer the price and the 
full size of each customer limit order they hold at a price that would 
improve their bid or offer in the security.153 In addition, all 
market makers covered by the rule are obligated to reflect in their 
quotes the full size of a customer limit order that: (1) is priced 
equal to their bid or offer; (2) is priced equal to the national best 
bid or offer for the security; and (3) represents more than a de 
minimis change in relation to the size associated with their bid or 
offer.154
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    \147\ SRO rules that impose more stringent standards would 
continue to apply.
    \148\ Although the Commission consolidated certain sections of 
the proposed rule for clarity, the rule as adopted applies to the 
same entities identified in the proposed rule.
    \149\ Section 240.11Ac1-4(b)(1).
    \150\ Section 240.11Ac1-4(b)(2).
    \151\ Section 240.11Ac1-4(b)(2).
    \152\ Section 240.11Ac1-4(b)(1).
    \153\ Section 240.11Ac1-4(b)(1)(i) and (b)(2)(i). The Commission 
wants to clarify that references to a specialist's or OTC market 
maker's bid or offer include instances where the bid or offer is a 
proprietary quote, as well as instances where the bid or offer 
represents a customer limit order. Further, if a market maker is not 
quoting publicly (e.g., a market maker that does not meet the 1% 
threshold of the Quote Rule), it still must publish a quotation that 
displays the limit order, or avail itself of one of the exceptions. 
Moreover, the Commission notes that some commenters suggest that the 
rule should require broker-dealers that are not specialists or OTC 
market makers to immediately transmit limit orders they receive to 
an entity or system that will display the orders in a manner 
consistent with the rule. See, e.g., CSE Letter; Madoff Letter; 
Whitcomb Letter. Also, at least one commenter believes that 
institutional firms trading in block size should be considered ``OTC 
market makers'' for purposes of the rule and subject to the display 
requirement. Amex Letter. See generally infra notes 191-193 and 
accompanying text. The fact that the Commission has not adopted 
these suggestions as part of the Display Rule does not relieve 
broker-dealers which receive such orders from compliance with their 
obligation to obtain best execution for those orders.
    \154\ Section 240.11Ac1-4(b)(1)(ii) and (b)(2)(ii).
---------------------------------------------------------------------------

a. ``Covered Securities'' and ``Customer Limit Orders''
    Rule 11Ac1-4 applies to ``customer limit orders'' in ``covered 
securities.'' A covered security is defined as any reported security 
and any other security for which transaction reports, last sale data or 
quotation information is disseminated through an automated quotation 
system that is sponsored by a registered securities association. This 
definition is designed to encompass all exchange-listed securities, 
Nasdaq National Market securities and Nasdaq SmallCap 
securities.155
---------------------------------------------------------------------------

    \155\ Securities listed on regional exchanges that do not 
substantially meet NYSE or Amex original listing criteria do not 
satisfy the definition of ``covered security.'' Such securities are 
not ``reported securities'' as that term is defined, nor do they 
meet the other elements of the definition of covered security. OTC 
Bulletin Board (``OTCBB'') securities also do not satisfy the 
definition of covered security. The Commission has determined not to 
extend the display requirement to any of those securities at the 
present time.
---------------------------------------------------------------------------

    The Commission received several comments regarding the application 
of the rule to Nasdaq securities. Some commenters believe that the rule 
should not extend to all Nasdaq securities, and that some measure of 
liquidity should be used to determine which Nasdaq securities should be 
subject to the rule.156 For example, one commenter suggests 
limiting the rule's application to the top 250 Nasdaq National Market 
securities with the highest average daily trading volume over the 
previous calendar quarter.157 In contrast, another commenter 
favors the inclusion of Nasdaq SmallCap securities within the 
definition of ``covered security.'' 158 Further, at least one 
commenter suggests that the rule apply not only to all Nasdaq 
securities, but also to OTCBB securities.159
---------------------------------------------------------------------------

    \156\ See, e.g., Bear Stearns Letter; Lehman Letter; Merrill 
Letter; NASD Letter; SIA Letter.
    \157\ SIA Letter.
    \158\ PSE Letter.
    \159\ Ricker Letter.
---------------------------------------------------------------------------

    As noted above, the Commission believes that the Display Rule 
should apply equally to exchange-traded as well as non-exchange-traded 
securities. In addition, the Commission believes it is appropriate to 
include all Nasdaq securities within the definition of ``covered 
security.'' The Commission believes that, regardless of the current 
trading volume of a particular security, the investors in any security 
can benefit from the uniform display of customer buying and selling 
interest if all quotations in that security are required to be firm. As 
noted previously,160 data analyzed by the Commission shows that 
limit orders are used frequently for transactions in NYSE securities 
with ADTVs under $100,000. On average, 63% of customer orders in such 
securities are limit orders. Of those limit orders, 30% narrowed the 
NYSE quote and 32% matched the quote. This data indicates that the 
display requirement may lead to increased customer trading interest in 
securities that are currently thinly traded.161
---------------------------------------------------------------------------

    \160\ See supra notes 50 and 52.
    \161\ As stated previously, because dealers are not required to 
register as OTC market makers in OTCBB securities and are not 
required to enter and maintain continuous firm two-sided quotations 
in OTCBB securities, the Commission does not believe that the 
Display Rule should be extended to such securities at this time.
---------------------------------------------------------------------------

    The Commission reiterates that limit order display is not solely an 
issue of improved transparency. The Display Rule will improve the 
handling of customer orders across all markets and increase the 
probability that a customer limit order will be executed. Therefore, 
the Commission believes that a uniform limit order display requirement 
is

[[Page 48303]]

closely related to a broker-dealer's ability to obtain best execution 
for limit orders.
    The Commission recognizes, however, that the rule represents a 
significant change for the OTC market. The Commission, therefore, has 
determined to provide a phase-in period for application of the rule to 
customer limit orders in Nasdaq securities.162 The Commission 
believes that the phase-in period will allow the Commission to monitor 
the effects of the rule on the most liquid Nasdaq securities first, 
while ensuring that customer limit orders in all Nasdaq securities will 
receive the benefits of the rule within one year of its adoption. This 
schedule also will provide OTC market makers with time to adjust their 
systems to comply with the rule's requirements.163
---------------------------------------------------------------------------

    \162\ See description of the phase-in at section III.A.3.d., 
infra.
    \163\ See, e.g., Amex Letter.
---------------------------------------------------------------------------

    Under the rule, a customer limit order includes any order to buy or 
sell a covered security at a specified price not for the account of a 
broker or dealer. Customer limit orders transmitted from one broker-
dealer to another for execution are included in the definition. 
Although some commenters believe that the rule should be extended to 
orders for the account of a broker or dealer, the Commission does not 
believe such extension is appropriate at this time. The Commission 
acknowledges that the display of all limit orders, including those of a 
broker or dealer, would further enhance transparency.164 Requiring 
the display of broker-dealer limit orders, however, would be a 
significant extension of the rule that could change its impact on 
market maker participation and increase its operational burdens. 
Therefore, the Commission believes that the effects of the rule should 
be observed, and additional comment should be solicited, before the 
rule is expanded.165
---------------------------------------------------------------------------

    \164\ The Commission also is sensitive to the fact that 
providing suitable opportunities for broker-dealers, including 
options market makers, to lay off risk is an important component of 
overall market liquidity and efficiency. See Manning II, supra note 
24.
    \165\ The Commission notes that other actions recently taken by 
the Commission address certain anti-competitive behavior in the 
Nasdaq market that heretofore may have negatively impacted the 
ability of some broker-dealers, including options market makers, to 
efficiently perform their market making function. See 21(a) Report, 
supra note 28.
---------------------------------------------------------------------------

b. Size
    As noted above, some commenters expressed concern regarding the 
requirement that specialists and OTC market makers display the full 
size of a customer limit order. These commenters suggest that the rule 
only require the display of representative size.166 They argue 
that the use of representative size would preserve the ability of a 
specialist or OTC market maker to exercise some discretion in 
determining the best execution of the order.167
---------------------------------------------------------------------------

    \166\ See, e.g., BSE Letter; CSE Letter; Madoff Letter; NASD 
Letter; NYSE Letter; PSE Letter; SIA Letter; Specialists Assoc. 
Letter; see also LJR Letter (questioning whether the display of 
size, at least with respect to institutional orders, would be 
consistent with best execution obligations).
    \167\ See, e.g., Madoff Letter; NASD Letter; NYSE Letter; SIA 
Letter; Specialists Assoc. Letter.
---------------------------------------------------------------------------

    Other commenters, however, believe that the full size of a customer 
limit order should be required to be displayed.168 Such commenters 
argue that the display of full size is an important element in the 
Commission's effort to improve transparency and, therefore, no dealer 
discretion should be permitted unless a customer expressly requests 
that its order not be displayed, or expressly grants discretion, 
pursuant to the Display Rule.169
---------------------------------------------------------------------------

    \168\ See, e.g., Amex Letter; CHX Letter; D.E. Shaw Letter.
    \169\ See, e.g., Amex Letter; CHX Letter; D.E. Shaw Letter; ICI 
Letter.
---------------------------------------------------------------------------

    The Commission continues to believe that the display of full size 
is important to improved transparency. The display of full size will 
provide the most accurate picture of the depth of the market at a 
particular price.170 The Commission believes that size, as well as 
price, is a factor in attracting order flow and that the display of 
full size increases the likelihood that a limit order will be executed. 
The Commission, however, understands that there may be instances where 
a customer would not want its order displayed, or does not want the 
full size of its order displayed. The Display Rule, therefore, still 
contains an exception for a customer that decides to rely on the 
discretion of a broker-dealer rather than to take advantage of the 
display requirement for its limit order.171 The Display Rule also 
permits a customer to state explicitly what portion, if any, the 
customer wants displayed.172 Furthermore, the Display Rule 
contains other exceptions to the display requirement that will ease any 
potential operational burdens associated with the display of full 
size.173
---------------------------------------------------------------------------

    \170\ A few commenters believe that all customer limit orders 
should be displayed, including the size of those orders that equal 
the specialist's or OTC market maker's bid or offer, but are not 
equal to the NBBO. See, e.g., CHX Letter; Letter from Edward J. 
Johnsen, Vice President and Counsel, Morgan Stanley & Co., to 
Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 (``Morgan 
Stanley Letter''); Peake Letter; Weaver Letter. The Commission 
believes, however, that the burden associated with the commenters' 
suggestion would outweigh the corresponding benefit to market 
transparency. Of course, the rule represents a floor, rather than a 
ceiling. An exchange, association, or broker-dealer may determine to 
adopt more stringent display requirements. Requiring display of size 
when the limit order is away from the NBBO and equals the market 
maker's or specialist's quote would provide some additional market 
information but also would require market makers not quoting at the 
NBBO to change their quote size on an ongoing basis. Although some 
market makers or specialists may choose to do so to be prepared if 
their quotation becomes the NBBO, on the whole the Commission 
believes the increased transparency that would result from this 
updating would not outweigh the burdens imposed by a display 
requirement.
    \171\ Section 240.11Ac1-4(c)(2).
    \172\ Id.
    \173\ As noted above, a specialist or OTC market maker has the 
ability to execute a customer limit order upon receipt; transmit the 
order to another exchange member or OTC market maker that will 
display the limit order in accordance with the rule; or transmit the 
order to an exchange or association sponsored system pursuant to the 
rule. Additionally, a specialist or OTC market maker may transmit an 
order to an ECN that provides for public display of limit orders and 
provides access to these orders. Moreover, the rule contains an 
exception to the display requirement for certain orders of de 
minimis size.
---------------------------------------------------------------------------

    The following example illustrates the application of the Display 
Rule where a customer limit order improves the price of a specialist's 
or market maker's quote. Assume that a market maker covered by the rule 
is quoting 10-10\1/2\ (2,000 x 2,000) when it receives a customer limit 
order in a covered security to buy 4,000 shares at 10\1/4\. Under the 
rule, the market maker must change the price and size associated with 
its quote to 10\1/4\-10\1/2\ (4,000 x 2,000). If this new quote 
represents the NBBO, the Display Rule would require the market maker to 
increase the size associated with the quote upon the receipt of 
additional customer limit orders. For example, if the market maker 
subsequently accepts another customer limit order to buy 4,000 shares 
at 10\1/4\, the market maker must change its quote to 10\1/4\-10\1/2\ 
(8,000 x 2,000).
    The rule as adopted contains a de minimis standard applicable in 
situations where a customer limit order equals a specialist's or market 
maker's displayed price and that price is equal to the NBBO. One 
commenter states that the use of representative size would eliminate 
the Commission's need to rely on a de minimis standard.174 Another 
commenter believes that the rationale underlying the de minimis 
standard demonstrates that the display of size does not benefit public 
customers.175 Some commenters also believe that the de minimis 
standard should be clarified or even eliminated.176
---------------------------------------------------------------------------

    \174\ CSE Letter.
    \175\ Dean Witter Letter.
    \176\ See, e.g., Amex Letter; CHX Letter; Schwab Letter.
---------------------------------------------------------------------------

    The Commission proposed the de minimis standard to strike a balance

[[Page 48304]]

between the benefits of increased transparency and operational burdens 
that might arise under the display requirement in displaying limit 
orders irrespective of size. The de minimis standard was intended to 
reduce the burdens of displaying the smallest of limit orders where the 
frequent updating of the quote for smaller orders would not result in 
significant improvements in quotation size. The Commission believes 
that the size of a customer limit order should be considered de minimis 
if it is less than or equal to 10% of the displayed size associated 
with a specialist's or OTC market maker's bid or offer.177
---------------------------------------------------------------------------

    \177\ Any SRO may set more stringent display requirements 
through its own rules.
---------------------------------------------------------------------------

    The Commission believes that this de minimis standard will ease 
potential operational burdens associated with the display of additional 
size in a specialist's or OTC market maker's quote. The following 
example illustrates the application of the de minimis standard.
    Assume a market maker's quote is 10-10\1/2\ (1,000 x 1,000), and 
the NBBO is 10-10\1/4\ when the market maker receives a customer limit 
order to buy 2,000 shares at 10. Under the rule, the market maker is 
obligated to change the size of its quote immediately to 10-10\1/2\ 
(3,000 x 1,000).178 In this case, the 2,000 share order size is 
more than de minimis in relation to the size associated with the market 
maker's quote. If the limit order was for 100 shares, however, the 
market maker would not be required to change its quotation size because 
the order is de minimis in relation to its quote.179 
Alternatively, the market maker could voluntarily display the 
additional 100 shares.
---------------------------------------------------------------------------

    \178\ If the original 1,000 shares displayed represents the 
market maker's proprietary quote and, consistent with Rule 11Ac1-1, 
the market maker no longer wishes to trade for its own account at 
10, the market maker may quote at 10-10\1/2\ (2,000 x 1,000).
    \179\ The Commission stresses that all other orders previously 
considered de minimis and not displayed must be added to the order 
under consideration for purposes of the de minimis calculation. 
Therefore, in the case of a 100 share limit order to buy at 10, 
where the market maker had a previous 100 share limit order to buy 
at 10 that was not displayed pursuant to the de minimis standard, 
both orders must be considered together for purposes of making the 
de minimis calculation. Because 200 shares is more than 10% of the 
displayed size of 1,000, the market maker must include the 200 
shares in its quote.
    The Commission notes that if an OTC market maker chooses not to 
display a de minimis limit order, the NASD's interpretation 
regarding limit orders would prohibit the market maker from trading 
ahead of the limit order. See Manning I & II, supra note 24. In 
addition, the NASD has indicated that market makers must establish 
and consistently follow policies regarding the priority in which 
limit orders received from customers, which would include de minimis 
orders, will be executed. See Special NASD Notice to Members 95-43 
(June 5, 1995).
---------------------------------------------------------------------------

c. Exceptions
    The rule requires the ``immediate'' display of certain customer 
limit orders. To satisfy this requirement, a specialist or OTC market 
maker must display the limit order immediately upon receipt unless 
there exists an applicable exception to the display requirement. Some 
commenters have asked for clarification of the ``immediate'' display 
requirement.180 The Commission is mindful that some measure of 
time is needed for specialists or market makers to display limit orders 
in the quote. Assuming that a specialist or OTC market maker does not 
rely on one of the exceptions to the Display Rule, however, such 
specialist or OTC market maker must display the order as soon as is 
practicable after receipt which, under normal market conditions, would 
require display no later than 30 seconds after receipt.181
---------------------------------------------------------------------------

    \180\ See, e.g., Amex Letter; D.E. Shaw Letter; NYSE Letter; PSE 
Letter.
    \181\ The Commission stresses that specialists and OTC market 
makers still are under an obligation to protect the customer limit 
order even during the time the limit order is not displayed. See, 
e.g., Manning I & II, supra note 24 (prohibiting trading ahead of 
customer limit orders). It should also be noted that this standard 
would supersede SRO rules that are less stringent with regard to the 
time in which limit orders are to be displayed. Those rules that 
impose more stringent standards may continue to apply.
---------------------------------------------------------------------------

    There are seven exceptions to the general requirements of the rule. 
The first exception applies to any customer limit order that is 
executed upon receipt of the order.182 If the order is executed 
upon receipt, then no duty arises under the rule.
---------------------------------------------------------------------------

    \182\ Section 240.11Ac1-4(c)(1).
---------------------------------------------------------------------------

    The second exception applies to any limit order that is placed by a 
customer who expressly requests that the order not be 
displayed.183 This request may take place on an order by order 
basis, or may be agreed to prospectively. Most commenters that 
addressed the issue were in favor of the exception.184 The 
Commission included this exception because there could be instances in 
which a customer prefers to exclude its order from public display. For 
example, a customer with a large limit order could wish to let its 
broker work the order rather than display the entire order. This 
exception gives the customer the right to decide if the order should be 
displayed in its entirety, in part, or not at all.185 The 
Commission notes that under this exception, a customer may leave the 
decision to display an order to the discretion of a broker-dealer. 
Therefore, rather than instructing a broker-dealer not to display an 
order, a customer, consistent with this exception, may instruct the 
broker-dealer to use its discretion in determining whether to display 
the order. Although allowing some orders to not be displayed or to be 
displayed partially in the system reduces transparency, the Commission 
believes this exception is appropriate to give investors flexibility in 
deciding how their orders should be handled.
---------------------------------------------------------------------------

    \183\ Section 240.11Ac1-4(c)(2).
    \184\ But see, e.g., Madoff Letter; Morgan Stanley Letter.
    \185\ Any portion of a customer limit order that is not 
displayed pursuant to this exception shall not be included in the 
calculation for determining whether any other limit order is de 
minimis. See supra note 179.
---------------------------------------------------------------------------

    The exception to the rule requires a customer to expressly request 
that an order not be displayed.186 A customer request that an 
order be placed in a particular non-public trading system would not, by 
itself, be deemed to be a non-display request. The Commission expects 
that most retail customers will want their limit orders displayed 
pursuant to the rule. Thus, the Commission has written the rule to 
require specialists and OTC market makers to assume that retail 
customers wish to have their orders displayed unless the customer 
specifically requests that the order not be displayed.
---------------------------------------------------------------------------

    \186\ At least one commenter believes that documentation of such 
customer requests should be required. CHX Letter. Although the 
Commission does not believe it necessary to mandate a particular 
method of record keeping, the Commission expects the compliance 
departments of individual firms to discharge their responsibilities 
in such a manner as to allow adequate supervision of compliance with 
the customer's request not to display or to display pursuant to 
discretionary authority provided by the customer.
---------------------------------------------------------------------------

    The exception also permits any customer to negotiate with its 
broker-dealer an individual agreement regarding the display of its 
limit orders either on an order-by-order basis or prospectively. 
Standardized disclaimers or contractual language in broker-dealer new 
account agreements, however, would not be deemed to be an individual 
request by a customer that its order or orders not be displayed.
    The third exception applies to odd-lot orders.187 The rule 
does not require the display of an order for less than a unit of 
trading as established by the rules of the exchange or association. In 
the event that a round-lot limit order represented in the quote is 
partially filled and, as a result, the remainder of the order would 
then be deemed an odd-lot order, the remainder of the order may be 
treated as an odd-lot for purposes of this exception. For example, 
assume a

[[Page 48305]]

market maker is quoting at the NBBO (10\1/4\-10\3/8\ (200 x 1000)) and 
is representing a 200 share customer limit order to buy when a market 
order to sell 150 shares is received. Upon execution of 150 shares of 
the 200 share customer limit order, the market maker is not required to 
display the remaining 50 shares of the order at 10\1/4\.188
---------------------------------------------------------------------------

    \187\ Section 240.11Ac1-4(c)(3).
    \188\ The market maker still will have best execution 
obligations with respect to the remaining odd-lot portion of the 
customer limit order.
---------------------------------------------------------------------------

    The fourth exception applies to block size orders.189 Orders 
of at least 10,000 shares or for a quantity of stock having a market 
value of at least $200,000 need not be displayed in accordance with the 
rule, unless the customer so requests.190 The Commission 
recognizes that the display of block size orders would add to market 
transparency. In practice, however, the handling of block size orders 
differs from other orders. For example, in the OTC market, market 
makers often negotiate terms and conditions with respect to the 
handling of block size orders, and display of block size orders may 
impact market maker quotations in a security more than would smaller 
limit orders.191 Further, one of the major objectives in proposing 
the Display Rule was to improve the handling and execution 
opportunities afforded to customers that lack the power to negotiate 
better terms. Because most investors that trade in block size have such 
power, the Commission has chosen not to mandate the display of block 
size orders, unless the customer so requests.192 The Commission is 
satisfied that the current definition strikes an appropriate regulatory 
balance by requiring a presumption in favor of display for those orders 
requiring enhanced protection, while not extending the presumption to 
those orders less likely to need such protection. Of course, the 
Commission may reevaluate its treatment of block size orders at a later 
date.
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    \189\ Section 240.11Ac1-4(c)(4).
    \190\ This block definition is consistent with the current 
definition used in NYSE Rule 127.10. Some commenters, however, 
suggest that the parameters for such orders be increased or made 
flexible depending on the liquidity of a particular security. See, 
e.g., D.E. Shaw Letter; PSE Letter; Schwab Letter. Still others 
believe that there should be no exception for orders of block size. 
Instead, these commenters want such orders to be included within the 
scope of the rule so as to add to market transparency. See, e.g., 
Amex Letter; ICI Letter; Lehman Letter; Peake Letter; Ricker Letter. 
One commenter suggests the use of a ``block indicator'' to give a 
specialist or OTC market maker the option of displaying the full 
size of the order or using the indicator to identify the quote as 
representing a block size order. Lehman Letter.
    \191\ See, e.g., Manning II, supra note 24.
    \192\ Customers placing block orders, however, may request that 
the order be displayed in accordance with the requirements of the 
rule; a specialist or OTC market maker that accepts the order will 
be obligated to honor such a request. Section 240.11Ac1-4(c)(4). The 
Commission expects that adequate procedures will be developed to 
ensure compliance with a customer request. See supra note 186.
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    As proposed, the fifth exception would have applied to a limit 
order that is delivered immediately to an exchange or association 
sponsored system that displays limit orders and complies with the 
requirements of the rule with respect to that order.193 This 
exception did not relieve a specialist or OTC market maker from its 
display obligation for orders it received through exchange or 
association facilities, unless the facility itself displayed the 
order.194
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    \193\ Section 240.11Ac1-4(c)(5). A facility would not be deemed 
to comply with the requirements of the Display Rule if the highest 
priced buy orders and lowest priced sell orders entered by a 
specialist or OTC market maker in the facility for a particular 
security were not included in calculating the best bid and offer for 
the market and incorporated in the consolidated quote.
    \194\ One commenter argues that the exception permits 
specialists and OTC market makers to become ``fair weather 
dealers,'' effectively allowing them to selectively withdraw from 
the national market system, which creates a misleading picture of 
liquidity. Madoff Letter. The Commission believes, however, that the 
exception provides a specialist or OTC market maker with an 
appropriate amount of discretion in handling a customer limit order 
while ensuring that orders at the best price are displayed to the 
marketplace.
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    In the Proposing Release, the Commission requested comment on 
whether to extend this exception from display to instances where 
customer limit orders are sent to ECNs or PTSs by a specialist or OTC 
market maker.195 As discussed below in connection with the 
amendments to the Quote Rule, the Commission is amending the Quote Rule 
to require specialists and OTC market makers to include priced orders 
they enter into ECNs in the bids and offers they communicate to their 
exchange or association for reflection in their published quotations, 
when such orders improve their published quotations.196 In 
recognition of the concerns raised by commenters, the Commission also 
has included an alternative to the amendment designed to preserve the 
anonymity of specialists and OTC market makers that is currently 
provided by certain ECNs, while still publicizing in the public 
quotation stream better prices entered into ECNs. The ECN display 
alternative in the Quote Rule is available only if the ECN provides for 
public dissemination of the price and full size of the orders entered 
by specialists and OTC market makers to an exchange or association and 
provides access to other broker-dealers to trade at those prices which 
is equivalent to that provided in the market where the prices are 
disseminated.197
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    \195\ See, e.g., Letter from James Lynch, General Counsel, ITG, 
Inc., to Jonathan G. Katz, Secretary, SEC, dated, January 15, 1996 
(``POSIT Letter'') (not supporting the extension of the exception); 
PSE Letter (extension of exception should be contingent on access 
provided by ECNs); Whitcomb Letter (doubtful that exception could be 
extended in today's environment); see also Madoff Letter (market 
makers and specialists should be able to represent a portion of the 
size of a customer limit order in other markets or ECNs, but the 
best price and some size should be reflected in their quote).
    \196\ See Sec. 240.11Ac1-1(c)(5)(i)(A); see also Amendments to 
the Quote Rule discussion at section III.B.2.c.ii., infra.
    \197\ As discussed, the Commission expects the SROs to work 
expeditiously with ECNs that wish to avail themselves of this 
alternative, and is prepared to act if necessary to ensure the 
effectiveness of the ECN display alternative, prior to the effective 
date of the Quote Rule amendments. See Introduction and Summary, 
supra; see also Sec. 240.11Ac1-1(c)(5)(ii); Amendments to the Quote 
Rule discussion at section III.B.2.c.iii., infra.
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    The Commission believes that ECNs that provide their best 
specialist and market maker prices to the public quotation system and 
provide ready access to their prices can provide an effective means for 
specialists and OTC market makers to ensure that customer limit orders 
are handled in a manner consistent with the Display Rule. In view of 
the ECN display alternative in the Quote Rule, the Commission believes 
it is appropriate to extend the exception in the Display Rule to orders 
entered into ECNs that comply with the Quote Rule alternative.198 
Accordingly, a specialist or OTC market maker that delivers a customer 
limit order to an ECN will be deemed to have satisfied its display 
obligation with regard to that order if the ECN complies with the 
requirements of the new alternative in the Quote Rule.199 The 
proposed exception for limit orders entered into exchange or 
association sponsored systems contemplated that such orders would be 
transparent and accessible. Therefore, expanding the exception to 
include the use of ECNs that provide for the requisite transparency and 
accessibility is consistent with the rule as proposed.
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    \198\ See Amendments to the Quote Rule discussion at section 
III.B.2.c.i., infra, for a description of the ECN definition; see 
also Sec. 240.11Ac1-1(a)(8); Sec. 240.11Ac1-4(a)(8).
    \199\ Section 240.11Ac1-4(c)(5). See also, Amendments to the 
Quote Rule discussion on accessibility at section III.B.2.c.iii., 
infra. Additionally, a specialist or OTC market maker may be 
relieved of its display obligation if it delivers the customer limit 
order to an exchange or association sponsored system that complies 
with the new alternative in the Quote Rule. Section 240.11Ac1-
4(c)(5).
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    The Commission notes that this exception to the Display Rule 
maintains the benefits, including increased transparency, provided to 
customer limit orders under the rule. The

[[Page 48306]]

exception ensures that customer limit orders will have equivalent 
public disclosure whether they are sent to an ECN that complies with 
the alternative or displayed directly in a specialist's or OTC market 
maker's quote.200
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    \200\ An OTC market maker or specialist choosing to enter 
customer limit orders for display through an ECN must still evaluate 
whether the customer order is likely to obtain best execution 
through display in that ECN. See section III.C.2., infra.
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    The sixth exception applies to a limit order that is delivered to 
another exchange member or OTC market maker that complies with the 
display requirements of the rule with respect to that order.201 
For example, a market maker that receives a limit order subject to the 
display requirement under the rule may immediately send the order to 
another market maker in the security if the other market maker will 
display the order in accordance with this rule.202
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    \201\ Section 240.11Ac1-4(c)(6).
    \202\ One commenter believes that the rule should require a 
specialist or OTC market maker to obtain assurances that a 
customer's limit order will be displayed in accordance with the rule 
before such an order is sent. MJT Letter. But see PSE Letter; 
Salomon Letter. As noted earlier, the Commission believes that it is 
best left to a firm's compliance department to decide on the 
necessary assurances that the order will be displayed in conformance 
with the rule.
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    The seventh exception applies to ``all-or-none limit orders.'' An 
``all-or-none limit order'' is an order accompanied by the customer's 
instruction that the order is to be executed in its entirety or not at 
all.203 Although this exception was not included in the proposed 
rule, the Commission believes that exempting all-or-none limit orders 
is necessary to avoid operational difficulties regarding partial 
executions at the public quote.204 In this regard, all-or-none 
limit orders typically are not displayed in the exchange markets 
today.205 The Commission believes, therefore, that this exception 
is consistent with the goals and objectives of the Display Rule.
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    \203\ See, e.g., NYSE Rule 13.
    \204\ For example, if an all or none order to buy 1,000 shares 
at 10\1/4\ were displayed in the quote and represented the NBBO, a 
subsequent market order to sell 500 shares could not be matched 
against the all or none order.
    \205\ See, e.g., NYSE Rule 13.
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    Finally, a new provision has been included that enables the 
Commission to exempt, conditionally or unconditionally, any 
transactions that it may determine are not encompassed within the 
purposes of the Display Rule. The Commission believes that this 
exemptive authority provides flexibility in applying the Display 
Rule.206
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    \206\ Section 240.11Ac1-4(d).
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d. Effective Date and Phase-In
    The Display Rule will become effective on January 10, 1997. As of 
this date, the Display Rule will apply to exchange-traded securities. 
Moreover, this date will mark the beginning of the first phase-in for 
Nasdaq securities. As of this date, the Display Rule will apply to the 
1,000 Nasdaq securities with the highest average daily trading volume 
in the previous quarter.
    The second phase-in date will be on March 28, 1997. From this date 
forward, the Display Rule will apply to the next 1,500 Nasdaq 
securities with the highest average daily trading volume over the 
previous quarter.207
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    \207\ Any security already covered by the rule will not be 
included as part of the calculation of the securities to be included 
in any subsequent group. Therefore, if a security is included as one 
of the 1,000 securities in the first group, such security will not 
be counted as one of the next 1,500 securities in the second group 
(even if such security's average daily trading volume over the 
previous calendar quarter would otherwise place it in the second 
group).
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    The third phase-in date will be on June 30, 1997. From this date 
forward, the Display Rule will apply to the next 2,000 Nasdaq 
securities with the highest average daily trading volume over the 
previous quarter.
    The final phase-in date will be on August 28, 1997. From this date 
forward, the Display Rule will apply to all remaining Nasdaq 
securities.
    Although the Commission believes that the Display Rule should apply 
equally to exchange-traded and non-exchange-traded securities, the 
Commission understands that the Display Rule will more significantly 
impact current order handling procedures for Nasdaq securities in light 
of existing practices in that market. The phase-in period will allow 
the Commission to monitor the effects of the Display Rule on successive 
groups of Nasdaq securities while ensuring that all covered securities 
receive the benefits of the display requirement within one year of the 
Display Rule's adoption.

B. Amendments to the Quote Rule

1. Background
    Public quotation reporting for equity securities is governed by the 
Commission's Quote Rule,208 as well as by exchange and NASD rules. 
These rules require registered exchanges and securities associations to 
file quotation reporting plans with the Commission that provide for the 
collection and transmission of quotation information on a real-time 
basis for securities covered by the Quote Rule.209 Market makers 
and exchange specialists communicate their quotes to the NASD or to an 
exchange pursuant to these plans and the NASD and exchanges in turn 
make this information available to vendors for dissemination to the 
public.210
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    \208\ 17 CFR 240.11Ac1-1. See also Securities Exchange Act 
Release No. 14415 (January 26, 1978), 43 FR 4342 (February 1, 1978) 
(``Quote Rule Adopting Release'').
    \209\ Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1) 
(dissemination requirements for exchanges and associations).
    \210\ Rule 11Ac1-2, 17 CFR 240.11Ac1-2 (``Vendor Display Rule'') 
requires vendors of market information to display quotation 
information in a non-discriminatory manner.
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    The Quote Rule requires the collection and public dissemination of 
the best bid, best offer, and size for each market quoting any security 
covered by the Quote Rule, as well as the consolidation of those 
markets' quotations and public dissemination of the national 
``consolidated'' best bid and offer (``NBBO'').211 These 
quotations must be firm, and a market maker or specialist generally is 
obligated to execute an order at a price at least as favorable as its 
published bid or offer up to the size of its published bid or 
offer.212 Broker-dealers covered by the Quote Rule, including 
dealers trading listed securities in the OTC market (i.e., third market 
makers), must supply quotations to their exchange or association for 
dissemination to quotation vendors.
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    \211\ Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1). Pursuant to 
the Quote Rule and the Joint Consolidated Quotation Plan (``CQS 
Plan''), the inside quotations collected and calculated by the 
exchanges and Nasdaq for exchange-listed securities are consolidated 
and disseminated to vendors by SIAC, the exclusive processor for 
consolidated quotations in listed securities. Similarly, Nasdaq is 
the exclusive processor for quotations in Nasdaq National Market 
(``Nasdaq NMS'') securities. Nasdaq collects and consolidates inside 
quotations furnished by OTC market makers and by exchanges pursuant 
to a Joint Self-Regulatory Organization Plan that provides for 
exchange trading of Nasdaq securities. Nasdaq then disseminates to 
vendors the inside bid and offer in Nasdaq NMS securities, and 
disseminates to various subscribers more specific information 
concerning the individual market maker and exchange quotes in each 
Nasdaq security. The terms ``consolidated quote'' and ``publicly 
available quotation,'' when used with respect to information 
disseminated by exchanges and Nasdaq via their exclusive processors, 
refer to the quotes that SIAC or Nasdaq furnishes to vendors for 
dissemination to the public. The terms ``public quote'' or 
``publicly available quote,'' when used with respect to a specialist 
or market maker, refer to the bid and offer that the specialist or 
market maker has furnished to its exchange or association for 
inclusion in the consolidated quote. The term ``public quotation 
system'' refers to this entire structure through which SROs collect 
quotations from market participants, and the exclusive processors 
collect, process, and disseminate those quotations to vendors.
    \212\ Rule 11Ac1-1(c)(1), 17 CFR 240.11Ac1-1(c)(1). This is 
referred to as the broker-dealer's ``firmness'' requirement.
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    The 1975 Amendments identified the need for a prompt, accurate and 
reliable

[[Page 48307]]

central quotation reporting system.213 The Quote Rule, in 
particular, was designed to facilitate the NMS by requiring specialists 
and market makers publishing quotes to provide these quotes to a 
central system so they could be made available to the public. Congress 
considered the public availability of quotation information to be 
critical to fair and competitive markets because published quotations 
provide investors, their brokers, and other market participants with 
essential information about the condition of the market. This 
information assists investors in making investment decisions and in 
finding the best market for a security, while making it possible for 
investors to evaluate the quality of their executions.
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    \213\ Senate Report, supra note 31. Cf. H.R. Rep. No. 229, 94th 
Cong., 1st Sess. 29 (1975) (``Conference Report'') (noting that the 
conference committee adopted the Senate's provisions on the NMS with 
minor revisions).
---------------------------------------------------------------------------

    Since the 1975 Amendments and the adoption of the Quote Rule, there 
have been dramatic changes in the markets and the technologies used by 
market participants. To ensure that the Quote Rule keeps pace with the 
evolution of the securities markets and continues to ensure the public 
availability of accurate, reliable, and comprehensive quotation 
information, the Commission has determined that certain amendments to 
the Quote Rule are necessary and appropriate in furtherance of the 
objectives of the Exchange Act.
    The Commission proposed an amendment to the Quote Rule to require 
specialists and market makers to reflect in their public quotes any 
better priced orders they place in certain systems that are not 
currently integrated into the NMS. In particular, the ECN amendment is 
intended to incorporate within the public quotes any better priced 
orders broadly displayed by market makers and specialists through ECNs. 
This amendment is being adopted with modifications to address concerns 
raised by some commenters. Specifically, in order to provide 
specialists and market makers with an alternative method to meet the 
ECN display requirement, the Commission is adopting an alternative 
suggested in the proposing release that deems a specialist or market 
maker in compliance with the ECN amendment if the ECN provides the best 
prices entered into the ECN by market makers or specialists for each 
covered security to an exchange or association for inclusion in the 
public quotation system and provides access to those prices equivalent 
to the access currently available to other quotes published by the 
exchange or association. In addition, the Commission is amending the 
Quote Rule to expand the categories of securities covered by certain 
existing Quote Rule provisions. The quotation requirements that 
previously applied to substantial specialists and market makers in only 
certain exchange-listed securities now will apply to substantial 
specialists and market makers in all exchange-listed securities. 
Further, certain Quote Rule provisions that previously applied to 
market makers electing to quote particular Nasdaq securities now will 
apply to market makers electing to quote any Nasdaq security. The 
Commission is adopting these amendments substantially as proposed, 
along with minor technical amendments to the Quote Rule that are 
discussed more fully below.
2. Public Dissemination of Market Maker and Specialist Prices in ECNs
a. Basis for the ECN Amendment
    Over 20 years ago, the Commission noted that an essential purpose 
for the establishment of the NMS was ``to make information on prices, 
volume, and quotes for securities in all markets available to all 
investors, so that buyers and sellers of securities, wherever located, 
can make informed investment decisions and not pay more than the lowest 
price at which someone is willing to sell, or not sell for less than 
the highest price a buyer is prepared to offer.'' 214 At the time, 
the lack of consolidated quote information made it difficult to 
ascertain the different prices that were often available in the various 
markets for a particular security. This lack of transparency as to the 
best prices among competing markets was widely recognized as preventing 
investors and their brokers from ascertaining accurate trading interest 
for a security and obtaining the best prices for their orders.215 
To address these concerns, Congress directed the Commission to 
facilitate the creation of a national market system that would link the 
various markets trading a security. The price and quotation 
transparency resulting from the Commission's ensuing NMS initiatives 
has produced extremely liquid, successful, and, in most cases, 
competitive markets.
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    \214\ Securities and Exchange Commission, Statement of the 
Securities and Exchange Commission on the Future Structure of the 
Securities Markets (February 2, 1972) (``Future Structure 
Statement'') at 9-10, 37 FR 5286, 5287 (February 4, 1972) (emphasis 
added). See also Securities and Exchange Commission, Policy 
Statement of the Securities and Exchange Commission on the Structure 
of a Central Market System (1973) at 25-28.
    \215\ See Senate Report, supra note 31.
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    As discussed in the Proposing Release, the Commission for many 
years has been concerned that the development of so-called ``hidden 
markets,'' in which a market maker or specialist publishes quotations 
at prices superior to the quotation information it disseminates on a 
general basis, impedes these NMS objectives.216 Over the course of 
the last decade, certain trading systems that allow market makers and 
specialists to widely disseminate significant trading interest to 
certain market participants without making this trading interest 
available to the public market at large have become significant markets 
in their own right. Although offering benefits to some market 
participants, widespread participation in these hidden markets has 
reduced the completeness and value of publicly available quotations 
contrary to the purposes of the NMS. Because these systems are not 
registered as exchanges or associations, they are currently not 
required to integrate into the public quote the prices at which their 
subscribers, including subscribing market makers and specialists, are 
willing to trade.217 The use of these systems by market makers and 
specialists to quote prices not incorporated into the NMS has resulted 
in fragmented and incomplete dissemination of quotation information.
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    \216\ See Proposing Release at 4.
    \217\ Certain ECNs may be registered with the Commission as 
broker-dealers and indeed perform various brokerage functions. 
Nevertheless, the Commission recognizes that in providing a 
mechanism by which system subscribers can (1) broadcast prices to 
other system subscribers and (2) trade with one another at those 
prices, these systems also function as securities markets.
---------------------------------------------------------------------------

    Certain markets, in particular ECNs that allow subscribers 218 
to enter priced orders that are widely disseminated to third parties 
219 and permit such orders to be executed in whole or in part 
through the system, communicate orders that are closely analogous to 
quotations. These ECNs, in effect, allow market makers and specialists 
to display different prices to different market participants.
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    \218\ ECN subscribers may include institutional investors, 
broker-dealers, and market makers. ECNs provide their services to 
subscribers for a fee or commission equivalent. Some ECNs (such as 
SelectNet) have been available only to broker-dealers and not to 
investors generally.
    \219\ ''Third parties'' in this context refers to subscribers or 
any other entities (such as customers of subscribers) that receive 
information from the ECN concerning any priced order entered into 
the ECN by another subscriber.
---------------------------------------------------------------------------

    Although these ECNs can facilitate the execution of their 
subscribers' orders and allow institutions to participate

[[Page 48308]]

directly in price discovery, the display of better prices privately in 
ECNs reduces the reliability and completeness of consolidated 
quotations, the accuracy of which continues to be an essential element 
of the NMS. These private markets have resulted in fragmented 
quotations and a reduction in the reliability of public quotations as 
an accurate indicator of market makers' and specialists' best prices, 
the identical situation that prompted Congress to adopt the NMS 
amendments in 1975. The unavailability of full market maker and 
specialist quotation information prevents investors and their brokers 
from ascertaining the true trading interest for a security, and 
obtaining the best price for market orders, and prevents investors from 
monitoring the efforts of their brokerage firms to obtain best 
execution for their orders.
    The Commission's analysis of the trading activity in these ECNs has 
produced clear evidence of the existence of a two-tiered market in 
which market makers routinely trade at one price with retail customers 
and at better prices with ECN subscribers.220 For example, 
analysis of trading activity in the two most significant ECNs in the 
Nasdaq market, Instinet and SelectNet, reveals that approximately 85% 
of the bids and offers displayed by market makers in Instinet and 90% 
of the bids and offers displayed on SelectNet were at better prices 
than those posted publicly on Nasdaq.221 Furthermore, 
approximately 77% of the trades executed on Instinet and 60% of the 
trades executed on SelectNet occurred at prices between the Nasdaq best 
bid and offer. Market makers participated on at least one side of 
approximately 90% of the trades in these ECNs. The trading activity in 
Instinet, which comprised approximately 17% of trades and 15% of the 
volume in Nasdaq securities, represents a significant portion of the 
overall market for Nasdaq securities.222
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    \220\ For example, a market maker with a public offer 
constituting the best public offer of 20\3/4\ might offer to sell 
shares in an ECN at 20\5/8\. If the market maker did not change its 
public offer to reflect this improved selling price, public 
customers buying from the market maker would pay the higher price of 
20\3/4\ for the security because they do not have access to the 
market maker's price in the ECN.
    \221\ The Commission's analysis is based on Instinet and 
SelectNet data for the months April through June 1994. See 21(a) 
Report at notes 48-52 and accompanying text and Appendix at notes 
18-28 and accompanying text.
    \222\ More trading volume now occurs on Instinet than on any of 
the organized U.S. stock markets other than the NYSE and Nasdaq. In 
1994, trading volume on Instinet totalled approximately 10.8 billion 
shares with an approximate dollar volume of $282 billion. In 
comparison, Nasdaq traded approximately 74 billion shares, with an 
approximate dollar volume of $1,449 billion. Id. at note 50 and 
accompanying text.
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    The Commission's recent investigation into various trading 
practices in Nasdaq stocks revealed that the existence of this two-
tiered market facilitated the maintenance of wide spreads on Nasdaq. As 
discussed in the 21(a) Report, Nasdaq market makers engaged in a 
widespread course of conduct that resulted in artificially wide spreads 
in a large percentage of Nasdaq stocks. The maintenance of wide spreads 
was made possible at least in part by the fact that ECNs like Instinet 
and SelectNet did not affect the prices at which market makers traded 
with the general public, thus allowing market makers to attract trading 
interest at prices inside the spread without adjusting their Nasdaq 
quotes. Integrating the better prices market makers quote in ECNs 
should significantly limit the types of uncompetitive practices 
identified in the investigation without limiting the usefulness of 
these systems as efficient alternative mechanisms for negotiating 
transactions.
    The Commission firmly believes that all investors should have an 
opportunity to have their orders filled at the best prices made 
available by market makers. Consistent with Congress's goals for a NMS, 
these opportunities must be made available to all customers, not just 
those customers who, due to size or sophistication, may avail 
themselves of prices in ECNs not currently linked with the public 
quotation system. The vast majority of investors may not be aware of 
the better prices widely disseminated by market makers or specialists 
through ECNs and many do not have the ability to route their orders 
directly or indirectly to such systems. As a result, many customers, 
both institutional and retail, do not always obtain the benefit of the 
better prices entered by a market maker or a specialist into an ECN.
    Brokers frequently use the consolidated quote as the benchmark for 
automated execution of customer orders and for the starting point in 
negotiating execution prices with institutional investors.223 
Consolidated quotations in listed stocks are provided by CQS to 
vendors, who then provide this information to the public. In approving 
the CQS as the mechanism to serve this vital function, the Commission 
stressed that it would expect broker-dealers to take into account 
pricing information made available through the CQS in fulfilling their 
best execution obligations.224 Similarly, for OTC securities, 
Nasdaq disseminates to market makers, vendors, and investors multiple 
market maker quotations, and a ``best'' bid and offer derived from 
these quotations. As broker-dealers and markets have developed 
automated order-routing and order execution systems, they have relied 
on these consolidated quotes in pricing and executing customer orders 
routed through their systems.225 Including the prices entered into 
ECNs by market makers and specialists in the consolidated quotation 
will help broker-dealers using these automated systems to provide their 
customers' orders with improved executions, and will improve 
institutions' ability to ascertain true market prices.
---------------------------------------------------------------------------

    \223\ Some commenters argue that the ECN amendment focuses on 
expanding the availability of these systems to small investors, and 
ignores the fact that small investors already benefit from these 
systems in that institutional subscribers in ECNs primarily 
represent the collective interests of small investors, e.g., through 
mutual funds and 401(k) plans. See, e.g., CALpers Letter; Dillon 
Letter; Instinet Letter; LJR Letter; Northern Trust Letter; SIA 
Letter; STAIC Letter. The objectives of the ECN amendment, however, 
are not limited to improving market transparency and accessibility 
for small investors. Comprehensive and transparent information about 
market conditions is critical to efficient and competitive markets 
for all investors, whether retail or institutional. Indeed, while 
large institutional investors often have access to ECNs, the public 
quotes nevertheless frequently serve as a benchmark for their 
negotiations with market makers. In any event, while retail 
investors directly account for a significantly smaller percentage of 
trading volume than institutional investors, they still account for 
half of the direct equity investment in U.S. markets. NYSE 1995 Fact 
Book at 57. The Commission recognizes that direct retail 
participation provides critical liquidity and therefore limited 
access and transparency to the best prices available undermines the 
efficiency of our markets and jeopardizes public confidence in their 
fairness.
    \224\ See Securities Exchange Act Release No. 15009 (July 28, 
1978), 43 FR 34851 (declaring the CQS Plan temporarily effective); 
Securities Exchange Act Release No. 16518 (Jan. 22, 1980), 45 FR 
6521 (permanently approving the CQS Plan).
    \225\ See discussion of best execution principles, infra section 
III.C.2.
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    In light of the stated fundamental purposes of the 1975 Amendments 
and clear evidence of a two-tiered market, the Commission believes it 
is imperative to amend the Quote Rule to ensure the public 
dissemination of accurate quotes that represent the best prices that 
market makers and specialists widely disseminate. Thus, the ECN 
amendment is intended to integrate into the public quote the prices of 
market makers and specialists that are now widely disseminated to ECN 
subscribers but are not available to the rest of the market.226
---------------------------------------------------------------------------

    \226\ Several commenters characterize ECNs as ``wholesale'' 
markets, and argue that the ECN rule would require market makers to 
trade with retail customers at wholesale prices. See, e.g., Davis 
Letter; Instinet Letter; LJR Letter; Merrill Letter. The Commission 
notes that market makers are compensated by the spread between their 
bid and offer prices, and nothing in the ECN rule prevents market 
makers from buying at the bid from one customer and selling at the 
offer to another.

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[[Page 48309]]

    Most commenters support the Commission's goal of improving the 
quality of quotation information made available to the public, although 
many raise questions, discussed below, about the proposal. In 
particular, and as discussed below, some commenters expressed concern 
about the potential impact of the rule on benefits provided to the 
market as a whole by ECNs. Upon review of the comments received, the 
Commission has determined that it is appropriate to adopt the proposed 
ECN amendment. Furthermore, in response to the concerns noted, and to 
facilitate compliance with the ECN amendment, the Commission has 
included the ECN display alternative that permits a market maker or 
specialist to comply with the amendment through an ECN that meets two 
conditions. First, the ECN into which the market maker or specialist 
enters its order must ensure that the best prices market makers and 
specialists have entered therein are communicated to the public 
quotation system. Second, the ECN must provide brokers and dealers 
access to orders entered by market makers and specialists into the ECN, 
so brokers and dealers that do not subscribe to the ECN can trade with 
those orders. The ECN display alternative therefore allows a market 
maker or specialist to comply with the ECN amendment directly by 
changing its quote, or alternatively by using an ECN that meets the 
above two conditions.
    As discussed above, the Commission expects the SROs to work 
expeditiously with ECNs that wish to avail themselves of the ECN 
display alternative to develop rules or understandings of general 
applicability. The Commission is prepared to act as necessary to ensure 
implementation of the ECN display alternative prior to the effective 
date of the Quote Rule.
b. Response to Comments 227
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    \227\ This section includes a discussion of the principal 
arguments advanced by the commenters. A more detailed discussion of 
the comments is provided in the Summary of Comments.
---------------------------------------------------------------------------

    The Commission solicited comment on whether the proposed amendment 
achieves the goals of deterring fragmented markets and promoting 
improved quotations. The Commission also invited comment on whether 
there are any feasible alternatives to the rule, and on possible 
business or economic justifications for permitting market makers and 
specialists to publish prices in ECNs that differ from their public 
quotations. The Commission requested comment on the competitive effects 
of the proposal on existing ECNs, subscribers, and users.228 In 
addition, the Commission solicited comment on alternatives to the 
proposal that would minimize any negative effects, yet still achieve 
the Commission's goals. The Commission specifically asked whether ECNs 
should, as an alternative, furnish market makers' and specialists' best 
prices to the applicable exchange or association for further 
dissemination, and provide access to those prices through some form of 
linkage.229
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    \228\ The Commission also specifically solicited comment on 
whether exceptions to the rule would be appropriate, particularly if 
a customer requests that the market maker refrain from publicly 
disseminating its order. The Commission also solicited comment on 
whether market makers should be required to disseminate publicly the 
full size of orders placed in ECNs. The Commission received only 
minimal response to these questions, which is discussed in the 
Summary of Comments.
    \229\ See Proposing Release at 28-29.
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i. General Comments
    The Commission received numerous comments on the ECN proposal. Many 
commenters support the proposal as an important initiative designed to 
further investor protection by improving publicly available quotation 
information and assuring best execution of customer orders.230 
Some commenters recognize that a number of brokers and dealers have 
adopted the practice of placing superior priced orders in ECNs without 
including these better prices in their public quotes.231 These 
commenters agree that the Commission should be concerned that some 
retail investors may have neither knowledge nor access to the best 
available prices under these circumstances.232 They voice general 
support for the rule, and recommend one or more mechanisms 233 by 
which the Commission could ensure that public quotes contain the best 
prices otherwise widely disseminated by market makers and specialists.
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    \230\ See, e.g., DOJ Letter; Lehman Letter; Madoff Letter; Amex 
Letter; NASD Letter.
    \231\ See, e.g., Amex Letter; DOJ Letter; Madoff Letter; RPM 
Letter.
    \232\ See, e.g., Letter from Gerri Detweiler, Policy Director, 
National Counsel of Individual Investors, to Jonathan G. Katz, 
Secretary, SEC, dated January 22, 1996 (``NCII Letter''); Goldman 
Sachs Letter; PaineWebber Letter; SIA Letter; Madoff Letter; Lehman 
Letter; DOJ Letter.
    \233\ See discussion of alternative approaches, infra at section 
III.B.2.b.iv.
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ii. Impact on ECNs, Market Makers and Specialists, and Institutions
    Some commenters express concern that the amendment could negatively 
impact services provided by ECNs and caution the Commission not to 
diminish the benefits provided by ECNs to the market as a whole. Some 
commenters argue that, under the proposal, market makers and 
specialists that use ECNs would lose the anonymity that these 
commenters believe is crucial to successfully execute large trades for 
institutional investors.234 Some commenters anticipate the 
adoption of the ECN amendment prompting a potential decline in the use 
of certain ECNs.235 In addition, some commenters contend that this 
amendment, because of the impact on ECNs and their subscribers, will 
lead to a loss of liquidity in both ECNs and the public markets 
236 and to a decline in the variety of available trading options 
which could be detrimental to all investors.237 Other commenters 
argue that the proposal would effectively double the risk of a 
specialist or market maker that enters orders into an ECN because the 
specialist or market maker could be simultaneously responsible for 
multiple executions based on its disseminated quote as well as its ECN 
order.238 Moreover, at least one commenter argues that quotes, 
bids, offers, and orders have historically had different meanings and 
that the proposal's treatment of priced orders as quotes confuses the 
essence of the terms, thereby resulting in inadvertent anti-competitive 
effects.239 Some commenters also argue that the better prices 
frequently available in ECNs reflect the lower costs of doing business 
in those systems, and therefore, it would be inappropriate to require 
market

[[Page 48310]]

makers and specialists to match their ECN prices in their public 
quotes.240
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    \234\ See AZX Letter; Instinet Letter; ICI Letter; Investors 
Research Letter; NASD Letter; Ruane Letter; STAIC Letter; Letter 
from Edward G. Shufro, Partner, Shufro, Rose & Ehrman, to Jonathan 
G. Katz, Secretary, SEC (``Shufro Letter''); Sutro Letter.
    \235\ See Goldman Sachs Letter; STA Letter; AZX Letter; Instinet 
Letter; Schwartz and Wood Letter; Ruane Letter.
    \236\ See DOJ Letter; STA Letter; Alex. Brown Letter; Letter 
from Jeffrey L. Davis, Economists Incorporated, to Jonathan G. Katz, 
Secretary, SEC, dated October 25, 1995 (``Davis Letter''); Dillon 
Letter; Instinet Letter; Merrill Letter. (citing the ``deleterious 
effects concerning liquidating inventory and replacing necessary 
capital'' at pp. 7-8); Schwartz and Wood Letter; Letter from Mary 
Kay Wright, Second Vice President and Senior Equity Trader, The 
Northern Trust Company, to Jonathan G. Katz, Secretary, SEC, dated 
February 28, 1996 (``Northern Trust Letter'').
    \237\ See Letter from Anthony R. Gray, Chairman and CIO, STI 
Capital Management, to Jonathan G. Katz, Secretary, SEC, dated 
February 12, 1996 (``STI Capital Letter''); Ruane Letter; DOJ 
Letter; and LJR Letter.
    \238\ See, e.g., Merrill Letter.
    \239\ See Instinet Letter. Instinet also bases much of its 
arguments on its regulatory identification as a broker-dealer. 
Instinet argues that the proposal targets its ECN operations for 
treatment different from other broker-dealers. The Commission notes 
that Instinet (and similar systems) provides to its customers ECN 
services that are significantly different from the services provided 
by other broker-dealers to their customers. Specifically, Instinet, 
without discretion, publicizes subscriber orders and enables other 
subscribers to trade with these orders at their stated price.
    \240\ See, e.g., Dillon Letter; HHG Letter; LJR Letter; Merrill 
Letter; STA Letter; Goldman Sachs Letter.
    There appear to be counter arguments. For example, there is no 
reason to suppose that adverse selection costs--that is, the risks 
of trading with an informed trader--are any lower in ECNs, whose 
subscribers typically can include market makers, other broker-
dealers, institutional money managers, hedge funds, momentum 
traders, and options market makers. Second, because traders can more 
easily mask their identities and thus their trading motives in ECNs 
than in the primary market, informed traders may prefer to trade in 
ECNs. These higher information asymmetries would be expected to lead 
to higher, rather than lower, trading costs. Finally, ECNs often 
impose transactions charges that may not otherwise be incurred by 
dealers trading in the primary market.
    Furthermore, it does not appear that the better prices available 
in ECNs can be explained by differences in the size of orders and 
transactions given that the average order size and trade size in one 
ECN (Instinet) is substantially similar to the average size of 
quotes and trades in the primary market. In any event, the 
Commission generally would not expect larger size orders to receive 
better prices in view of the considerable literature suggesting that 
in equities markets, larger orders tend to get worse prices because 
of the risk of trading with an informed trader. See, e.g., David 
Easley and Maureen O'Hara, 19 J. Fin. Econ. 69, (No. 1, September 
1987).
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    The Commission agrees with commenters that ECNs provide certain 
valuable benefits to their subscribers. It also recognizes the benefits 
competing systems bring to the market as a whole, particularly systems 
that take advantage of new technologies to offer improved trading 
opportunities. The Commission, therefore, has adopted an alternative 
method of compliance with the ECN requirement discussed in the 
proposing release to reduce the amendment's potential impact on 
existing ECNs and their subscribers, and to maintain incentives and 
opportunities for new ECNs to enter the marketplace.241 The 
Commission continues to believe it is important that the best prices of 
orders entered into these markets by market makers and specialists are 
properly integrated into the public market so that all market 
participants can benefit from the price discovery taking place within 
these markets.
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    \241\ The Commission believes that although the ECN amendment 
may marginally reduce the incentive of some subscribers to 
participate in an ECN, on the whole the effect on ECNs should not be 
so significant as to affect their viability. Moreover, given the 
availability of the ECN display alternative, which is designed to 
minimize any potentially detrimental effects of the rule on ECNs, 
the Commission believes that the benefits of the amendment to 
investors of publicizing the better prices entered by market makers 
and specialists outweigh the limited likely costs to ECNs. Many of 
the comments received that addressed the ECN proposal raised concern 
about the importance of preserving the anonymity offered by these 
systems. See, e.g., Alex. Brown Letter; AZX Letter; Dillon Letter; 
Estep Letter; ICI Letter; Instinet Letter; NASD Letter.
---------------------------------------------------------------------------

    In its comment letter, the NASD stated its view that the proposal 
could discourage market makers' use of ECNs because a market maker 
placing an order in an ECN at a better price would have to 
simultaneously change its quote, thereby telegraphing its interest. In 
proposing a solution to this situation, the NASD specifically referred 
to the ECN alternative noting ``* * * this problem can be addressed 
without discouraging market maker use of ECNs through the approach 
suggested by the Commission as a possible alternative, i.e., by 
reflecting the better ECN prices in the inside market display, rather 
than in individual quotes.'' 242
---------------------------------------------------------------------------

    \242\ NASD Letter at 14.
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    In response to the concerns raised by the NASD and other 
commenters, the ECN display alternative is designed to preserve the 
benefits associated with the anonymity that some ECNs currently offer 
to subscribing market makers and specialists and their 
customers.243 This alternative will ensure that the best prices of 
market makers and specialists are publicly disseminated and that non-
ECN-subscribing brokers and dealers can trade with the ECN orders 
represented by those prices. Under the display alternative, the best 
prices and sizes of orders entered into an ECN by specialists and 
market makers would be publicly disseminated while the specialists and 
market makers themselves would remain anonymous. This alternative not 
only preserves anonymity, but also eliminates the risk that a market 
maker or specialist could be exposed to multiple executions at the ECN 
price.244
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    \243\ The Commission recognizes that in certain securities, 
specific market makers or specialists may be viewed as price leaders 
for those securities. Therefore, if the market knows that one of 
those firms has changed its quote, other market makers or 
specialists are likely to follow that price change and frustrate the 
first's firms ability to obtain an execution at the improved price. 
The ability to place an anonymous order in an ECN allows the firm to 
change its price without triggering corresponding price changes from 
other market makers or specialists and thereby increases its 
potential to obtain an execution at the improved price.
    \244\ Certain commenters fear that, as originally proposed, the 
amendment would have an adverse impact on institutional investors 
which currently subscribe to ECNs. These commenters appeared to 
believe that the ECN amendment would seriously harm ECNs, and thus 
harm institutional users. See, e.g., ICI Letter; Ruane Letter. The 
Commission does not believe that the amendments will significantly 
interfere with the operations of ECNs. Moreover, the Commission 
believes that as adopted, particularly with the addition of the ECN 
display alternative, ECNs will continue to be able to provide 
services to institutional investors of similar value to those they 
provide today. The Commission also believes that the benefits of the 
amendments, including increased market maker competition and 
decreased fragmentation, will flow to all investors, institutional 
as well as retail. See 21(a) Report.
---------------------------------------------------------------------------

    The ECN amendment, as proposed, sought to minimize the potential 
impact on market makers, specialists, and ECNs by requiring a market 
maker or specialist to display in its public quote only the size 
required by its exchange or association, rather than the actual size of 
any order the firm places into an ECN. This part of the amendment is 
being adopted as proposed for orders for the accounts of market makers 
and specialists. However, for customers' orders entered into an ECN by 
a market maker or specialist that are smaller than the quote size 
required by the market maker's or specialist's exchange or association, 
the Commission has amended the rule to allow market makers and 
specialists to display only the customer's order size.245 The 
requirement to display no more than the required size for market 
makers' and specialists' own orders should reduce any disincentives to 
use ECNs that could otherwise result from the ECN amendment, and 
responds to the concern that disclosure of the full size of the order 
in the market maker's or specialist's quote could impede its ability to 
execute the order.246 Moreover, permitting the display of customer 
orders of less than the minimum quote size should reduce the potential 
burden on a specialist or market maker of having to publish a public 
quote for more than the customer's order size when the customer's order 
is for less than the minimum quotation size required by the 
specialist's or market maker's exchange or association.
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    \245\ As discussed supra in footnote 144, SROs may wish to allow 
market makers or specialists to quote in sizes smaller than the 
minimum quotation increment when the quote represents a customer 
limit order.
    \246\ The Commission received several comments that support this 
aspect of the proposal. See, e.g., Lehman Letter; and Smith Barney 
Letter. These commenters believe that display of full size in a 
market maker's quote could impair the quality of an execution 
obtained for a customer because the display in the public quotation 
system is broader than the display in the ECN.
---------------------------------------------------------------------------

    Market makers and specialists who avail themselves of the ECN 
display alternative will be required to furnish to the public quotation 
system the full size of the best buy and sell orders they enter into 
the ECN. The Commission believes that the display of full size by the 
ECN will help inform the public market of the true trading interest 
entered by specialists and market makers, without impeding the 
execution of these orders by disclosing the identity of the specialist 
or market maker placing the order. Under the ECN display alternative, 
the market maker or specialist will be able to continue to represent 
the order on an anonymous basis both in the ECN and in the public

[[Page 48311]]

quote, substantially reducing any negative impact of the amendment on 
ECN users.
    Where the order entered by the market maker or specialist is on 
behalf of a customer, the display of full size under the ECN display 
alternative is consistent with the requirement under the Display Rule, 
which requires market makers and specialists to display the full size 
of their customer limit orders. Therefore, the full size of customer 
limit orders will be displayed whether the specialist or market maker 
displays the order itself or enters the order into an ECN complying 
with the ECN display alternative.247
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    \247\ The Commission notes that the exceptions under the Display 
Rule for limit orders of block size and for limit orders that a 
customer has asked not to be displayed will not apply to customer 
limit orders entered by a market maker or specialist into an ECN. If 
entered into an ECN, these orders must either be reflected in the 
market maker's or specialist's own quote or displayed via the ECN 
alternative. As discussed previously, the Commission believes that a 
customer should have discretion to permit a market maker or 
specialist to handle its limit order without public display, and 
large limit orders should not be required to be displayed unless the 
customer makes a request. However, the Commission does not believe 
these orders should be withheld from public display if they are 
being displayed in an ECN. The Commission believes that if these 
orders, when handled by market makers or specialists, are displayed 
widely through an ECN to the ECN's subscribers, then they should 
also be displayed to the public generally. Moreover, limiting 
display to only one market would be inconsistent with Congress's 
goal for a NMS in which trading interest in disparate markets would 
be consolidated and publicly disseminated.
---------------------------------------------------------------------------

    The Commission believes that the concerns expressed by some 
commenters about a potential loss of liquidity resulting from the 
proposal have been substantially addressed by the alternative adopted 
today. Because this alternative preserves the anonymity some ECNs 
afford to the users of their systems, the proposal maintains incentives 
for subscribers to continue participating in such systems. In fact, a 
market maker or specialist, who presumably wants its orders executed at 
prices it is widely displaying through the ECN, should benefit from 
attracting greater trading interest by having the prices of its orders 
displayed to the entire market.
    Finally, under the proposal, priced orders of institutions and 
other non-market makers entered directly into ECNs would not be 
required to be reflected in the public quote. Some commenters 
criticized the proposal because it did not require the inclusion of all 
better priced orders in the public quote. This result, however, is 
consistent with existing quotation principles. Institutional bids, 
offers, and orders handled independent of a market maker historically 
have been outside the scope of the Quote Rule, and the Commission's 
proposal was not intended to expand the scope of the Quote Rule in this 
respect.248 Furthermore, the Commission believes that, although 
institutional investors' direct orders in ECNs provide valuable 
liquidity, the amendments will substantially strengthen the public 
quotation system by publishing orders entered by market makers and 
specialists without creating new requirements for orders not controlled 
by market makers or specialists.249 Nevertheless, the Commission 
will continue to monitor closely issues involving the display of prices 
published by institutions in light of the Quote Rule and its 
objectives.
---------------------------------------------------------------------------

    \248\ The fact that ECNs will continue to contain institutional 
investors' orders priced better than the public quotes will provide 
another incentive for market participants to continue to participate 
in those systems.
    \249\ The Commission notes that, as described in the 
Commission's 21(a) Report, institutions trading with dealers or 
others accounted for less than 20% of trades in one ECN (Instinet). 
See Appendix to the 21(a) Report at A-11.
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iii. Technology and Innovation
    Some commenters predict that the proposal may have a chilling 
effect on technological innovation, primarily because the proposal 
applies only to ECNs and not to all available communication 
technologies that may be used for disseminating interest to buy and 
sell a particular number of shares at a specified price.250 Some 
commenters argue that the proposal is anti-competitive and otherwise 
antithetical to the purposes of the Exchange Act because it will deter 
future technological advances in automated trading environments by 
favoring less automated trading methods (e.g., telephone 
transactions).251
---------------------------------------------------------------------------

    \250\ See DOJ Letter; SIA Letter; Instinet Letter; Schwab 
Letter; STI Capital Letter; Sutro Letter.
    \251\ See, e.g., Instinet letter.
---------------------------------------------------------------------------

    The Commission is cognizant of the importance of the continued 
development of innovative trading systems and services. New 
technologies have expanded the ways in which investors' buying and 
selling interest can be brought together and have fostered additional 
competition in the securities markets. The Commission believes that 
this competition should be encouraged. Nonetheless, to promote 
competition, efficiency, and transparency in the securities markets, 
and insure the integrity of publicly available information, the 
Commission believes it is appropriate to set minimum standards that 
apply to the entry of the functional equivalent of quotations by market 
makers and specialists in trading systems.252 Indeed, consistent 
with the Commission's experience with previous NMS initiatives,253 
these minimum standards will permit and foster the development of new 
technologies that improve the public availability of trading 
information, while discouraging practices that are inconsistent with 
the purposes of the 1975 Amendments. The Commission believes that the 
Quote Rule as amended will not unduly diminish the beneficial services 
provided by existing ECNs, nor will it stifle the development of new 
trading technologies or new ECNs.
---------------------------------------------------------------------------

    \252\ The Commission notes that the focus of the proposal is not 
on any particular system or systems but, rather, on the types of 
orders that are the fundamental equivalent of quotations, and the 
fragmented market that results when the prices of these orders are 
not integrated into publicly available quotations.
    \253\ See Simon and Colby, supra note 58. The Commission also 
notes the growth in technologies over the past twenty years, 
including broker-dealer and exchange automated execution systems, 
that clearly rely on, and were facilitated by, successful operation 
of NMS and joint industry initiatives such as the Quote Rule, CTA, 
and the ITS Plan.
---------------------------------------------------------------------------

iv. Alternative Approaches
    In the Proposing Release, the Commission suggested alternatives to 
the proposal, and solicited comment on these alternatives. The 
Commission also invited commenters to suggest possible alternatives. 
The Commission specifically asked whether it should require ECNs to 
furnish prices to the applicable exchange or association for public 
dissemination and to provide some access, such as a linkage, to the 
prices in the ECN.254 A number of commenters supported this 
approach.
---------------------------------------------------------------------------

    \254\ See Proposing Release and e.g., NASD Letter.
---------------------------------------------------------------------------

    The NASD recommended, as an alternative to the proposed rule, that 
the better ECN price be reflected in the inside market, rather than in 
individual quotes. Under the alternative described by the NASD, an ECN 
would report its best market maker or specialist inside prices to the 
SRO that is the primary market in the security. The NASD also 
recognizes that more assured access to orders in the ECNs would be 
necessary under this option.255 Similarly, one commenter agreed 
that the inside market available to the public should reflect the best 
bid and offer prices whether in a market maker's quote or in a market 
maker's order on an ECN. The Commenter suggested that this could be 
accomplished by requiring quotations in ECNs to be made part of the 
public quotation and by separately identifying the ECN into which the 
order is entered rather than the market maker that

[[Page 48312]]

placed the order.256 Finally, certain commenters state that 
expanding ITS to include orders entered into ECNs would be a better 
alternative to the proposal.257
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    \255\ See NASD Letter.
    \256\ Morgan Stanley Letter. See also, PaineWebber Letter 
(recommending that priced orders in ECNs be included in the NBBO).
    \257\ See, e.g., STAIC Letter; ICI Letter.
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    The Commission believes that the ECN display alternative adopted 
today is consistent with these suggested alternatives and will minimize 
many of the asserted negative effects of the rule. The adopted 
provision provides an alternative to an ECN that disseminates 
specialists' and market makers' best prices to the public quotation 
system. Thus, the amendment enables a market maker or specialist to 
comply with the Quote Rule either directly by sending to its exchange 
or association the prices of orders it places into ECNs that improve 
the market maker's or specialist's public quote, or indirectly by using 
an ECN that transmits the best prices entered therein by market makers 
and specialists for publication in the public quotation system.
    The ECN display alternative is consistent with the alternative 
recommended by the NASD because the adopted provision enables the 
specialists' or market makers' best prices in ECNs to be consolidated 
with the exchange's or association's best prices for dissemination 
within the consolidated quotes. In addition, the adopted amendment 
requires the ECNs to provide an equivalent means of access to those 
best prices.
    The Commission recognizes that this alternative may reduce the 
content of information that is publicly available because under the ECN 
display alternative, the identity of the market maker or specialist 
that entered the better priced order in the ECN will be 
withheld.258 The Commission believes this result is justified 
because the inside prices and full sizes of orders entered by market 
makers and specialists will be in the public quotation system to inform 
the entire market of these prices and ECNs will provide equivalent 
access to those prices. Moreover, the Commission believes the benefits 
of facilitating the use of ECNs, by permitting the continued anonymity 
of market makers and specialists, more than offset the reduced 
information available on the identity of a particular market maker or 
specialist.
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    \258\ The Commission also notes that under the alternative, a 
specialist or market maker that puts an order into an ECN that is 
priced better than that specialist's or market maker's public quote, 
but is not the best priced quote from any specialist or market maker 
in the ECN, will not have its better priced order reflected in the 
public quote. The prices will be displayed, however, if the better 
price in the ECN is executed or withdrawn and the lower specialist's 
or market maker's priced quote then becomes the best priced quote.
---------------------------------------------------------------------------

    As an alternative to the ECN amendment, certain commenters 
suggested that enforcement of best execution principles would be 
sufficient to protect public investors.259 As discussed in more 
detail in section III.C.2., the Commission does not believe this is a 
practical alternative because ECNs do not provide broker-dealers with 
automated links and thus may not be reasonably available for the 
handling of retail orders on an automated basis. Furthermore, investors 
and their brokers cannot efficiently ascertain if they have received 
the best prices for their orders if publicly available prices do not 
reflect the best prices at which specialists and market makers are 
willing to trade. Under these circumstances, providing customers the 
best executions available can be achieved most effectively by ensuring 
that the consolidated quotes systematically include the better prices 
that market makers and specialists have entered into an ECN.
---------------------------------------------------------------------------

    \259\ See, e.g., Instinet Letter.
---------------------------------------------------------------------------

    Finally, certain commenters argue that, as an alternative to 
adopting the ECN proposal, the Commission should defer any action until 
further study is completed on the use of ECNs because the Proposing 
Release provides insufficient data regarding whether customers 
currently get the best available price, or market maker and specialist 
use of ECNs results in harm to customers.260 The Commission has 
determined to go forward with the amendments now because of compelling 
concerns presented by two-tiered markets. Many of the commenters to the 
proposed rules also recognize these concerns. Furthermore, as part of 
its recently concluded Nasdaq investigation, the Commission has 
conducted an extensive analysis since the proposals were published that 
supports the Commission's proposal and clearly evidences the existence 
of a ``two-tiered'' market in which customer orders are executed at 
publicly available prices inferior to prices contemporaneously 
available in existing ECNs.261 Moreover, Commission data shows 
that the pricing opportunities available in at least two ECNs (Instinet 
and SelectNet) are not limited to block trades, but extend to smaller 
orders executed in the system.262 The Commission believes, 
therefore, that further study is not necessary to address a structural 
disparity in market information that disadvantages investors who lack 
access to ECNs.
---------------------------------------------------------------------------

    \260\ See, e.g., Instinet Letter, asserting that the Commission 
should obtain and study data on this matter and that, absent such 
data, adoption of the proposed amendment is unwarranted.
    \261\ As discussed previously, the Commission believes the data 
it has reviewed supports the need for prompt adoption of the ECN 
amendment to the Quote Rule. See supra notes 222 and 223, and 
accompanying text. Given the strong evidence that investors would 
benefit from public dissemination of the hidden prices that are 
broadly disseminated to subscribers in these systems, the Commission 
believes that it is appropriate to adopt the amendments to the Quote 
Rule.
    \262\ As noted above, the Appendix to the 21(a) Report states 
that average trade size for Nasdaq NMS securities on Instinet was 
approximately 1,600 shares for the period studied, while the average 
trade size generally in the securities was approximately 1,900 
shares. See Appendix to the 21(a) Report at A-8.
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c. Operation of the Rule Amendment
i. Definition of the Term ``Electronic Communications Network''
    The proposed amendment did not specifically define the term 
``electronic communications network.'' The Commission did state, 
however, that priced orders that market makers and specialists enter 
into certain ECNs are bids and offers for the purposes of the Quote 
Rule.263 The proposal applied to systems that widely disseminate 
priced orders to third parties and permit such orders to be executed 
against in whole or in part. The Commission further explained that the 
term ``electronic communications network'' was intended to include 
continuous auction trading systems, but was not intended to include 
crossing systems or broker-dealer internal order routing systems.
---------------------------------------------------------------------------

    \263\ As a result, relevant provisions of the Quote Rule, such 
as the obligation on exchanges and associations to disseminate 
quotes, and the firmness requirement placed on a market maker or 
specialist who furnishes the quotes, become operative with respect 
to a security when a market maker or specialist enters an order for 
that security into an ECN. See section III.B.2.c.v., infra.
---------------------------------------------------------------------------

    Several commenters suggested the need for a definition of the term 
``electronic communications network.'' 264 The Commission agrees 
that it is appropriate to define the term in the Quote Rule and has 
decided to adopt a definition that reflects the fundamental 
characteristics of an ECN as discussed in the Proposing Release.
---------------------------------------------------------------------------

    \264\ See Goldman Sachs Letter; Instinet Letter; Schwab Letter. 
In addition, one commenter argues that ECNs should include SRO stock 
crossing systems and all non-market-maker broker-dealers. NYSE 
Letter.
---------------------------------------------------------------------------

    As discussed earlier, the objective of the ECN amendment is to 
incorporate within the consolidated public quote firm prices quoted by 
market makers and specialists in securities markets that widely 
disseminate those prices but are not registered as exchanges or 
associations and thus are not integrated

[[Page 48313]]

into the NMS. Therefore, the Commission has defined the term ``ECN'' as 
an electronic system that widely disseminates to third parties 265 
orders entered therein by a market maker or specialist, and permits 
such orders to be executed against in whole or in part. The definition 
specifically excludes any system that crosses multiple orders at one or 
more specified times at a single price set by the system and that does 
not allow orders to be crossed or executed against directly by 
participants outside of such times. This exclusion is consistent with 
statements made in the Proposing Release that it was not the 
Commission's intention to cover crossing systems because these systems 
do not communicate to multiple market participants the prices at which 
system subscribers are willing to trade. Rather, the excluded crossing 
systems themselves establish an internal trading price for subscribers 
on an episodic basis.266
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    \265\ The Commission intends the term ``third parties'' to refer 
to subscribers to the ECN, other than the ECN and the market maker 
or specialist that is entering its priced order into the ECN. The 
ECN also may disseminate to others, including non-subscribers.
    \266\ The Commission notes that broker-dealers that publish 
quotes through a vendor are already covered by the rule.
---------------------------------------------------------------------------

    The ECN definition also excludes any system operated by, or on 
behalf of, a market maker or specialist that executes customer orders 
primarily for its own account as principal, other than as riskless 
principal. This exclusion is intended to ensure that, as discussed in 
the Proposing Release, internal broker-dealer order routing systems in 
which the market maker trades primarily with customer orders on a 
principal basis are not ECNs within the scope of the amendment. The 
exclusion would not except from the ECN definition systems that involve 
multiple market makers or specialists competing as principal in a 
security or that cross multiple market maker and customer orders.
    Furthermore, the Commission believes the definition should be read 
broadly to include systems that match orders internally and deliver the 
matched order to some other market for execution. Thus, the term 
``permits such orders to be executed against'' should not be read to 
exclude systems where a narrow technical reading of ``executed'' is the 
only reason that the system would not fall within the ECN definition. 
For example, if a system puts buy orders and sell orders together for 
execution, completes all necessary elements of the trade, and then 
sends the matched pair to an exchange or association merely to print 
the terms of the trade on the Consolidated Tape, the system would be an 
ECN.
ii. ``Priced Orders'' in ECNs
    Under this definition, the Commission intends to include in the 
public quotation system firm prices for securities entered by market 
makers or specialists, whether such firm prices are labeled as 
``quotes'' or ``orders.'' The Commission believes that priced orders 
entered by market makers or specialists into ECNs where the orders are 
widely disseminated and executable are the functional equivalent of 
market maker or specialist quotations, and like quotations, play a key 
role in the price discovery process. The Commission thus believes that 
these ``quotation-equivalents'' should be made part of the public 
quote.
    Although some commenters argue that priced orders entered into ECNs 
are more closely parallel to prices communicated over the telephone to 
other market makers than to market quotes, the Commission recognizes a 
fundamental distinction between limited communication of price in 
bilateral telephone negotiations and broad exposure of firm prices to 
multiple participants in a market.267 Accordingly, prices 
communicated by telephone are excluded because these prices generally 
are not widely disseminated to other parties for execution. The rule 
also would not cover indications of interest that do not constitute 
firm prices.
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    \267\ The Commission recognizes that market makers and 
specialists may be willing to trade with certain customers at 
better, negotiated prices, such as when market makers negotiate with 
customers over the telephone. In contrast, however, the prices 
quoted by market makers and specialists in ECNs are widely 
disseminated to market participants. In adopting the ECN amendment, 
the Commission is reaffirming the NMS principle that prices 
advertised in one market must be integrated into the national 
market--that is, the consolidated public quote.
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    In this connection, the Commission intended the term ``priced 
order,'' which is deemed under the ECN amendment to be a bid or offer, 
to encompass commitments to buy or sell a security at a particular 
price for a particular number of shares. The Commission also does not 
intend the term ``priced orders'' to include interest to buy or sell a 
security where price or the number of shares is not specified to system 
subscribers, unless the price or size is otherwise understood as part 
of the system's operation.268 The ECN amendment would, however, 
include priced orders entered into an ECN by a market maker or 
specialist that are visible only to some system subscribers if these 
orders can be executed against in the ECN. The ECN amendment is 
intended to require the public display of priced orders entered into 
ECNs by market makers and specialists where these priced orders are 
similar to quotations. Accordingly, the Commission does not intend the 
ECN amendment to apply to a priced order that is entered into an ECN by 
a market maker or specialist merely in order to execute against an 
existing order visible in the ECN, and not entered to elicit other 
buying or selling interest. If, however, the order entered by the 
market maker or specialist does not in fact execute immediately in full 
against an existing order but rather is itself disseminated as an open 
order in the ECN, the market maker or specialist must comply with the 
requirements of the ECN amendment with respect to the order.
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    \268\ The definition of an ECN specifically excludes any system 
that crosses multiple orders at one or more specified times at a 
single price set by the ECN (by algorithm or by any derivative 
pricing mechanism) and does not allow orders to be crossed or 
executed against directly by subscribers outside of such times. See 
11Ac1-1(a)(8).
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    In order to ensure that customers consistently receive the benefit 
of better prices entered into ECNs, a market maker or specialist 
entering an all-or-none or minimum size order for its own account into 
an ECN would be required to include this price in its public quote, or 
disseminate the price via the ECN display alternative, and thereby 
publicly display the order for the full number of shares for execution 
in whole or in part. Although the execution of an all-or-none order is 
typically conditioned on execution of the entire size of the order, the 
Commission believes that allowing market makers to avoid public display 
of an unconditional quote when using this type of order could seriously 
undermine the purposes of the rule.269 The rule will permit, 
however, a market maker or specialist to enter an all-or-none customer 
order into an ECN without requiring public display of the quote for 
that order where the customer specifically requests that the order be 
executed on an all-or-none basis. This latter provision accommodates 
the desire of some customers to trade only at a specific size 
associated with a specific price.
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    \269\ All-or-none and minimum size orders are rarely used by 
market makers and specialists in ECNs and are prohibited from being 
included in the public quotes by the registered exchanges and 
Nasdaq.
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iii. ECN Display Alternative
    Pursuant to the amendment as adopted, a priced order entered by a 
market maker or specialist into an ECN that widely disseminates the 
order is deemed to be a bid or offer for the

[[Page 48314]]

purposes of the market maker's or specialist's quotation reporting 
obligations under the Quote Rule. As a result, specialists and market 
makers are required to include such orders in the bids and offers they 
communicate to their exchange or association for inclusion in the 
published quotations made available by the exchange or 
association.270
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    \270\ An OTC market maker that places priced orders for 
execution into any ECN will in effect be making an election to 
communicate quotations to its association bids, offers and quotation 
sizes in the security. See 11Ac1-1(a)(25)(ii)(B).
---------------------------------------------------------------------------

    As discussed above, in response to the concerns of some commenters, 
the adopted amendment includes an alternative to the specialist or 
market maker itself revising its public quotation to reflect its better 
priced order entered in an ECN. This alternative allows the ECN to act 
as an intermediary in communicating to the public quotation system the 
best price and size of orders for each security that have been entered 
into the ECN by a specialist or market maker. To communicate the 
quotations publicly, the ECN must submit the best price entered by a 
specialist or market maker to an exchange or association, or to a 
securities information processor acting on behalf of one or more 
exchanges or associations.
    The alternative reduces the impact of the amendment on specialists 
and market makers because they have a choice regarding how to comply 
with their obligation. This alternative also reduces the impact of the 
amendment on ECNs by offering these systems an opportunity to provide 
additional services to their subscribers, and creating an opportunity 
to generate additional order flow from non-subscribers. At the same 
time, more accurate prices are provided through public quotation 
systems than are currently available.
    Under this alternative, consistent with the goals of the initial 
proposal, the ECN must comply with two conditions. First, the ECN must 
provide the best prices and sizes that market makers or specialists 
have entered in the ECN to the public quotation system for inclusion in 
the consolidated quotation. The market maker or specialist responsible 
for the price does not have to be identified.271 The ECN must, 
however, at a minimum, publicly identify itself as the originating 
system for these prices. Accordingly, if a market maker puts an order 
that improves the NBBO into an ECN and the ECN disseminates that price 
to the public quotation system, the disseminated price must either be 
identified as originating from the market maker or from the ECN.
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    \271\ An ECN that does not offer the option of anonymity to its 
subscribers could choose to include the identity of the market maker 
or specialist with the prices furnished to the SRO for public 
dissemination. As discussed below, the ECN also must provide access 
to these prices.
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    Second, the ECN must provide non-subscriber brokers and dealers 
with a means of access to those prices entered in the ECN by market 
makers and specialists. This access must be equivalent to the access 
that would have been available for the relevant security if these 
prices had been published in the market makers' or specialists' 
quotation.272 The extent and form of this access will depend on 
the form(s) of access available in the market to which the ECN supplies 
the bids and offers for public dissemination.273
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    \272\ For access to be ``equivalent'', the ECN must enable non-
subscribing broker-dealers to execute against the ECN's published 
best price to the same extent as would be possible had that best 
price been reflected in the public quote of a specialist or market 
maker. The ECN, however, may impose charges for access to its 
system, similar to the communications and systems charges imposed by 
various markets, if not structured to discourage access by non-
subscriber broker-dealers.
    \273\ The extent and form of the access will not necessarily be 
the same as the access available in the market to which the 
specialist or market maker would otherwise supply its bid and 
offers.
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    For example, market makers in Nasdaq NMS and SmallCap securities 
typically can be reached through the telephone and through the NASD's 
Small Order Execution System. Therefore, an ECN that chooses, pursuant 
to the alternative, to act as an intermediary for its market maker and 
specialist subscribers for Nasdaq NMS and Smallcap securities would 
have to be prepared to receive and execute telephone orders from 
broker-dealers against those market makers' and specialists' orders 
entered in the ECN. The ECN will have to execute these orders promptly 
at the prices the market makers and specialists have entered into the 
ECN. In addition, because a market maker with the best price in a 
Nasdaq NMS security is subject to SOES executions, this equivalent 
access condition would require the ECN to provide broker-dealers who 
use SOES with equivalent automated access to the best priced market 
maker orders in the ECN. This could be accomplished either through an 
electronic linkage to SOES or by other means agreed upon with the NASD. 
For example, the ECN could supply the NASD with an identifier for the 
market maker who entered the best priced order, which the NASD could 
use in assigning SOES executions to that market maker.274
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    \274\ As discussed supra section II., the NASD has proposed a 
new facility, NAqcess, which, as part of its proposed services, 
would widely disseminate priced orders for execution in whole or in 
part. Supra note 45. As proposed, Naqcess would publish its best 
prices in the Nasdaq quotation system stream and would be accessible 
to all NASD members for order entry and execution against those 
orders. Thus, NAqcess, as proposed, would appear to make prices 
entered by market makers into NAqcess available, and provide 
equivalent access under the alternative. Therefore, a market maker 
that entered its best priced order into NAqcess would comply with 
the requirements of the ECN amendment without reflecting the order 
in the market maker's own quote. Moreover, a market maker that 
entered an order into another ECN at a price better than its quote 
could satisfy the requirements of the ECN amendment by entering an 
order reflecting this price into NAqcess, even if the other ECN does 
not directly provide the price to the public quotation system, 
because this use of NAqcess, as proposed, would meet the 
requirements of the amendment. Similarly, an ECN availing itself of 
the ECN display alternative could provide prices directly to 
NAqcess. The ECN and the NASD also could develop mechanisms to 
ensure public anonymity of market makers that use ECNs, while 
providing to the NASD the identity of the market makers that are at 
the inside quote solely for the purpose of direct order-routing 
between NAqcess and the market maker.
---------------------------------------------------------------------------

    Similarly, in exchange-listed securities, the degree of access that 
the ECN must offer would depend on the current access that the market 
receiving the information from the ECN offers to broker-dealers in the 
relevant type of security. If the ECN communicates prices for exchange-
listed securities to an exchange, the specialist or market maker orders 
in the ECN must be accessible to broker-dealers in the same manner as 
quotes on that exchange. This access would include any automated 
execution features offered to broker-dealers by the exchange. The ECN 
must provide to the exchange, or to the exchange specialist in each 
security, access to the market maker or specialist orders in the ECN. 
Such access must provide broker-dealers with the ability to enter and 
obtain executions for their orders at least as promptly as that 
exchange offers to its own members through its order-routing and 
execution systems. Because the ITS Plan applies to exchange-trading of 
listed securities, orders received from other markets through ITS must 
have the same ability to trade with ECN orders whose prices are 
displayed through the exchange as they have with the exchange's own 
quotations. For instance, if the exchange specialist typically receives 
incoming ITS commitments and executes them manually, the ECN must at a 
minimum enable the incoming ITS commitment to be manually entered into 
the ECN for execution.
    If the ECN instead provides orders in exchange-listed securities to 
the NASD for inclusion in the public quotation system, the orders must 
be as accessible to broker-dealers as the quotes published by third 
market makers in

[[Page 48315]]

exchange-listed securities. At a minimum, these prices must be included 
as part of the third market quotation display and identified as 
originating from a named market maker or from a named ECN. For non-Rule 
19c-3 securities, broker-dealers must be able to contact the ECN by 
telephone and have an order promptly entered into the ECN for 
execution. For Rule 19c-3 securities, the ECN also must be accessible 
through the ITS/CAES linkage, operated by the NASD, in the same manner 
as other third market maker quotes in those securities.275
---------------------------------------------------------------------------

    \275\ As discussed below concerning expansion of the ITS/CAES 
linkage, currently non-Rule 19c-3 securities may not be traded via 
the ITS/CAES linkage.
---------------------------------------------------------------------------

    Under the ECN display alternative, the ECN must furnish to an 
exchange or association the full size associated with the best priced 
orders placed in the ECN by market makers and specialists to buy and to 
sell a security. This full size requirement under the alternative is 
intended to give the public information about the depth of the market 
at the ECN prices, while maintaining the anonymity of market makers and 
specialists. For example, if an ECN is furnishing quotation information 
to Nasdaq under this alternative, and a market maker enters a 4,000-
share order into the ECN at a price that is better than other market 
maker or specialist prices for that security in the ECN, the ECN will 
be required to provide Nasdaq that price and size of 4,000 shares as a 
quotation for public dissemination. If 2,500 shares of this order is 
executed, the ECN must display the remaining 1,500 shares. If two 
market makers enter 4,000-share orders for a security at the same 
price, which is the best price in the ECN for that security, the ECN is 
required to show all 8,000 shares publicly. In contrast, if a market 
maker enters a 100-share order for a Nasdaq security at the best price 
in the ECN for that security, the alternative requires the ECN to 
furnish the price for only 100 shares, even though NASD rules require 
Nasdaq market makers to display no less than 1000, 500, or 200 shares 
in Nasdaq, depending on the characteristics of that security.
    The Commission recognizes that the means of providing equivalent 
access will vary for different markets, and that ECNs operating under 
the ECN display alternative that currently do not provide access to 
their systems to non-subscribers will have to develop methods to 
provide this access. Meeting this requirement may be achieved in a 
variety of ways, including a linkage between ECNs and one or more of 
the SROs. The Commission believes an SRO that accepts the prices 
provided by an ECN for publication should be authorized to impose 
reasonable rules related to the public dissemination of those prices 
upon market makers and specialists who avail themselves of this 
alternative. The rules an SRO imposes in this regard, however, may not 
establish standards for the dissemination of these prices that are more 
burdensome for market makers and specialists using ECNs than the SRO 
rules that apply to quotations delivered directly to the SRO by 
specialists and market makers.
    The Commission looks forward to working closely with all market 
participants to effect the necessary market developments to ensure that 
this alternative method of compliance with the Quote Rule is made 
possible. In order to ensure prompt implementation of the necessary 
changes before the effective date of the rule amendments, the 
Commission requests each SRO, individually or jointly as signatories to 
the CQS Plan, to notify the Commission in writing by October 28, 1996 
regarding its willingness and its plan to afford ECNs the opportunity 
to communicate, for inclusion in the public quotation system, the 
prices of market makers and specialists.
    In order to implement the changes to the Quote Rule under new 
subsection (c)(5), the prices sent to an ECN by market makers and 
specialists will have to be displayed in the public quotations 
disseminated by SROs, and order routing or access linkages will have to 
be in place. After hearing from the SROs, the Commission will determine 
whether it will be necessary to use its authority under Section 
11A(a)(3)(B) of the Exchange Act to require the SROs to act jointly to 
provide means to accomplish these objectives.
iv. Minimum Price Variations
    In the Proposing Release the Commission recognized that there may 
be different minimum price variations in any given security between the 
SROs providing a market for the security and ECNs through which the 
security is also traded. Currently most exchange-listed securities tend 
to be quoted and traded with a minimum price variation of \1/8\ point 
or \1/16\ point.276 Nasdaq securities can be publicly reported in 
variations as low as \1/64\, and can be quoted in minimum variations as 
low as \1/32\, depending on the price at which the security 
trades.277 Some ECNs allow priced orders in variations as low as 
\1/256\; other systems provide for orders priced in decimals as small 
as one cent.
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    \276\ NYSE Rule 62 provides that bids or offers in stocks 
selling above one dollar per share may not be made at a variation of 
less than one-eighth of a dollar or twelve and a half cents; Amex 
Rule 127 allows for one-sixteenth spreads for stocks priced under 
ten dollars, and one-eighth spreads for stocks priced ten dollars 
and over.
    \277\ The NASD does not have a minimum variation policy for 
Nasdaq stocks. Nasdaq, however, is designed to process quotes and 
trades in particular minimum variations.
---------------------------------------------------------------------------

    Most commenters did not address the issue of ECN minimum price 
variations. Some commenters that did address the issue, however, 
recommended that the ECN quote be rounded for public dissemination 
either downward from or upward to better prices in increments of \1/16\ 
or smaller.278 Other commenters recommended rounding in 
decimals,279 while still others strongly opposed the use of 
decimals.280 One commenter asserted that non-standard increments 
(i.e., increments not approved by the primary market for the relevant 
security) should be prohibited in non-primary markets.281 To 
address situations where the priced order in an ECN is at a non-
standard increment, the Commission has determined that it is 
appropriate to interpret the ECN amendment to allow market makers and 
specialists to comply with the amendment (either individually or 
through the ECN) by rounding up or down to the nearest fraction 
accepted by the market disseminating the quote provided by the 
ECN.282 The Commission believes, however, that rounding is 
appropriate only if the rounded public quotes are accompanied by an 
identifier that marks the quote as rounded.283 Market makers, 
specialists, and ECNs will be permitted to round the prices of ECN buy 
orders

[[Page 48316]]

down to the nearest quote increment, and round the prices of ECN sell 
orders up to the nearest increment. For example, under this 
interpretation, if a market maker or specialist enters a priced buy 
order into an ECN at 10\5/16\ and the market receiving the price from 
the ECN for dissemination has a minimum quote increment of \1/8\, a bid 
of 10\1/4\ will be displayed in the public market and identified as a 
rounded price. This result reflects an SRO rule that prohibits 
dissemination of quotes in \1/16\ variations. If the market maker or 
specialist already is bidding publicly at 10\1/4\ when it enters the 
10\5/16\ buy order in an ECN, the market maker or specialist publishing 
a quote must reflect the ECN order by identifying its 10\1/4\ bid as 
rounded.
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    \278\ See, e.g., NASD Letter; Lehman Letter; Instinet Letter.
    \279\ See, e.g., Letter from Leslie M. Marx, Assistant Professor 
of Economics and Management, and Eugene Kandel, William E. Simon 
Graduate School of Business Administration, University of Rochester, 
to Commissioner Steven Wallman, SEC, dated November 27, 1995 (``Marx 
and Kandel Letter''), concluding that the markets should move toward 
decimal pricing.
    \280\ See CHX Letter.
    \281\ See Madoff Letter.
    \282\ The Commission believes this alternative is preferable to 
imposing particular trading increments on the markets. At the same 
time, however, this alternative will provide the markets with an 
incentive to voluntarily move towards finer trading increments.
    \283\ In order to facilitate compliance with the rule, it will 
be necessary for SROs to provide a means for rounded prices to 
include a ``rounded'' identifier that makes clear that a better 
price is available in the ECN. The Commission notes that SROs, and 
the public quotation system, may not currently have such a field 
available for identifying quotations as rounded. The Commission, 
therefore, requests that the SROs work jointly to modify the public 
quotation system to ensure that specialists, market makers, and ECNs 
that are disseminating rounded prices have the ability to 
distinguish those rounded quotes.
---------------------------------------------------------------------------

    In addition, market makers and specialists entering orders into 
ECNs that are reflected at rounded prices in the public quote will be 
expected to give their customers an execution at the superior non-
rounded price. Thus, the market maker or specialist quoting a rounded 
price of 10\1/4\ to reflect a 10\5/16\ buy order must give a customer 
sell order an execution at 10\5/16\ up to the published size. 
Similarly, an ECN providing market maker or specialist prices pursuant 
to the rounding alternative must execute an incoming order at the non-
rounded price. The Commission recognizes that it may not be feasible 
for market makers or specialists that have not entered the rounded 
order into an ECN to determine, in an efficient manner, the actual 
price of the better order in the ECN. This may particularly be true 
with respect to market makers or specialists operating automated 
execution systems. The Commission believes that it is appropriate in 
such instances for such market makers and specialists that did not 
enter the rounded order to execute orders at the displayed rounded 
price.284
---------------------------------------------------------------------------

    \284\ See also, section III.C.2. for a discussion of best 
execution, infra.
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    The Commission recognizes that this interpretation will allow 
prices in ECNs that are denominated in non-standard quotation 
increments not to be fully displayed, but believes this interpretation 
is appropriate to accommodate ECN prices in the existing public 
quotation system without imposing uniform trading increments.285 
The rounding identifier will inform investors that a better price is 
behind the rounded quote. Thus, even though the actual price cannot be 
readily displayed, investors will be aware of, and will be able to 
obtain, the better price in the ECN or from the market maker or 
specialist.
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    \285\ If primary markets in the future allow narrower quotation 
increments, these ECN prices between the existing quotation 
increments could be more accurately displayed in the public quote.
---------------------------------------------------------------------------

v. Effect on the Voluntary Aspect of the Quote Rule
    If an OTC market maker uses an ECN that does not rely on the 
alternative of communicating that market maker's best prices to the 
public quotation system, then the market maker must publish in its own 
quote that better priced order entered into the ECN. Once a market 
maker publishes a quote through its association to reflect a priced 
order it entered into an ECN, pursuant to Rule 11Ac-1(c)(5)(i)(A), it 
will be deemed to have elected to publish quotations in that 
security,286 and will therefore be subject to the quotation 
provisions of the Quote Rule. Moreover, pursuant to certain existing 
SRO rules,287 withdrawal of that quotation after the ECN order has 
been executed or withdrawn prevents the market maker from immediately 
reinstating quotes in that security.288 As a practical matter, 
once electing to quote, a withdrawal then precludes the market maker 
from continuing to enter priced orders for the security in an ECN 
because of the SRO prohibition on re-entering quotes after withdrawal.
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    \286\ 17 CFR 240.11Ac1-1(b)(5), as amended. See also, 17 CFR 
240.11Ac1-1(a)(25), 17 CFR 240.11Ac1-1(c)(4)(ii), and 11Ac1-
1(c)(5)(ii), as amended, acting jointly to ensure that OTC market 
makers publish quotations pursuant to the Quote Rule in securities 
they trade via ECNs.
    \287\ See NASD Manual, Marketplace Rules, Rule 4600 et. seq., 
Nasdaq Market Maker Requirements (requiring members to maintain 
continuous two-sided quotations in the Nasdaq securities for which 
they are registered as market makers). See also, ITS Plan, Section 
6(A)(i)(B), Furnishing Quotations (requiring each ITS Participant to 
furnish the current bid-asked quotation emanating from its floor or, 
in the case of the NASD, the best bid and offer emanating from ITS/
CAES market makers in eligible securities). Unexcused withdrawal of 
quotations violates these NASD rules and ITS provisions.
    \288\ This will be true even if the market maker traded less 
than 1% of the share volume in the security in the previous quarter 
because the 1% threshold of the Quote Rule for mandatory quotes 
would not exempt the market maker from disseminating quotes once the 
market maker has ``elected'' to quote the security by using the ECN.
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    The Commission solicited comment on this aspect of the ECN 
proposal. Although most commenters were silent concerning this issue, 
certain comments indicate confusion as to the effect on market makers 
who currently use ECNs but who do not voluntarily quote under the 
existing Quote Rule.289 The Commission, therefore, reiterates that 
the combined operation of the ECN amendment and SRO rules may require a 
market maker or specialist who enters an order into an ECN that does 
not rely on the ECN display alternative, and publishes a quote 
reflecting that price, to continue to publish quotes in the public 
market regardless of the number of shares traded by the market maker or 
specialist in the security during the previous quarter.
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    \289\ See, e.g., Madoff Letter; Instinet Letter. In its comment 
letter, Instinet notes that some market makers that make a 
continuous market in a security, but do not normally publish 
quotations in that security, will now be required to disseminate 
quotations for that security if the market maker places a priced 
order for that security on an ECN. The Commission recognizes this 
result, but notes the ECN display alternative of allowing such 
market makers to continue to place orders in a security into an ECN 
without having to directly publish quotes in that security.
---------------------------------------------------------------------------

    In determining whether a market participant will be required to 
publish quotes after entering orders in an ECN, the Commission notes 
that, with respect to any given security, the quote rule requirements 
only apply if the market participant falls within the definition of the 
term ``OTC market maker'' for that security. To be an OTC market maker, 
the participant must hold itself out as willing both to buy and sell on 
a regular or continuous basis.290
---------------------------------------------------------------------------

    \290\ Rule 11Ac1-1(a)(8), as amended.
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    The ``OTC market maker'' definition is not intended to capture 
subscribers who enter orders into ECNs on one side of the market to 
limit or offset their risk, such as options market makers who use ECNs 
to hedge their positions in the securities underlying the options they 
trade. They would not be required to publish public quotes in a 
security simply because they had entered an order for the security into 
an ECN, unless they regularly or continuously hold themselves out as 
willing to buy and sell the security. An entity that holds itself out 
via contract, marketing, or other communications with its customers, as 
being willing both to buy and sell a specific security on a regular or 
continuous basis would be an ``OTC market maker'' for the security. 
This latter market maker's entry of a superior priced order into an ECN 
for a security that itself does not publish quotes would compel the 
market maker to publish a quote and potentially, depending on SRO 
rules, trigger on-going quotation obligations.
vi. Exemptive Relief
    Finally, the Commission is amending Section (d) of the Quote Rule 
concerning exemptive relief. Under that section, the Commission 
previously could exempt from the provisions of the Quote Rule, either 
conditionally or on specified terms and conditions, any responsible 
broker or dealer (which now will include a specialist or market

[[Page 48317]]

maker under the ECN amendment), exchange, or association if the 
Commission determined that such an exemption was consistent with the 
public interest, the protection of investors and the removal of 
impediments to and perfection of an NMS. The Commission is adding a 
provision allowing it to exempt an ECN from the definition in the rule. 
The Commission did not solicit comment on expanding its authority to 
grant exemptive relief in this manner. The Commission believes, 
however, that the added exemptive authority is appropriate because it 
provides flexibility in applying the ECN amendment.
3. Amendments to the Quote Rule Concerning Definitions
a. Introduction
    In the Proposing Release the Commission proposed to expand the 
Quote Rule's existing requirements to include quotation information 
from broker-dealers that, while internalizing order flow, hold 
themselves out as willing to buy and sell on a regular or continuous 
basis. This expansion of the Quote Rule would be accomplished by 
amending the definition of OTC market maker. The Proposing Release also 
recommended that quotation requirements be imposed on substantial 
broker-dealers in non-Rule 19c-3 securities by amending the definition 
of subject security, and on broker-dealers in Nasdaq SmallCap 
securities by amending the definition of covered security.291 In 
putting forward this proposal, the Commission noted that some dealers 
quote on a selective basis, choosing not to display quotes for 
securities that they actively trade because these securities are 
subject only to the voluntary quote provisions of the Quote Rule.
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    \291\ OTC market makers and specialists are not required by the 
Quote Rule to provide continuous two-sided quotations for any Nasdaq 
security. As amended, an OTC market maker or specialist may make an 
election, pursuant to paragraph (b)(5)(i) of the Quote Rule, to 
collect, process, and make available quotations for Nasdaq NMS or 
Nasdaq SmallCap securities. The Commission is soliciting comment on 
a proposed amendment which would require continuous two-sided 
quotations from OTC market makers and specialists responsible for 
more than 1% of the aggregate transaction volume for a Nasdaq 
security. See Companion Release.
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    The amendments adopted by the Commission today are substantially 
the same as those proposed.292 The Commission believes these 
amendments will benefit investors by improving price discovery and 
liquidity, and increasing competition between OTC market makers and 
specialists. The Commission further believes that these amendments are 
in keeping with Congress's directive that the Commission use its 
rulemaking authority to remove impediments to competition.
---------------------------------------------------------------------------

    \292\ The only substantive difference between the amendments as 
adopted today and as proposed is the definition of the term ``OTC 
market maker.'' The definition as proposed read ``* * * sell to a 
customer * * *'' but has been modified to read ``* * * sell to its 
customers * * *.'' Rule 11Ac1-1(a)(13), 17 CFR 240.11Ac1-1(a)(13). 
See infra note 308.
    In addition to the amendments discussed in detail herein, the 
Commission is making technical, non-substantive amendments to the 
Quote Rule. The terms ``association'', ``revised bid or offer'', and 
``revised quotation size'' will be separately defined in the rule. 
The definition of ``exchange-traded security'' has been revised to 
exclude OTC securities traded on an exchange pursuant to unlisted 
trading privileges. The definition of ``plan processor'' has been 
amended to reflect the appropriate cross-reference. The definition 
of ``principal market'' has been removed from the Quote Rule because 
it is no longer applicable. In addition, the definitions have been 
arranged in alphabetical order.
    Paragraph (b)(1)(i) of the rule has been reorganized to 
separately set forth the exclusions in subparagraphs (A) and (B). 
Paragraph (b)(1)(iii) has been eliminated and the substance of the 
provision has been incorporated into paragraphs (b)(1)(i) and 
(b)(1)(ii).
    The Commission is also amending the definition of the term 
``reported security'' as it appears in Rule 11A3-1(a)(4). The 
amendment alters the form but not the meaning of the term or its 
application. The amendment will make the term consistent with the 
definition of ``reported security'' in the Quote Rule.
    The amendments to Rule 11Ac1-1(a) are being adopted 
prospectively. Outstanding Quote Rule interpretations and no-action 
letters continue to be operative, to the extent that the positions 
taken therein are not materially in conflict with the amendments 
adopted today. Persons seeking clarification regarding the status of 
outstanding no-action letters should contact the Office of Market 
Supervision, Division of Market Regulation, Securities and Exchange 
Commission.
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b. Basis for Amendments to Rule 11Ac1-1(a)
i. Amendment to 11Ac1-1(a)(25) (Definition of a ``Subject Security'')
    The Commission is amending the Quote Rule's definition of subject 
security to require continuous two-sided quotations from OTC market 
makers and exchanges that are responsible for more than 1% of the 
volume in a non-Rule 19c-3 security. The Commission believes that this 
amendment removes an impediment to competition that exists under the 
current rule. Broker-dealers that held themselves out as willing to buy 
and sell non-Rule 19c-3 securities on a regular or continuous basis 
were not previously required to disseminate quotation information 
unless they transacted the largest percentage of the aggregate trading 
volume in a particular security. Consequently, regardless of the volume 
transacted by other exchanges or OTC market makers, the primary market, 
which was the market responsible for transacting the largest percentage 
of the aggregate trading volume, was the only market participant 
required to disseminate quotations in these securities.293
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    \293\ An OTC market maker or specialist, although not the 
principal market for a listed security, could elect to disseminate 
quotes for the security. Under the amended 11Ac1-1(a)(25) an OTC 
market maker or specialist may still elect to disseminate quotations 
if it is responsible for 1% or less of the volume in that security.
---------------------------------------------------------------------------

    As noted in the Proposing Release, third market trading in non-Rule 
19c-3 securities has increased considerably since the Quote Rule was 
last amended.294 Third market trading in Rule 19c-3 securities now 
accounts for a greater number of stocks and a more substantial 
percentage of U.S. trading volume than it did when the Commission 
initially established disparate regulatory treatment under the Quote 
Rule for Rule 19c-3 securities and non-Rule 19c-3 securities.295 
In view of the growth of third market trading volume, the Commission 
believes that requiring all broker-dealers trading more than 1% of the 
volume in a listed security to publish quotations will provide more 
accurate and comprehensive quotation information for non-Rule 19c-3 
securities.
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    \294\ Third market maker trading interest is more concentrated 
in non-Rule 19c-3 securities, as evidenced by the fact that the 
percentage of third market quotes in non-Rule 19c-3 securities (36%) 
is greater than that for Rule 19c-3 securities (28%). See 
Fragmentation vs. Consolidation of Securities Trading: Evidence of 
the Operation of Rule 19c-3, Office of Economic Analysis, SEC, at 5 
(March 29, 1995) (``Fragmentation vs. Consolidation'').
    \295\ Third market trading volume has grown, at least in part, 
because the universe of securities subject to Rule 19c-3 has 
increased considerably. For example, nearly 60% of the stocks listed 
on the NYSE are subject to Rule 19c-3, accounting for approximately 
48% of the total NYSE volume. See Fragmentation vs. Consolidation at 
4-5.
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    The Commission believes that disparate regulatory requirements for 
Rule 19c-3 and non-Rule 19c-3 securities can no longer be justified by 
differences in the trading of the two types of securities. Moreover, 
the Commission finds that differences in regulatory treatment have 
impaired transparency. Because of the growth of third market trading in 
non-Rule 19c-3 securities, the absence of quotes revealing the 
substantial third market makers in a security and the prices they are 
prepared to publicly quote results in the consolidated quotations in 
the security being incomplete.296 The Commission therefore 
believes that significant dealers in non-Rule 19c-3 securities should 
become subject to the same standards required for trading

[[Page 48318]]

Rule 19c-3 securities.297 As a result of this amendment, market 
participants will have more complete information about significant OTC 
market makers and specialists in a security and the prices at which 
they are willing to trade. The majority of commenters who addressed the 
amendment to Rule 11Ac1-1(a)(25) endorse the Commission's proposal to 
end the disparity between Rule 19c-3 securities and non-Rule 19c-3 
securities, noting that there is no basis for continuing to draw a 
regulatory distinction between Rule 19c-3 and non-Rule 19c-3 
securities, and that the extension of the Quote Rule will provide 
meaningful information about significant market makers in listed 
securities.298 One commenter asserts that requiring quotations 
from all significant OTC market makers will succeed in improving the 
quality of the NMS for all listed securities while at the same time 
leveling the playing field for all market makers.299
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    \296\ See, e.g., supra note 294.
    \297\ OTC market makers that trade a significant volume in non-
Rule 19c-3 securities have not been subject to the same requirements 
as third market makers that meet the 1% threshold for Rule 19c-3 
securities. For example, an OTC market maker meeting the 1% 
threshold is required to quote in a Rule 19c-3 security and 
therefore must register as a CQS market maker with the NASD. NASD 
Manual, Rule 6320. CQS market makers are subject to the NASD's CQS 
market maker rules, which include firm and continuous two-sided 
quote obligations and mandatory participation in the ITS through 
Nasdaq's Computer Assisted Execution System. NASD Manual, Rules 6320 
and 6330.
    \298\ See, e.g., Amex Letter; Blume Letter; BSE Letter; CHX 
Letter; CSE Letter; NASD Letter; PSE Letter; Alex. Brown Letter; 
Schwab Letter; D.E. Shaw Letter; Dean Witter Letter; Lehman Letter; 
Madoff Letter; Merrill Letter; PaineWebber Letter; Salomon Letter; 
Smith Barney Letter; STA Letter.
    There were some commenters who did not support the extension of 
the Quote Rule's requirements to non-Rule 19c-3 securities. See, 
e.g., NYSE Letter; and Specialists Assoc. Letter, which note that 
the Commission, rather than expanding the Quote Rule to include non-
Rule 19c-3 securities, should re-examine the validity of Rule 19c-3. 
See, e.g., Letter from Alexander H. Slivka, Executive Vice-
President, National Securities Corporation, to Jonathan G. Katz, 
Secretary, SEC, dated October 25, 1995 (``NSC Letter''); Fahnestock 
Letter; Letter from Samuel Lieberman, President, Rothschild 
Lieberman Ltd., to Jonathan G. Katz, Secretary, SEC (``Rothschild 
Letter''); Letter from Mark T. DeFelice, Vice President, Roosevelt & 
Cross, Inc., to Jonathan G. Katz, SEC, dated January 24, 1996 
(``Roosevelt Letter''), which note that the extension of the 
quotation requirements to include non-Rule 19c-3, will have an 
impact on small firms. See infra note 307.
    \299\ Madoff Letter.
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    Nevertheless, many commenters suggest modifications to the 1% 
volume threshold. Some commenters suggest that Nasdaq, on behalf of all 
third market makers, should be viewed as one market participant, and 
that once its volume exceeds 1% for a listed security, all OTC market 
makers in that security should be required to maintain continuous two-
sided quotations.300 Other commenters believe that the Commission 
should adopt a ``continuousness of execution'' standard rather than a 
rigid 1% volume threshold.301 This suggestion would require a 
dealer to quote if it executes orders on a regular or continuous basis, 
even if it accounts for less than 1% of the volume, while excluding 
from quotation requirements a dealer that executes a few large trades 
that account for more than 1% of the volume. The NYSE suggests an 
additional threshold, to be used in the alternative with the 1% of 
volume threshold.302 This alternative would have the effect of 
requiring public quotations from market makers who, while not 
accounting for more than 1% of the aggregate transaction volume, have 
an active retail business in small-sized trades.
---------------------------------------------------------------------------

    \300\ See PSE Letter; Specialists Assoc. Letter.
    A comparable alternative is to require quotations from all OTC 
market makers who account for more than 1% of the Nasdaq-reported 
volume in a security. See Investors Research Letter.
    In the same vein, two commenters suggest that once an OTC market 
maker or specialist displays a quotation in a listed security, it 
should be subject to the requirements of the rule. See BSE Letter; 
CSE Letter.
    The NYSE and CSE suggest further application of the rule to 
include brokers and their private trading systems. See NYSE Letter; 
CSE Letter.
    \301\ See CHX Letter; Fahnestock Letter; Jefferies Letter; 
Salomon Brothers Letter; STA Letter. See also Rothschild Letter.
    \302\ NYSE Letter. See also RPM Letter; Specialists Assoc. 
Letter.
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    The Commission believes that extending the 1% threshold based on 
quarterly aggregate trading volume to non-Rule 19c-3 securities is a 
reasonable method to improve the scope of quotation information to 
include significant OTC market makers and specialists. This 1% 
threshold, currently in effect for Rule 19c-3 securities, has proved 
effective in supplying comprehensive quotation information to the 
market at large. Moreover, based on the increase in third market 
trading volume for these securities, the Commission does not believe 
this standard is unduly burdensome on OTC market makers or 
specialists.303 Rather, the Commission believes this threshold 
strikes a balance between requiring the dissemination of all quotation 
interest and accommodating those specialists and OTC market makers that 
are small entities. The Commission believes that OTC market makers and 
specialists that account for 1% or less of the aggregate volume are not 
active enough to justify the additional expense of providing continuous 
quotation display.304
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    \303\ The Commission seeks to avoid imposing burdens on market 
participants that are not necessary to achieve the Quote Rule's 
objective of reliable public quotations from all significant markets 
in a security. The Commission notes that the 1% threshold for 
quotations in Rule 19c-3 securities has not impaired trading in 
these securities. Since the Quote Rule was amended, OTC market 
makers' volume in Rule 19c-3 securities has increased. See 
Fragmentation vs. Consolidation at 4-5. The Commission has no reason 
to believe that imposing mandatory quotations on specialists and OTC 
market makers that are responsible for more than 1% of the volume in 
a non-Rule 19c-3 security will affect market making in these 
securities.
    \304\ A few commenters expressed concern that the amendment to 
the Quote Rule would have a detrimental impact on small firms. See 
Fahnestock Letter; NSC Letter; Roosevelt Letter; Rothschild Letter. 
The Commission believes the requirement that a dealer must transact 
greater than 1% of the volume in a security before quotations are 
mandated prevents the rule from becoming unnecessarily burdensome on 
small firms. For example, a firm would not have to publish 
continuous two-sided quotations in AT&T unless it transacted more 
than 1% of the aggregate transaction volume, which the Commission 
considers more than modest volume.
---------------------------------------------------------------------------

    Similarly, the Commission believes that applying the 1% threshold 
to the total over-the-counter volume in a listed security would extend 
the quotation requirements to inactive market makers. The Commission 
questions whether the added quotation information would justify the 
added burden.305 The Commission also believes that reliance on 
something other than a numerical standard in this circumstance would 
lead to confusion in the marketplace. Accordingly, the Commission 
believes the ``greater than 1% aggregate trading volume'' threshold for 
mandatory quotations continues to be appropriate.
---------------------------------------------------------------------------

    \305\ In a related release issued today, the Commission is 
proposing an amendment that would require continuous two-sided 
quotations from OTC market makers and specialists provided that the 
OTC market maker or specialist is responsible for more than 1% of 
the aggregate transaction volume for a security included on the 
Nasdaq Stock Market. See Companion Release for a detailed discussion 
on the proposed amendment to the Quote Rule.
---------------------------------------------------------------------------

ii. Amendment to 11Ac1-1(a)(13) (Definition of an ``OTC Market Maker'')
    Amended Rule 11Ac1-1(a)(13) 306 revises the definition of 
``OTC market maker'' to include any dealer who holds itself out as 
willing to buy from and sell to its customers, or otherwise, a covered 
security for its own account on a regular or continuous basis otherwise 
than on an exchange in amounts of less than block size.307 
Accordingly, dealers that internalize customer order flow in particular 
stocks, by holding themselves out to customers as willing to buy and 
sell on an ongoing basis, would fall within the definition even though 
they may not hold themselves out to all other market participants. In 
addition, dealers

[[Page 48319]]

that hold themselves out to particular firms as willing to receive 
customer order flow, and execute those orders on a regular or 
continuous basis, also would fall within the definition of an OTC 
market maker.
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    \306\ 17 CFR 240.11Ac1-1(a)(13).
    \307\ The definition, as proposed, read ``* * * sell to a 
customer * * * '' but has been modified to read ``* * * sell to its 
customers * * *. ''
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    This change was in response to the requests of commenters for 
consistency in the definition of OTC market maker between proposed Rule 
11Ac1-1(a)(13) and proposed Rule 11Ac1-4(a)(9).See, e.g., NASD Letter. 
Additionally, the Commission stated in the Proposing Release that 
``[a]s in the past, broker-dealers will not be considered to be holding 
themselves out as regularly or continuously willing to buy or sell a 
security if they occasionally execute a trade as principal to 
accommodate a customer's request.'' Proposing Release at 24. The 
Commission believes the new language more accurately reflects that 
premise.
    Most commenters addressing this issue assert that it is appropriate 
to include in the definition of OTC market maker those dealers who 
internalize customer order flow because they believe that dealers that 
hold themselves out to their customers as willing to buy and sell 
securities on a continuous basis should be required to publish 
quotations.308 One commenter asserts that the amendment will 
broaden the definition of who should be required to provide 
transparency and liquidity to the NMS to include dealers that transact 
business with other firms' order flow and with their own customers, 
thus ensuring a minimum level of quotation commitment from those NMS 
participants vying for public order flow.309 Some commenters, 
however, advocate that more than internalization of order flow should 
be required before a dealer is deemed an OTC market maker. These 
commenters suggest the Commission adopt some form of a ``holding itself 
out'' standard, so that the rule would capture the quotations of 
professional liquidity providers but not dealers that occasionally 
accommodate a customer's request.310 Other commenters, deeming the 
definition too inclusive, suggest the Commission add an exception for 
broker-dealers that act solely as agents.311
---------------------------------------------------------------------------

    \308\ See Amex Letter; BSE Letter; CHX Letter; CSE Letter; D.E. 
Shaw Letter; Madoff Letter; NYSE Letter; PSE Letter; RPM Letter; SIA 
Letter; STA Letter.
    \309\ Madoff Letter.
    \310\ See NASD Letter; Jefferies Letter; SIA Letter; PaineWebber 
Letter; STA Letter. It should be noted that the amended definition 
includes a requirement that the broker-dealer hold itself out to, at 
a minimum, its customers on a regular and continuous basis in order 
to be an OTC market maker.
    \311\ See Fahnestock Letter; Salomon Brothers Letter; Rothschild 
Letter; Investors Research Letter.
---------------------------------------------------------------------------

    One commenter believes that excluding firms that transact primarily 
block size orders and therefore account for significant volume is 
inconsistent with the Commission's goals for increased 
transparency.312 However, several commenters note that block size 
orders are excluded from the existing definition of OTC market maker 
and argue strongly that it is consistent with the purposes of the rule 
to continue to exclude them.313
---------------------------------------------------------------------------

    \312\ Amex Letter.
    \313\ See Fahnestock Letter; Dillon Letter; Goldman Sachs 
Letter; Merrill Letter; Salomon Brothers Letter.
---------------------------------------------------------------------------

    The Commission believes that adoption of the amendment is warranted 
to ensure the availability of quotation information that accurately 
reflects the interests of all significant market participants. 
Increased transparency is fundamental to the fairness and efficiency of 
the securities markets. As noted in the Market 2000 Study, enhanced 
transparency helps link various market segments.314 Currently, a 
dealer can receive order flow from internalization or pre-existing 
order routing arrangements but avoid publishing quotations, even when 
it accounts for more than 1% of the volume in a non-Rule 19c-3 
security, because it is not currently deemed to be an OTC market 
maker.315 Allowing significant market makers that deal actively in 
securities without publicizing their activity or making available their 
prices undermines the NMS goal of transparency. The Commission believes 
that those dealers should be classified under the rule as market makers 
and be required to publicize their quotations so that investors may 
know of, and trade on similar terms with, those market makers.
---------------------------------------------------------------------------

    \314\ See Market 2000 Study at III-7.
    \315\ Although NASD rules require dealers who are registered as 
CQS market makers to provide quotations, registration is not 
mandated. A dealer in reported securities may elect to disseminate 
quotations by registering as a NASD market maker and 
``communicating'' its best bids and offers to the association by 
entering two-sided quotations in the Nasdaq System. See NASD Manual, 
Rule 4611.
---------------------------------------------------------------------------

    The Commission has considered commenters' suggestions regarding 
alternative definitions. In fact, in response to the suggestions of 
some commenters, the Commission has modified the proposed amendment to 
make clear that more than an isolated transaction is necessary before a 
dealer is designated an OTC market maker.
    The Commission, in regard to orders of block size, has determined 
to continue to exclude dealers that hold themselves out as only willing 
to deal in orders equal to or greater than 10,000 shares. Orders of 
block size are generally negotiated with the dealer and exposed upon 
execution. Block positioners usually do not maintain prices at which 
they are willing to buy and sell a particular security; rather, they 
make known their role of assisting in the purchase and sale of large 
positions in securities at some price. Consequently, these dealers do 
not function as typical dealers that maintain a regular or continuous 
price quote. The Commission has concluded that requiring quotations 
from these dealers would not provide useful price information and 
therefore a dealer that acts solely as a block positioner should remain 
excluded from the definition.
iii. Amendment to 11Ac1-1(a)(6) (Definition of a ``Covered Security'')
    As amended, Rule 11Ac1-1(a)(6) 316 defines ``covered 
security'' to include any security for which a transaction report, last 
sale data or quotation information is disseminated through an automated 
quotation system as described in Section 3(a)(51)(A)(ii) of the 
Exchange Act.317 This amendment would extend the Quote Rule 
provisions to OTC market makers and exchange specialists quoting in 
Nasdaq SmallCap securities.
---------------------------------------------------------------------------

    \316\ Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1(a)(6).
    \317\ 15 U.S.C. 78c(a)(51)(A)(ii).
---------------------------------------------------------------------------

    The Proposing Release noted that the Quote Rule presently does not 
reflect certain developments in the Nasdaq market, including the large 
number of securities included on the Nasdaq SmallCap market. Only one 
commenter addressed this amendment. That commenter, MJT, expressed 
strong support for the proposal, noting that it is both fair and 
equitable to apply the Quote Rule to Nasdaq SmallCap 
securities.318 The Commission believes it is appropriate to extend 
coverage of the Quote Rule to these securities in recognition of the 
development of a liquid trading market and increased investor demand 
for these securities. NASD rules concerning quotations already require 
firm quotations for both Nasdaq SmallCap securities and Nasdaq/National 
Market securities.319 Thus, the amendment simply extends coverage 
of the Quote Rule requirements to the same range of securities as

[[Page 48320]]

existing NASD firm quote requirements.320
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    \318\ MJT Letter.
    \319\ See NASD Manual, Rule 4613.
    \320\ Section 11A(c)(1) of the Exchange Act grants the 
Commission the authority to prescribe, among other matters, rules 
and regulations to assure accurate and reliable quotations ``with 
respect to any security other than an exempted security.'' The 
Commission believes that extending the requirements of the Quote 
Rule to Nasdaq SmallCap securities will further these interests. No 
new costs should be imposed on market participants because the NASD 
rules concerning quotations already treat Nasdaq/National Market and 
SmallCap securities similarly.
---------------------------------------------------------------------------

c. Response to Other Specific Requests for Comments
    In addition to the Quote Rule amendments discussed above, the 
Proposing Release solicited comment on whether: (1) revisions are 
necessary to an NASD rule that restricts certain computer generated 
quotations; 321 and (2) whether the ITS linkage should be expanded 
to allow NASD CAES members access to the linkage in non-Rule 19c-3 
securities.
---------------------------------------------------------------------------

    \321\ NASD Manual, Rule 6330. The NASD, however, provides an 
automated quotation update capability (``auto-refresh'') as part of 
the Small Order Execution System which market makers may elect to 
use. Specifically, the quote of a market maker using auto-refresh 
will be automatically updated when the market maker exhausts its 
exposure limit in the NASD's Small Order Execution System.
---------------------------------------------------------------------------

i. Automatic Generation of Quotations
    Requiring active third market makers in non-Rule 19c-3 securities 
to quote also raises the issue of whether NASD members should continue 
to be prohibited from using computer systems to generate quotations 
automatically.322 Currently, exchange specialists may use 
automated mechanisms to track the NBBO in a security if they maintain a 
quotation size of no more than 100 shares.323 OTC market makers, 
however, are prohibited by NASD requirements from using automated 
quotation tracking systems.
---------------------------------------------------------------------------

    \322\ See supra note 288, concerning the impact of the ECN 
amendment to the 1% rule.
    \323\ The 100-share limitation follows the ITS Plan requirement 
that no ITS Participant may use an automated computer tracking 
system to generate quotes for more than 100 shares in any security 
the Participant trades through the ITS system.
---------------------------------------------------------------------------

    The Commission requested comment on whether computer generated 
quotations should be permitted if active third market makers are 
required to quote in non-Rule 19c-3 securities, and if so, under what 
conditions. Commenters in favor of lifting the NASD's automated 
quotation ban believe that worthwhile computer generated quotes should 
be permitted.324 For example, one commenter stresses that a ban on 
all computer generated quotations impedes technological innovation, 
protecting the franchise of inefficient market makers at the expense of 
the investing public. Moreover, the commenter asserts, given the same 
regulatory environment, there is no reason to believe that firms that 
make automated markets will quote away from the market any more than 
firms posting quotes manually.325
---------------------------------------------------------------------------

    \324\ See, e.g., BSE Letter; CSE Letter; D.E. Shaw Letter; 
Investors Research Letters; Lehman Letter; Madoff Letter; Merrill 
Letter; NSC Letter; NYSE Letter; Smith Barney Letter.
    \325\ D.E. Shaw Letter.
---------------------------------------------------------------------------

    Certain commenters, including the NASD, believe that the ban should 
continue in effect. In general, these commenters believe that lifting 
the ban could create systems capacity and data traffic problems, and 
result in useless quotations that are automatically maintained away 
from current market prices.326
---------------------------------------------------------------------------

    \326\ See, e.g., Dean Witter Letter; NASD Letter; PSE Letter; 
RPM Specialist Letter.
---------------------------------------------------------------------------

    Even commenters in favor of lifting the ban tend to believe that, 
while some types of computer generated quotes are appropriate, others, 
such as quotations automatically maintained away from the best market 
quotation, should not be permitted. The NASD, which generally favors 
the ban on automated quotes, believes it may be appropriate to revise 
its autoquote policy to permit a market maker to automatically update 
its quote to match either the best bid or best offer, provided 
liquidity is not withdrawn from the contra-side of the quotation. In 
this situation, the NASD believes a market maker will be exposed to an 
execution and will be genuinely contributing to market liquidity.
    The Commission believes that a total prohibition on the use of 
computer generated quotes is not appropriate. Such an approach 
excessively limits the use of sophisticated trading strategies that 
rely on automation in the quotation process for their success, and it 
also may act as a competitive disadvantage to market makers and 
specialists that would otherwise rely on technology to meet their 
quotation obligations more efficiently. In the latter instance, broad 
prohibitions on the use of computer generated quotes may cause some 
market makers and specialists to restrict the number of stocks in which 
they are willing to make markets.
    While the Commission recognizes traditional concerns related to the 
accessibility of computer generated quotes and the impact of such 
quotes on systems capacity, it believes that more can and should be 
done in this area. This is particularly true given the enhanced 
quotation obligations that will be imposed on some market participants 
under the revised Quote Rule. The Commission urges the NASD, ITS 
Participants,327 and other interested market participants to 
develop revised standards that would permit the use of computer 
generated quotes that contribute value to the market. Specifically, the 
Commission requests that the NASD and ITS Participants resolve this 
issue before the effective date of the Quote Rule amendments. In the 
absence of such progress, the Commission recognizes that it will 
consider invoking its own authority to address this issue.
---------------------------------------------------------------------------

    \327\ The ITS Plan also places certain restrictions on the use 
of computer generated quotes. See supra note 323. Given the 
technologies that have developed during the nearly 20 years that 
these ITS Plan restrictions have been in place, the Commission 
requests that the ITS Participants review these limitations and 
whether they continue to be appropriate, in whole or in part, and 
whether new limitations should replace the existing provisions or 
whether there should be any ITS Plan limitations on automated 
quotes.
---------------------------------------------------------------------------

ii. Expansion of ITS/CAES Access
    As discussed in the Proposing Release, the uniform application of 
the Quote Rule to all exchange-listed securities raises the issue of 
the disparate treatment of Rule 19c-3 and non-Rule 19c-3 securities 
under the ITS Plan. The Commission solicited comment on this disparate 
treatment. The same issue arises with the provision allowing the use of 
an ECN as an intermediary in communicating quotes to the public 
quotation system if equivalent access is provided.
    Currently, the ITS Plan provides access to the ITS System to any 
Participant in any Rule 19c-3 security in which the Participant 
disseminates continuous two-sided quotations, but excludes OTC market 
makers from ITS access for non-Rule 19c-3 securities. In the past, 
market makers in non-Rule 19c-3 securities were not subject to 
mandatory quote requirements. The amendments to the Quote Rule adopted 
today will subject OTC market makers and exchange specialists to the 
same quotation requirements for all exchange-listed securities.
    The Commission requested comment on whether the Quote Rule 
amendments justify an expansion of the linkage between ITS and the 
NASD's CAES interface to provide ITS access to and from any market 
maker for any exchange-listed security in which that market maker 
disseminates continuous two-sided quotations. Numerous commenters 
support expanding the linkage in this manner because they believe an 
expansion will enhance fair competition and increase opportunities

[[Page 48321]]

for best execution.328 Several commenters also assert that 
arguments previously made to exclude OTC market maker quotes in non-
Rule 19c-3 securities from ITS are no longer valid.329
---------------------------------------------------------------------------

    \328\ See, e.g. D.E. Shaw Letter; Investors Research Letter; 
Lehman Letter; NASD Letter; NSC Letter; Madoff Letter; Rothschild 
Letter; Schwab Letter; STA Letter.
    \329\ See, e.g., Madoff Letter.
---------------------------------------------------------------------------

    One commenter specifically argues that adoption of the Commission's 
proposals should end any objection to the NASD's full participation in 
ITS because the operation of the Quote Rule will reduce opportunities 
for OTC market makers to trade in ECNs while simultaneously availing 
themselves of the voluntary aspect of the Quote Rule, and therefore, 
will expand the imposition of NASD quotation requirements upon OTC 
market makers. These requirements, according to the commenter, are 
equal to those of any other market and add greater transparency and 
liquidity to the markets for exchange-listed securities as well as the 
NMS.330
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    \330\ Id. Madoff states that the NASD now requires every OTC 
market maker to conform with NMS principles, respect all other NMS 
quotations in listed securities, and not trade through better quotes 
in the NMS. Madoff further notes that, in contrast, exchanges do not 
impose similar restrictions with respect to trading through off-
exchange quotations.
---------------------------------------------------------------------------

    Those commenters opposed to the expansion generally believe that 
the existing limitation on ITS access is justified in view of 
disparities in customer protections afforded by exchanges and exchange 
members when compared to customer protections mandated by NASD 
rules.331
---------------------------------------------------------------------------

    \331\ See Amex Letter; BSE Letter; CHX Letter; CSE Letter; PSE 
Letter; Specialists Assoc. Letter.
---------------------------------------------------------------------------

    The Commission recognizes that the expansion of ITS/CAES is a 
significant issue of concern to many market participants. The 
Commission therefore encourages a continuing dialogue among the ITS 
Participants to solve this issue on a timely basis and in a manner 
beneficial to the market as a whole.
d. Operation of the Rule With Amended Definitions
i. Amendment to 11Ac1-1(a)(25) (Definition of a ``Subject Security'')
    As a result of the amendment adopted today, OTC market makers and 
exchange specialists who hold themselves out as willing to buy and sell 
non-Rule 19c-3 securities on a regular or continuous basis, and that 
account for more than 1% of the quarterly aggregate trading volume, 
will be subject to the Quote Rule and required to make continuous two-
sided quotations available to the public, even if they have not 
previously elected to register as CQS market makers with the NASD. This 
amendment will close a significant gap in the quotation information 
that has been available heretofore to market participants and 
investors. In a parallel action, the Commission is proposing for 
comment an additional amendment to the Quote Rule.332 The 
Commission believes that the additional proposal, if adopted, would 
further improve transparency by providing investors with quotation 
information on Nasdaq securities from significant OTC market makers and 
specialists.
---------------------------------------------------------------------------

    \332\ See Companion Release.
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ii. Amendment to 11Ac1-1(a)(13) (Definition of an ``OTC Market Maker'')
    The definition of OTC market maker now includes any dealer holding 
itself out as willing to transact business for its own account on a 
regular or continuous basis, whether it transacts exclusively with its 
own customers or with the customers of other dealers. Those dealers 
that hold themselves out to customers as willing to execute orders on a 
regular or continuous basis, whether by the internalization of customer 
order flow in particular stocks or through arrangements with particular 
firms to execute their customer order flow, now fall within the 
definition of OTC market maker. Therefore, obligations under the Quote 
Rule will now apply to dealers that internalize customer order flow or 
hold themselves out to particular firms as willing to execute their 
customer order flow, and that execute those orders on a regular or 
continuous basis. As in the past, broker-dealers will not be considered 
to be holding themselves out as regularly or continuously willing to 
buy or sell a security if they occasionally execute a trade as 
principal to accommodate a customer's request.
iii. Amendment to 11Ac1-1(a)(6) (Definition of a ``Covered Security'')
    The amendment extends the coverage of the Quote Rule to all Nasdaq 
securities where the rule had previously applied only to Nasdaq/
National Market securities. As noted previously, NASD rules already 
require a dealer that makes a market in a Nasdaq SmallCap security to 
provide quotations.333 The Commission, therefore, does not believe 
extending the Quote Rule to include securities covered by an existing 
NASD rule will result in additional burdens on OTC market makers. 
Although the definition of covered security has been amended to include 
Nasdaq SmallCap securities, an exchange specialist or OTC market maker 
still must make an election, pursuant to paragraphs (b)(5) (i) and 
(ii), respectively, of the Quote Rule.334 Accordingly, although 
the definition has been amended, an OTC market maker or specialist is 
not mandated by the Quote Rule to provide quotations on Nasdaq SmallCap 
securities. If, however, an exchange specialist or OTC market maker 
makes an election to make available quotations, the firmness 
obligations under paragraph (c) of the Quote Rule become operative.
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    \333\ See NASD Rule 4613.
    \334\ 17 CFR 240.11Ac1-1(b)(5)(i)
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e. Effective Date
    The amendments to Rule 11Ac1-1 adopted by the Commission today will 
become effective on January 10, 1997.

C. Price Improvement for Customer Market Orders

1. Proposed Rule
    In the Proposing Release, the Commission sought comment on a 
market-wide Price Improvement Rule for customer market orders. The 
proposed rule was designed to apply across exchange and OTC markets to 
promote the execution quality of orders by providing increased 
opportunities for customer orders to interact at better prices without 
the intervention of a dealer. The proposal included a non-exclusive 
safe harbor as one means by which a specialist or OTC market maker 
could be assured that an order received a sufficient opportunity for 
price improvement for purposes of the rule.
    The proposed rule was intended to encourage market participants to 
take advantage of current technologies and provide customer market 
orders with improved access to price improvement opportunities, 
regardless of where such orders are routed for execution. Although the 
proposed rule would have required specialists and OTC market makers to 
provide price improvement opportunities for customer orders, the 
Commission did not prescribe any particular method of achieving price 
improvement in recognition of the fact that competition can produce 
innovative price improvement mechanisms. The Commission proposed a non-
exclusive safe harbor, however, to provide certainty regarding one 
alternative by which a specialist or OTC market maker would be deemed 
to have satisfied its price improvement obligation.
    Under the safe harbor, a specialist or OTC market maker would have 
been deemed in compliance with the

[[Page 48322]]

proposed price improvement rule if it exposed, in its quote, a customer 
market order at an improved price and provided the customer with a 
guaranteed execution at the ``stop'' price.335 This procedure was 
designed to promote the interaction of exposed orders at prices better 
than the NBBO with orders or trading interest in other markets. The 
safe harbor also was intended to lead to increased competition by 
encouraging specialists and OTC market makers to compete more actively 
for order flow on the basis of their published quotations. The 
Commission made clear, however, that the order exposure procedures set 
out in the proposed safe harbor neither would be mandatory, nor the 
exclusive means by which to satisfy the obligation to provide an 
opportunity for price improvement.
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    \335\ The proposed safe harbor provided for an order to be 
``stopped'' at the national best bid (for a sell order) or offer 
(for a buy order) for the lesser of either the full size of the 
order, or the size associated with the national best bid (for a sell 
order) or offer (for a buy order).
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    Many of the 145 commenters discussed the proposed Price Improvement 
Rule. The commenters raise numerous questions and concerns regarding 
the proposed rule. For example, some commenters claim that an absolute 
rule would reduce the broker-dealer's fiduciary obligation of best 
execution to an algorithm, eliminating the exercise of professional 
judgment in identifying price improvement opportunities.336 
Instead, the commenters argue that customers and market professionals 
should be able to use discretion in deciding when and how price 
improvement should be sought.337
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    \336\ See, e.g., Goldman Sachs Letter; Jefferies Letter; Madoff 
Letter; Merrill Letter; NYSE Letter; PaineWebber Letter; PSE Letter.
    \337\ See, e.g., CSE Letter; Goldman Sachs Letter; Madoff 
Letter; Merrill Letter; NSC Letter; NYSE Letter; PSE Letter.
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    In addition, several commenters are concerned that the proposed 
safe harbor would become the industry standard. These commenters 
believe that, although non-exclusive, the proposed safe harbor would 
dictate the minimum acceptable standard to follow, thereby stifling 
innovation and competition.338 Many commenters also are troubled 
by various technical aspects regarding the application of the safe 
harbor. For example, some commenters believe the 30-second exposure 
period would be insufficient to allow other market participants to 
respond to the exposed order, even with today's technology.339 
Other commenters are concerned with the mechanics of the ``stopping'' 
procedures.340 At least one commenter argues that the requirement 
to stop stock blurs the distinction between price guarantees and price 
improvement opportunities.341
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    \338\ See, e.g., AZX Letter; Blume Letter; HHG Letter; Lehman 
Letter; Merrill Letter; Morgan Stanley Letter; NASD Letter; Salomon 
Letter; Schwab Letter; Smith Barney Letter; PaineWebber Letter; 
Ruane Letter.
    Some commenters believe their current operations would satisfy 
the rule and, therefore, they would not need to utilize the safe 
harbor procedures. See, e.g., Amex Letter; BSE Letter; CHX Letter; 
NYSE Letter; PSE Letter.
    \339\ See, e.g., Amex Letter; Blume Letter; BSE Letter; CHX 
Letter; CSE Letter; NYSE Letter; PSE Letter; Schwab Letter;. But 
see, e.g., Letter from Raymond E. Wooldridge, Chief Executive 
Officer, Southwest Securities, to Mr. Jonathan G. Katz, Secretary, 
SEC, dated January 9, 1996 (``Southwest Letter''); STANY Letter.
    \340\ See, e.g., Madoff Letter; MJT Letter; Smith Barney Letter.
    \341\ See Sutro Letter.
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    The potential costs associated with the proposed rule also concern 
many commenters. They claim that necessary systems upgrades would be 
expensive.342 In addition, several commenters claim that the 
number of quotes generated as a result of the safe harbor would pose a 
serious threat to system capacity.343 Many commenters warn that 
the increased traffic would reduce trading efficiency, decrease 
transparency and increase overall risk.344 Some commenters also 
state that market price integrity would be reduced due to the 
proliferation of flickering, ephemeral quotations.345
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    \342\ See, e.g., Blume Letter; Dean Witter Letter; Fahnestock 
Letter; Goldman Sachs Letter; LJR Letter; NASD Letter; PaineWebber 
Letter; Ruane Letter; Salomon Letter; Schwab II Letter; SIA Letter.
    \343\ See, e.g., Bear Stearns Letter; FIF Letter; Merrill 
Letter; PSE Letter; STANY Letter.
    \344\ See, e.g., Amex Letter; Bear Stearns Letter; Blume Letter; 
FIF Letter; LJR Letter; Madoff Letter; Merrill Letter; Morgan 
Stanley Letter; NASD Letter; PSE Letter; Salomon Letter; STA Letter; 
STANY Letter; Specialist Assoc. Letter.
    \345\ See, e.g., Dean Witter Letter; ICI Letter; Merrill Letter; 
Morgan Stanley Letter; NASD Letter; NYSE Letter; PSE Letter; Salomon 
Letter; Schwab II Letter; Specialist Assoc. Letter; STANY Letter.
---------------------------------------------------------------------------

    A common suggestion from the commenters is that the Commission not 
adopt the proposed rule prior to evaluating the effects of the other 
initiatives contained in the proposal.346 Some commenters believe 
that the amendments to the Quote Rule and the proposed Limit Order 
Display Rule should act to narrow spreads by eliciting the true market 
for a given security, thereby decreasing the utility and necessity of 
seeking better prices for customer orders. According to these 
commenters, if such results are achieved through the other initiatives, 
the potential costs and significant market operations changes 
associated with the proposed Price Improvement Rule would far outweigh 
any potential benefit.
---------------------------------------------------------------------------

    \346\ See, e.g., Bear Stearns Letter; Dean Witter Letter; DOJ 
Letter; Goldman Sachs Letter; Lehman Letter; Madoff Letter; Morgan 
Stanley Letter; NASD Letter; NSC Letter; Schwab II Letter; SIA 
Letter; Sutro Letter.
---------------------------------------------------------------------------

    Although the Commission continues to believe that the opportunity 
for price improvement can contribute to providing customer orders with 
enhanced executions, the Commission has determined to defer action on 
the proposed Price Improvement Rule for the present time. The 
Commission believes that the other initiatives adopted today will 
greatly improve the price discovery process and the opportunity for 
customer orders to receive enhanced execution prices. These initiatives 
should act to narrow spreads by making available to all market 
participants the true buying and selling interest in a given security. 
The Commission believes, therefore, that the most appropriate course of 
action is to monitor the operation of the initiatives adopted today, 
and assess their impact on spreads, the quality of markets, and the 
quality of executions. This assessment will enable the Commission to 
better determine the need for further Commission action regarding 
specific price improvement obligations.
2. Best Execution Obligations
    The proposed Price Improvement Rule was designed to complement the 
long-standing duties of broker-dealers to seek to obtain best execution 
of their customer orders; the Commission did not intend for the 
proposed rule to modify this existing best execution 
obligation.347 Therefore, the Commission's decision to defer 
consideration of the proposed rule in no way should be taken as an 
indication that the duty of best execution has been altered.
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    \347\ Proposing Release at 49.
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    A broker-dealer's duty of best execution derives from common law 
agency principles and fiduciary obligations, and is incorporated both 
in SRO rules and, through judicial and Commission decisions, in the 
antifraud provisions of the federal securities laws.348 This duty 
of best execution requires a broker-dealer to seek the most favorable 
terms reasonably available under the circumstances for a customer's 
transaction.349 The scope of this duty of best execution must 
evolve as changes occur in the market that give rise to improved 
executions for customer orders, including

[[Page 48323]]

opportunities to trade at more advantageous prices. As these changes 
occur, broker-dealers' procedures for seeking to obtain best execution 
for customer orders also must be modified to consider price 
opportunities that become ``reasonably available.'' 350
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    \348\ See Market 2000 Study, Study V at V-1, 2 and sources cited 
therein.
    \349\ See Market 2000 Concept Release, supra note 10; Market 
2000 Study, Study V.
    \350\ Proposing Release at 7-10.
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    In the past the Commission has recognized the practical necessity 
of automating the handling of small orders, and has indicated that 
automated routing or execution of customer orders is not necessarily 
inconsistent with best execution.351 At the same time, the 
Commission has emphasized that best execution obligations require that 
broker-dealers routing orders for automatic execution must periodically 
assess the quality of competing markets to assure that order flow is 
directed to markets providing the most beneficial terms for their 
customers' orders.352 While in the past quote-based executions in 
OTC securities were generally recognized as satisfying best execution 
obligations, the development of efficient new facilities has altered 
what broker dealers must consider in seeking best execution of customer 
orders.353 The Commission thus noted the importance of the 
opportunity for price improvement as a factor in best execution, 
speaking in the context of aggregate order handling decisions for both 
listed and OTC stocks.354 Therefore, the Commission believes that 
routing order flow for automated execution, or internally executing 
order flow on an automated basis, at the best bid or offer quotation, 
would not necessarily satisfy a broker-dealer's duty of best execution 
for small orders in listed and OTC securities.355
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    \351\ Id. at 8.
    \352\ Payment for Order Flow Release, supra note 23, at n. 30 
and accompanying text; See Securities Exchange Act Release No. 37046 
(March 29, 1996), 61 FR 15322 (April 5, 1996) (``CSE Approval 
Order''); Securities Exchange Act Release No. 37045 (March 29, 
1996), 61 FR 15318 (April 5, 1996) (``BSE Approval Order'').
    \353\ Proposing Release at 10.
    \354\ Id.; see also Payment for Order Flow Release, supra note 
23 at text accompanying notes 31-33. See CSE Approval Order, supra 
note 352; BSE Approval Order, supra note 352.
    \355\ Proposing Release at 9-10; see also note 360 and 
accompanying text (factors relevant to best execution).
---------------------------------------------------------------------------

    Both the rule and the amendments adopted today should further 
improve a broker-dealer's ability to obtain improved executions for 
customer orders. These changes will enhance the public quote by 
including in the public quotation system many superior prices not 
currently reflected there. The ECN amendment is intended to publicize 
superior market maker ECN prices in the public quote, which should make 
these prices more easily accessible. Similarly, the Display Rule will 
include more customer prices in the public quote through requiring the 
display of customer limit orders.
    Nonetheless, various markets and market makers may continue to 
provide opportunities for executions at prices superior to the enhanced 
national best bid and offer for their customer orders.356 For 
example, some markets or market makers may continue to offer price 
improvement opportunities, based on internal order flow or execution 
algorithms. The Commission believes that broker-dealers deciding where 
to route or execute small customer orders in listed or OTC securities 
must carefully evaluate the extent to which this order flow would be 
afforded better terms if executed in a market or with a market maker 
offering price improvement opportunities. In conducting the requisite 
evaluation of its internal order handling procedures, a broker-dealer 
must regularly and rigorously examine execution quality likely to be 
obtained from the different markets or market makers trading a 
security.357 If different markets may be more suitable for 
different types of orders or particular securities, the broker-dealer 
will also need to consider such factors.
---------------------------------------------------------------------------

    \356\ Id.
    \357\ CSE Approval Order, 61 FR at 15329. ``Price improvement'' 
in this context is defined as the difference between execution price 
and the best quotes prevailing in the market at the time the order 
arrived at the market or market maker. Any evaluation of price 
improvement opportunities would have to consider not only the extent 
to which orders are executed at prices better than the prevailing 
quotes, but also the extent to which orders are executed at inferior 
prices.
---------------------------------------------------------------------------

    Where material differences exist between the price improvement 
opportunities offered by markets or market makers, these differences 
must be taken into account by the broker-dealer. Similarly, in 
evaluating its procedures for handling limit orders, the broker-dealer 
must take into account any material differences in execution quality ( 
e.g., the likelihood of execution) among the various markets or market 
centers to which limit orders may be routed. The traditional non-price 
factors affecting the cost or efficiency of executions also should 
continue to be considered; 358 however, broker-dealers must not 
allow an order routing inducement, such as payment for order flow or 
the opportunity to trade with that order as principal, to interfere 
with its duty of best execution.359 Of course, as the Commission 
has previously noted, in light of a broker-dealer's obligation to 
assess the quality of the markets to which it routes packaged order 
flow absent specific instructions from customers, the Commission does 
not believe that a broker-dealer violates its best execution obligation 
merely because it receives payment for order flow or trades as 
principal with customer orders.360
---------------------------------------------------------------------------

    \358\ See Market 2000 Study, Study V at V-2, 3.
    \359\ Payment for Order Flow Release, supra note 23.
    \360\ Id.
---------------------------------------------------------------------------

    Prices superior to the public quote may at times be available in 
ECNs, even after adoption of the ECN amendment, based, for example, on 
orders of institutional participants and others not covered by the ECN 
amendment. Superior prices also may be available in other systems not 
classified as ECNs. As the Commission noted in the Proposing Release in 
September, 1995, and reiterates today, where reliable, superior prices 
are readily accessible in such systems, broker-dealers should consider 
these prices in making decisions regarding the routing of customer 
orders.361 The Commission recognizes that many of these systems 
are less accessible and involve higher costs for broker-dealers than 
the public markets. In addition, in many cases it is not currently 
feasible to efficiently obtain price information from these systems or 
link to these systems on an automated basis. The Commission is not 
suggesting that broker-dealers must engage in manual handling of small 
orders if necessary to access these systems.362 Nonetheless, the 
Commission believes that because technology is rapidly making these 
systems more accessible, broker-dealers must regularly evaluate whether 
prices or other benefits offered by these systems are reasonably 
available for purposes of seeking best execution of these customer 
orders. For example, if an ECN provides an automated link that makes it 
cost effective for a broker-dealer to access these systems for its 
retail orders on an automated basis, the broker-dealer must take the 
prices and other relevant costs in that system into account in handling 
these customer orders.
---------------------------------------------------------------------------

    \361\ Proposing Release at 10.
    \362\ The Commission has recognized that it may be impractical, 
both in terms of time and expense, for a broker that handles a large 
volume of orders to determine individually where to route each order 
it received. Proposing Release at 8.
---------------------------------------------------------------------------

    Pursuant to the Display Rule, most customer limit orders at 
superior prices will be required to be displayed and

[[Page 48324]]

included in the public quote.363 The display of a limit order by a 
market maker directly affects its responsibilities in handling other 
customer orders. The Commission has long said that broker-dealers must 
consider quotation information contained in the public quotation system 
in seeking best execution of customer orders.364 In executing 
customer market orders, a market maker must give no less consideration 
to the price of its own displayed customer limit order than any other 
public quotation price. Therefore, under the new Display Rule, a market 
maker that has displayed a customer limit order would be expected to 
provide an offsetting customer market order an execution at that limit 
price at least up to the size of the limit order.
---------------------------------------------------------------------------

    \363\ The Commission notes that the NASD's interpretation 
prohibiting market makers from trading ahead of customer limit 
orders applies both to displayed and nondisplayed customer limit 
orders held by the market maker. See NASD Conduct Rule IM 2110-2 
(Trading Ahead of Customer Limit Orders).
    \364\ See Quote Rule Adopting Release, supra note 208.
---------------------------------------------------------------------------

    In addition, the Commission notes that currently, some market 
makers that hold a customer limit order on one side of the market, 
priced better than the market maker's own quote, and a customer market 
order on the other side of the market, will execute both orders as 
principal rather than crossing the two orders. As a result, the market 
order customer receives the best bid and offer rather than receiving 
the benefit of a better limit order price. In light of the increased 
opportunities for price improvement now available and the rules the 
Commission is adopting today, the Commission believes that going 
forward this practice is no longer appropriate given the broker-
dealer's obligation, as part of its duty of best execution, to its 
market order customer.365
---------------------------------------------------------------------------

    \365\ Cf., NASD Notice to Members 96-10 (February, 1996) at 43; 
NASD Notice to Members 95-67 (August, 1995) at 417.
---------------------------------------------------------------------------

    In conclusion, although the Commission has determined for the 
present to defer final action on the proposed Price Improvement Rule, 
the Commission's adoption of the Display Rule and the Quote Rule 
amendments should substantially improve public quotations. Moreover, 
the Commission firmly believes that broker-dealers, when deciding where 
to route or execute customer orders, must carefully consider and 
evaluate opportunities for obtaining improved executions.

IV. Authority

    As discussed above, the 1975 Act Amendments to the Exchange Act set 
forth Congress' goals for a national market system. Several commenters 
argue that the proposed rules violate Congress's direction that the 
Commission facilitate the establishment of, rather than design, a 
national market system.366 Many of these comments were directed at 
the proposed Price Improvement Rule and in particular the proposed 
price improvement safe harbor. The Commission today is deferring action 
on that rule proposal. To the extent that the comments relate to the 
rule and amendments adopted today, however, they reflect a fundamental 
misunderstanding regarding the purpose of the rules and the 
Commission's role in facilitating a national market system.
---------------------------------------------------------------------------

    \366\ See, e.g., ABA Letter; Fahnestock Letter; HHG Letter; LJR 
Letter; NSC Letter; PaineWebber Letter; RPM Letter; Ruane Letter; 
SIA Letter.
---------------------------------------------------------------------------

    The Commission's adoption of these rules is fully consistent with 
the role that Congress envisioned in 1975 for the Commission. 
Congress's direction to the Commission to ``facilitate'' the 
establishment of a national market system for securities that 
implemented Congressionally enumerated objectives was not intended as a 
limitation on the Commission's authority but rather was ``designed to 
provide maximum flexibility to the Commission and the securities 
industry in giving specific content to the general concept of the 
national market system.'' 367 Congress granted the Commission 
broad rulemaking authority over the national market system and market 
participants and this grant of specific rulemaking authority was not 
conditioned on the expectation that the Commission refrain from using 
it.
---------------------------------------------------------------------------

    \367\ Conference Report, supra note 213, at 92. See Senate 
Report, supra note 31, at 8-9 (``the sounder approach appeared * * * 
to be to establish a statutory scheme clearly granting the 
Commission broad authority to oversee the implementation, operation, 
and regulation of the national market system and at the same time to 
charging it with the clear responsibility to assure that the system 
develops and operates in accordance with Congressional determined 
goals and objectives.''). The Conference Committee report on the 
1975 Act Amendments indicates that the conferees adopted with minor 
revisions the Senate's provisions concerning the national market 
system. Conference Report, supra note 213, at 92.
---------------------------------------------------------------------------

    Although Congress expressed a preference that where possible the 
national market system evolve through the interplay of competitive 
forces, it recognized that ``competition may not be sufficient'' and 
that in such cases, the Commission should act ``promptly and 
effectively to insure that the essential mechanisms of an integrated 
secondary trading system [be] put into place * * *.'' 368 Congress 
specifically identified in 1975 some of the concerns addressed today 
and the Commission has examined these issues on several occasions over 
the intervening years in response to evolving market conditions and 
technologies. In view of the caution and deliberation with which the 
Commission has proceeded over the past 21 years, its actions today 
cannot fairly be viewed as arresting natural competitive forces, but 
rather should be regarded as an attempt to foster efficiency and 
redress shortcomings in the national market system that have developed 
since then, or that the securities industry on its own has been unable 
to resolve over this time.
---------------------------------------------------------------------------

    \368\ Conference Report, supra note 213 at 92.
---------------------------------------------------------------------------

    The subject matter of these rule and rule amendments is an area of 
the national market system in which Congress itself recognized that the 
Commission's expertise and authority were paramount. Indeed, Section 
11A was specifically enacted to eliminate ``arguments about the SEC's 
authority'' in this area. For that reason, the Commission was given 
``pervasive rulemaking power'' with respect to the business of 
collecting, processing, or publishing information relating to 
quotations for and transactions in securities.369 The rules 
adopted today implement Congress' goals as to dissemination of trading 
information: ``to insure the availability of prompt and accurate 
trading information, to assure that these communications networks are 
not controlled or dominated by any particular market center, to 
guarantee fair access to such systems by all brokers, dealers and 
investors, and to prevent any competitive restriction on their 
operation not justified by the purposes of the Exchange Act.'' 370
---------------------------------------------------------------------------

    \369\ Conference Report, supra note 213, at 93.
    \370\ Senate Report, supra note 31.
---------------------------------------------------------------------------

    It bears noting that the standards adopted by the Commission today 
are intended to allow markets to adapt and evolve in meeting the 
objectives of the national market system; the rules establish 
performance standards but do not dictate market structure. With regard 
to the Quote Rule, the rules do not determine how non-Rule 19c-3 market 
makers may make markets or how electronic communications networks may 
operate. Non-Rule 19c-3 market makers are free to operate as they 
please so long as they report their quotations to the extent they 
execute a certain level of volume in a security. Likewise, market 
makers and specialists may place priced orders in ECNs of many 
different designs as long as they change their quotes to reflect the 
orders in the ECN or the ECNs publicly report the quotes and provide 
access to such

[[Page 48325]]

priced orders. With regard to the Limit Order Display Rule, the rule 
does not seek to create a central limit order book or central limit 
order file. Broker-dealers are free to satisfy the rule in several 
different ways, so long as the result is that customer limit orders 
priced at or better than the NBBO are publicly displayed.
    Some commenters also argue that the proposed rules are contrary to 
Congress' direction to assure fair competition between auction and 
dealer markets as structures for the trading of securities 371 and 
inappropriately introduce auction market principles into dealer 
markets. Although requiring display of superior-priced customer limit 
orders could be viewed as an auction market principle, such a 
requirement does not supplant the basic features of a dealer market or 
undermine competition between the exchange and OTC markets. Congress 
clearly intended that dealer markets would benefit from use of some 
auction market principles 372 and the 1975 Amendments specifically 
announce as a goal of the national market system that customer orders 
be able to interact without the intervention of a dealer to the extent 
that such a goal is consistent with other national market system 
objectives.373 At a minimum, where feasible, customer limit orders 
should have a meaningful opportunity to interact with customer market 
orders.374
---------------------------------------------------------------------------

    \371\ See, e.g., Goldman Sachs Letter; Jefferies Letter; Merrill 
Lynch Letter; RPM Letter; Schwab I Letter; Schwartz & Wood Letter; 
SIA Letter; Specialist Assoc. Letter; see also Exchange Act Section 
11A(a)(1)(C)(ii), 15 U.S.C. 78k-1(a)(1)(C)(ii).
    \372\ Senate Report, supra note 31, at 16.
    \373\ Exchange Act Section 11A(a)(1)(C)(v).
    \374\ Exchange Act Section 11A(a)(1)(C)(v).
---------------------------------------------------------------------------

    One of the main benefits contemplated by Congress was that the 
national market system would enable investors in dealer markets to 
execute against another limit order or market order at a better price 
than currently being quoted by a dealer for his own account.375 
Display of superior-priced limit orders would permit investors to 
compete in some cases with market makers and specialists, thereby 
increasing the competitiveness of dealer markets in these securities 
and enhancing the quality of customer limit order execution. Display of 
customer limit orders, however, would not compromise the essential 
features of dealer markets. In the absence of any superior-priced 
customer limit orders, dealers would continue to compete for market 
orders at their published quotations and would be able to execute 
against customer limit orders that would otherwise prevent the market 
maker from trading with a market order. Further, the widespread use by 
OTC dealers of ECNs to trade at prices better than the dealers' 
published quotes is of such recent vintage that it can hardly be viewed 
as a necessary part of a dealer market structure.376
---------------------------------------------------------------------------

    \375\ Senate Report supra note 31, at 16.
    \376\ While the rule and rule amendments adopted today function 
as an integrated response to the problems the Commission has 
identified in the implementation of a NMS, each separately advances 
the Congressional goals of market efficiency, fair competition, 
transparency, and best execution, and accordingly the Commission 
intends that they be treated as severable for purposes of review.
---------------------------------------------------------------------------

V. Summary of Final Regulatory Flexibility Act Analysis

    This following discussion summarizes the Commission's analysis of 
the rules adopted today under the Regulatory Flexibility Act. A 
complete final copy of the Final Regulatory Flexibility Act is 
available in the Public File.
    The rules adopted today by the Commission are intended to allow 
markets to adapt and evolve in meeting the objectives of the national 
market system. In this regard, the rules establish performance 
standards but do not dictate market structure. The Quote Rule does not 
dictate how market makers or specialists that trade non-Rule 19c-3 
securities may conduct their market making activities or how ECNs may 
service their subscribers. Market makers will be able to continue their 
regular market making activities so long as they report their 
quotations if they trade more than 1% of the transaction volume in a 
security. Likewise, market makers and specialists may place priced 
orders in ECNs of many different designs as long as they change their 
quotes to reflect better priced orders they have entered in ECNs or, 
alternatively, such ECNs provide for the public reporting of these 
prices and provide access to such priced orders. Moreover, broker-
dealers are free to satisfy the Display Rule in several different ways, 
so long as the result is that customer limit orders priced at or better 
than the NBBO are publicly displayed in accordance with the rule.

A. Display Rule

    The Commission considered several significant alternatives to Rule 
11Ac1-4 consistent with the Rule's objectives and designed to minimize 
the impact of the rule on small entities. The Commission solicited 
comment on, among other things: (i) Whether the display requirement 
should be based on a de minimis threshold; (ii) the classes of 
securities to which the Rule should apply; (iii) whether to permit 
limit orders to be delivered to an exchange- or association-sponsored 
system that displays limit orders in accordance with the rule; and (iv) 
whether to permit limit orders to be delivered to an ECN or a PTS. The 
Commission believes that the rule as adopted imposes a smaller burden 
upon small brokers and dealers than do other alternatives considered.
    The Commission believes that the ability of brokers and dealers to 
send a limit order to another party or system that will display that 
order provides all brokers and dealers, including small brokers and 
dealers, with the greatest possible flexibility to satisfy the NMS 
objectives embodied in the rule in the most economical manner. In this 
regard, the Commission decided to expand one of the exceptions to the 
display requirement that will permit market makers to comply with the 
rule by delivering customer limit orders to an ECN that complies with 
the ECN amendment to the Quote Rule. Furthermore, the Commission added 
a new exemptive provision that enables the Commission to exempt any 
responsible broker or dealer, ECN, exchange, or association from the 
requirements of the Display Rule.
    The Commission considered allowing display of a representative size 
of a limit order rather than the full size, but concluded that display 
of the full size will provide the most accurate picture of the depth of 
the market at a particular price. The Commission does not believe that 
it is practicable to exempt small entities from the Display Rule 
because to do so would be inconsistent with the Commission's statutory 
mandate to protect investors. In that regard, the Commission believes 
that the pricing and size conventions documented in the 21(a) Report 
referenced above make it imperative that the requirements of the 
Display Rule apply to all market participants with equal force. The 
Commission notes that any exception for small brokers and dealers could 
create an incentive for Nasdaq market makers to create special market 
making subsidiaries qualifying as small broker-dealers which would be 
free to engage in the anti-competitive practices identified in the 
21(a) Report.

B. Quote Rule

    Allowing market makers that deal actively in securities without 
publicizing their activity or making available their prices undermines 
the NMS goal of transparency. The Commission believes that those 
dealers should be recognized as market makers and their quotations 
publicized so that investors may know of, and trade on similar terms 
with, those market makers. Therefore, the definition of OTC

[[Page 48326]]

market maker now includes any dealer holding itself out as willing to 
transact business for its own account on a regular or continuous basis, 
whether it transacts exclusively with its own customers or with the 
customers of other dealers. Thus, those dealers that internalize 
customer order flow in particular stocks or through arrangements with 
other firms to execute that order flow, now fall within the definition 
of OTC market maker and are subject to the obligations under the Quote 
Rule. As in the past, broker-dealers will not be considered to be 
holding themselves out as regularly or continuously willing to buy or 
sell a security if they occasionally execute a trade as principal to 
accommodate a customer's request. In response to the suggestions of 
some commenters, the Commission has modified the amendment to make 
clear that more than one isolated transaction is necessary before a 
dealer is designated an OTC market maker.
    In addition, the Commission believes that extending the 1% 
threshold based on quarterly aggregate trading volume to non-Rule 19c-3 
securities is a reasonable method to improve the scope of quotation 
information to include significant OTC market makers and specialists. 
This 1% threshold, currently in effect for Rule 19c-3 securities, has 
proved effective in supplying comprehensive quotation information to 
the market at large. Moreover, based on the increase in third market 
trading volume for these securities, the Commission does not believe 
this standard is unduly burdensome on OTC market makers. Rather, the 
Commission believes this threshold strikes a balance between requiring 
the dissemination of all quotation interest and accommodating those 
specialists and OTC market makers that may be small entities. The 
Commission believes that OTC market makers and specialists that account 
for 1% or less of the aggregate volume are not active enough to justify 
the additional expense of providing continuous quotation display. 
Accordingly, the Commission believes the ``greater than 1% aggregate 
trading volume'' threshold for mandatory quotations continues to be 
appropriate. To limit a possible inconsistency in the treatment of 
exchange-listed and Nasdaq securities, the Commission today is 
proposing that the 1% test be extended from all exchange-listed 
securities to all Nasdaq-listed securities.
    The Commission considered several significant alternatives to the 
proposed amendments to the Quote Rule consistent with the Rule's 
objectives and designed to minimize the impact of the amendments on 
small entities. The Commission solicited comment on numerous 
alternatives to the amendments proposed to ensure that investors 
receive consolidated quotations that truly reflect the best prices 
available for a security. The Commission solicited comment on, among 
other issues: (i) Whether the Commission should require SROs to amend 
their rules to permit computer-generated quotations; (ii) whether there 
existed alternatives to the ECN proposal that minimized certain 
consequences of the rule while assuring public dissemination of the 
best priced orders in such systems; (iii) whether there should be 
exceptions to the ECN proposal and under what circumstances; and (iv) 
whether the objectives of the Quote Rule and the ECN amendment could be 
achieved by allowing ECNs to furnish prices to the applicable SRO, 
while providing access to the prices in their ECN. The Commission 
believes that the amendments as adopted impose a smaller burden upon 
small brokers and dealers than does any other alternative considered.
    In recognition of the concerns raised by some commenters, the ECN 
display alternative is designed to preserve the benefits associated 
with the anonymity that certain ECNs currently offer to subscribing 
market makers and specialists. This alternative also ensures that the 
best market maker and specialist prices in the ECN are publicly 
disseminated and that non-subscribing brokers and dealers may trade 
with the orders represented by those prices. Under the display 
alternative, the price of a specialist's or market maker's order 
entered into an ECN would be publicly disseminated while the specialist 
or market maker remains anonymous. This alternative not only preserves 
anonymity, but also eliminates the risk that a market maker or 
specialist may be exposed to multiple executions at the ECN price. With 
the addition of the alternative, the ECN amendment permits the display 
of the best price either in the specialist's or market maker's quote or 
through an ECN that provides for the dissemination of the best market 
maker and specialist prices entered into the ECN.
    The Commission also notes that the ECN display alternative reduces 
the compliance burden on broker-dealers, including small entities, by 
permitting specialists and market makers to comply with the ECN 
amendment if the ECN into which the market maker's order is entered 
ensures that the best market maker prices entered therein are 
communicated to an exchange, association or securities information 
processor and the ECN provides a means for brokers and dealers to trade 
with the orders market makers and specialists put in the ECN.
    The Commission recognizes that the ECN display alternative may 
reduce the content of information that is publicly available because 
under this alternative, the identity of the market maker or specialist 
that entered the better priced order in the ECN will be withheld. The 
Commission believes this result is justified because the inside prices 
and full sizes of orders entered by market makers and specialists will 
be in the public quotation system to inform the entire market of these 
prices and ECNs will provide equivalent access to those prices. 
Moreover, the Commission believes the benefits of facilitating the use 
of ECNs, by permitting the continued anonymity of market makers and 
specialists, more than offset the reduced information available on the 
identity of a particular market maker or specialist.
    The Commission believes the data it has reviewed supports the need 
for prompt adoption of the ECN amendment to the Quote Rule. As 
discussed more fully in the Appendix to the 21(a) Report, an analysis 
of data for April through June 1994 shows that approximately 85% of 
bids and offers displayed by market makers on Instinet and 90% of bids 
and offers displayed on SelectNet (an ECN sponsored by the NASD) were 
at better prices than those disseminated to the public via Nasdaq. In 
addition, approximately 77% of trades executed on Instinet and 60% of 
trades executed on SelectNet were at prices superior to the Nasdaq 
inside spread. Given this strong evidence that investors would benefit 
from public dissemination of these hidden prices that are broadly 
disseminated to subscribers in these systems, the Commission believes 
that it is appropriate to adopt the amendments to the Quote Rule.
    The Commission does not believe that it is practicable to exempt 
small entities from the Quote Rule amendments because to do so would be 
inconsistent with the Commission's statutory mandate to protect 
investors. In this regard, the Commission notes the clear evidence of a 
two-tiered market, in which market makers routinely trade at one price 
with customers and at better prices with ECN participants. The 
Commission believes that it is imperative to further the long-standing 
objectives of the 1975 Amendments to ensure reliable and accurate 
quotes by making these prices available to the public. The Commission 
believes that any exception for small brokers and

[[Page 48327]]

dealers could create an incentive for Nasdaq market makers to create 
special market making subsidiaries qualifying as small broker-dealers 
which would be free to engage in the anti-competitive practices 
identified in the 21(a) Report.
    A final copy of the Final Regulatory Flexibility Act analysis is 
available in the Public File.

VI. Paperwork Reduction Act

    As set forth in the Proposing Release,377 the proposed 
amendments to Rule 11Ac1-1 and proposed Rule 11Ac1-4 contain 
collections of information within the meaning of the Paperwork 
Reduction Act (``PRA''). Accordingly, proposed amendments to Rule 
11Ac1-1 and proposed Rule 11Ac1-4 were submitted to the Office of 
Management and Budget (``OMB'') for review pursuant to Section 3507 of 
the PRA (44 U.S.C. 3507), and were approved by OMB which assigned the 
following control numbers: Amendments to Rule 11Ac1-1, control number 
3235-0461; Rule 11Ac1-4, control number 3235-0462. An agency may not 
conduct or sponsor, and a person is not required to respond to, a 
collection of information unless it displays a valid OMB control 
number. This is the final notice regarding the collection of 
information under Rule 11Ac1-4, the Display Rule. A new notice 
regarding the collections of information under Rule 11Ac1-1, the Quote 
Rule, may be found in the Companion Release (published elsewhere in the 
Federal Register today) which proposes an additional amendment to the 
Quote Rule. The PRA section in the preamble of the Companion Release 
provides new estimates of the burden in responding to the collections 
of information under the Quote Rule as a whole.
---------------------------------------------------------------------------

    \377\ Proposing Release at 70.
---------------------------------------------------------------------------

    The reporting requirement in Rule 11Ac1-4 is found in 17 CFR 
240.11Ac1-4. The collection of information is mandatory and responses 
are not confidential. The respondents are OTC market makers, as defined 
under the rule. (Although exchange specialists are also required to 
follow the rule, as noted in the Proposing Release the Commission does 
not anticipate any significant additional burden on exchange 
specialists in light of current exchange order handling practices.) The 
Rule requires market makers to change their published quotation to 
reflect the price and/or size of a customer limit order that would 
improve their published bid or offer or otherwise ensure that such 
limit order is displayed. The burden on market makers will depend on 
the extent and variety of their market-making activities and their 
choice of the various compliance options offered by the regulations. 
The ability of market makers to utilize facilities of national 
securities exchanges, registered national securities associations, and 
ECNs to comply with the reporting requirement should ease the 
compliance burden. The proposed rule would have permitted market makers 
to execute a limit order or send a limit order to another market maker 
or exchange or association facility that would ensure display of such 
orders in lieu of the market makers' own display. Rule 11Ac1-4 as 
adopted maintains these alternatives and also permits respondents to 
send a limit order to an ECN meeting certain criteria. The information 
reported will be displayed to all persons who have access to a 
quotation montage as that term is defined in 17 CFR 240.11Ac1-2(a)(16).
    The Commission carefully considered comments received from the NASD 
and SIA concerning the Commission's burden estimates.378 The NASD 
stated that the Commission underestimated the number of limit orders to 
be displayed per trading day, given the NASD's view that Rule 11Ac1-4 
will lead to increased limit order exposure. After considering the 
NASD's comment, and based upon further review of the market data, the 
Commission is revising its burden estimate for Rule 11Ac1-4 as follows. 
There are approximately 570 respondents. Each respondent on average 
will respond to the collection of information 42,000 times per year, 
based on a 252 trading day year. The total time burden for each 
respondent per year is estimated to be 35 hours, based on an estimate 
of 3 seconds per response (i.e., the time it takes to update a quote to 
reflect a limit order, or to transmit the order for display 
elsewhere).379 The total annual aggregate burden for all 
respondents is estimated to be 19,950 hours.
---------------------------------------------------------------------------

    \378\ The SIA noted that they join in the concerns expressed by 
the NASD that the Commission's estimates under the PRA are too low, 
and need to be revised and extended to include the proposed safe 
harbor under Rule 11Ac1-5. SIA Letter at 4. As noted above, the 
Commission is not adopting the Price Improvement Rule at this time.
    \379\ The NASD commented that it believes the PRA burden 
estimate should include the time market makers spend analyzing 
market trends and following quotation and last sale information. The 
Commission has determined not to revise its burden estimate based on 
this comment, because market makers otherwise engage in such 
activities apart from the collection of information requirement. For 
example, market makers are already required to monitor the markets 
to ensure that they do not trade ahead of customer limit orders.
---------------------------------------------------------------------------

VII. Effects on Competition

    Section 23(a)(2) of the Exchange Act 380 requires the 
Commission to consider the anti-competitive effects of any rules it 
adopts thereunder, and to balance them against the benefits that 
further the purposes of the Act. As discussed above, several commenters 
raised concerns regarding the competitive implications of the order 
handling proposals.381 The foregoing discussion contains extensive 
analysis of the competitive effects of both the rule and rule 
amendments; this section summarizes the Commission's conclusions. The 
Commission has considered the proposals in light of the comments and 
the standard embodied in Section 23(a)(2) and has concluded any burdens 
on competition imposed by the Display Rule and the amendments to the 
Quote Rule are necessary and appropriate in furtherance of the purposes 
of the Exchange Act, in particular, the purposes of Section 11A.
---------------------------------------------------------------------------

    \380\ 15 U.S.C. 78w(a)(2).
    \381\ See ABA Letter; HHG Letter; NASD Letter.
---------------------------------------------------------------------------

    The Commission notes that the primary burden imposed by the Display 
Rule will be to require exchange specialists and OTC market makers to 
ensure that customer limit orders improving their quotes are displayed. 
The Commission believes that if systems upgrades are necessary, those 
systems upgrades reflect one-time charges. The Commission also notes 
that ensuring public dissemination of limit orders enhances market 
transparency, increases pricing efficiency, and quote-based 
competition, and permits investors' orders to interact with all 
available market interest. Moreover, the limit order display rule will 
provide an opportunity for investors to compete directly in the market. 
This additional competition should limit certain anticompetitive 
practices identified in the 21(a) Report and discussed supra. For the 
reasons discussed above, the Commission does not believe the Display 
Rule will have a significantly different effect on wholesale and retail 
market makers.382 The Commission notes that the Antitrust Division 
of the U.S. Department of Justice similarly concluded that the Display 
Rule will promote competition and will thereby benefit the investing 
public.
---------------------------------------------------------------------------

    \382\ See supra note 124 and accompanying text.
---------------------------------------------------------------------------

    Similarly, the Commission notes that the primary burden imposed by 
the ECN Amendment to the Quote Rule will be to require exchange 
specialists and OTC market makers to add personnel or upgrade systems 
to ensure that their quotes reflect priced orders entered into those 
ECNs that do not disseminate

[[Page 48328]]

order information to the relevant exchange or association. The 
Commission believes that such systems upgrades reflect one-time 
charges. The Commission believes that the ECN amendment to the Quote 
Rule will impose only limited competitive burdens on ECNs. ECNs which 
have attributes that differentiate them from other types of electronic 
order routing and order execution systems, will have a choice whether 
to disseminate order information to the relevant exchanges or 
association. While choosing this alternative will result in some system 
costs, the Commission believes that the alternative will provide ECNs 
with additional business opportunities, including increased order flow. 
The ECN amendment should allow ECNs to function as valuable facilities 
for their subscribers, and should not harm ECNs significantly in their 
competition with other order execution systems.383 The Commission 
also notes that ensuring public dissemination of market makers' and 
specialists' priced orders entered into ECNs enhances market 
transparency, pricing efficiency, price competition, and allows 
investors' orders to interact with all available market interest.
---------------------------------------------------------------------------

    \383\ Although the Antitrust Division of the U.S. Department of 
Justice expressed concerns about the effects of the ECN amendment as 
originally proposed, the Commission believes that with the quote 
dissemination alternative, the amendment will not impose any 
unnecessary or inappropriate burdens on competition.
---------------------------------------------------------------------------

    Finally, with respect to the amendments extending the Mandatory 
Quote Rule to non-Rule 19c-3 securities, the primary burden imposed 
will be to require certain brokers and dealers to register as CQS 
market makers and make continuous two-sided quotes available to the 
public. The Commission believes that the benefit to the investing 
public of ensuring that available market interest is disseminated to 
the public will enhance competition by facilitating the routing of 
investor orders to the market center displaying the best quotation for 
a security. The Commission believes that the added transparency 
resulting from the amendment outweighs any burden to competition that 
may be imposed.

List of Subjects in 17 CFR Part 240

    Broker-dealers, Confidential business information, Reporting and 
recordkeeping requirements, and Securities.

Text of the Rules

    For the reasons set out in the preamble, the Commission amends Part 
240 of Chapter II of Title 17 of the Code of Federal Regulation as 
follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The general authority citation for Part 240 is revised to read 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 
77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1, 78l, 78m, 
78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-
23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
    2. Section 240.11Aa3-1 is amended by revising paragraph (a)(4) to 
read as follows:


Sec. 240.11Aa3-1  Dissemination of transaction reports and last sale 
data with respect to transactions in reported securities.

    (a) Definitions. * * *
    (4) The term reported security shall mean any security or class of 
securities for which transaction reports are collected, processed and 
made available pursuant to an effective transaction reporting plan.
* * * * *
    3. Section 240.11Ac1-1 is revised to read as follows:


Sec. 240.11Ac1-1  Dissemination of quotations.

    (a) Definitions. For the purposes of this section:
    (1) The term aggregate quotation size shall mean the sum of the 
quotation sizes of all responsible brokers or dealers who have 
communicated on any exchange bids or offers for a covered security at 
the same price.
    (2) The term association shall mean any association of brokers and 
dealers registered pursuant to Section 15A of the Act (15 U.S.C. 78o-
3).
    (3) The terms best bid and best offer shall mean the highest priced 
bid and the lowest priced offer.
    (4) The terms bid and offer shall mean the bid price and the offer 
price communicated by an exchange member or OTC market maker to any 
broker or dealer, or to any customer, at which it is willing to buy or 
sell one or more round lots of a covered security, as either principal 
or agent, but shall not include indications of interest.
    (5) The term consolidated system shall mean the consolidated 
transaction reporting system.
    (6) The term covered security shall mean any reported security and 
any other security for which a transaction report, last sale data or 
quotation information is disseminated through an automated quotation 
system as described in Section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 
78c(a)(51)(A)(ii)).
    (7) The term effective transaction reporting plan shall have the 
meaning provided in Sec. 240.11Aa3-1(a)(3).
    (8) The term electronic communications network, for the purposes of 
Sec. 240.11Ac1-1(c)(5), shall mean any electronic system that widely 
disseminates to third parties orders entered therein by an exchange 
market maker or OTC market maker, and permits such orders to be 
executed against in whole or in part; except that the term electronic 
communications network shall not include:
    (i) Any system that crosses multiple orders at one or more 
specified times at a single price set by the ECN (by algorithm or by 
any derivative pricing mechanism) and does not allow orders to be 
crossed or executed against directly by participants outside of such 
times; or
    (ii) Any system operated by, or on behalf of, an OTC market maker 
or exchange market maker that executes customer orders primarily 
against the account of such market maker as principal, other than 
riskless principal.
    (9) The term exchange market maker shall mean any member of a 
national securities exchange (``exchange'') who is registered as a 
specialist or market maker pursuant to the rules of such exchange.
    (10) The term exchange-traded security shall mean any covered 
security or class of covered securities listed and registered, or 
admitted to unlisted trading privileges, on an exchange; provided, 
however, That securities not listed on any exchange that are traded 
pursuant to unlisted trading privileges are excluded.
    (11) The term make available, when used with respect to bids, 
offers, quotation sizes and aggregate quotation sizes supplied to 
quotation vendors by an exchange or association, shall mean to provide 
circuit connections at the premises of the exchange or association 
supplying such data, or at a common location determined by mutual 
agreement of the exchanges and associations, for the delivery of such 
data to quotation vendors.
    (12) The term odd-lot shall mean an order for the purchase or sale 
of a covered security in an amount less than a round lot.
    (13) The term OTC market maker shall mean any dealer who holds 
itself out as being willing to buy from and sell to its customers, or 
otherwise, a covered security for its own account on a regular or 
continuous basis otherwise than on an exchange in amounts of less than 
block size.

[[Page 48329]]

    (14) The term plan processor shall have the meaning provided in 
Sec. 240.11Aa3-2(a)(7).
    (15) The term published aggregate quotation size shall mean the 
aggregate quotation size calculated by an exchange and displayed by a 
quotation vendor on a terminal or other display device at the time an 
order is presented for execution to a responsible broker or dealer.
    (16) The terms published bid and published offer shall mean the bid 
or offer of a responsible broker or dealer for a covered security 
communicated by it to its exchange or association pursuant to this 
section and displayed by a quotation vendor on a terminal or other 
display device at the time an order is presented for execution to such 
responsible broker or dealer.
    (17) The term published quotation size shall mean the quotation 
size of a responsible broker or dealer communicated by it to its 
exchange or association pursuant to this section and displayed by a 
quotation vendor on a terminal or other display device at the time an 
order is presented for execution to such responsible broker or dealer.
    (18) The term quotation size, when used with respect to a 
responsible broker's or dealer's bid or offer for a covered security, 
shall mean:
    (i) The number of shares (or units of trading) of that covered 
security which such responsible broker or dealer has specified, for 
purposes of dissemination to quotation vendors, that it is willing to 
buy at the bid price or sell at the offer price comprising its bid or 
offer, as either principal or agent; or
    (ii) In the event such responsible broker or dealer has not so 
specified, a normal unit of trading for that covered security.
    (19) The term quotation vendor shall mean any securities 
information processor engaged in the business of disseminating to 
brokers, dealers or investors on a real-time basis, bids and offers 
made available pursuant to this section, whether distributed through an 
electronic communications network or displayed on a terminal or other 
display device.
    (20) The term reported security shall mean any security or class of 
securities for which transaction reports are collected, processed and 
made available pursuant to an effective transaction reporting plan.
    (21) The term responsible broker or dealer shall mean:
    (i) When used with respect to bids or offers communicated on an 
exchange, any member of such exchange who communicates to another 
member on such exchange, at the location (or locations) designated by 
such exchange for trading in a covered security, a bid or offer for 
such covered security, as either principal or agent; provided, however, 
That, in the event two or more members of an exchange have communicated 
on such exchange bids or offers for a covered security at the same 
price, each such member shall be considered a ``responsible broker or 
dealer'' for that bid or offer, subject to the rules of priority and 
precedence then in effect on that exchange; and further provided, That 
for a bid or offer which is transmitted from one member of an exchange 
to another member who undertakes to represent such bid or offer on such 
exchange as agent, only the last member who undertakes to represent 
such bid or offer as agent shall be considered the ``responsible broker 
or dealer'' for that bid or offer; and
    (ii) When used with respect to bids and offers communicated by a 
member of an association to another broker or dealer or to a customer 
otherwise than on an exchange, the member communicating the bid or 
offer (regardless of whether such bid or offer is for its own account 
or on behalf of another person).
    (22) The term revised bid or offer shall mean a market maker's bid 
or offer which supersedes its published bid or published offer.
    (23) The term revised quotation size shall mean a market maker's 
quotation size which supersedes its published quotation size.
    (24) The term specified persons, when used in connection with any 
notification required to be provided pursuant to paragraph (b)(3) of 
this section and any election (or withdrawal thereof) permitted under 
paragraph (b)(5) of this section, shall mean:
    (i) Each quotation vendor;
    (ii) Each plan processor; and
    (iii) The processor for the Options Price Reporting Authority (in 
the case of a notification for a subject security which is a class of 
securities underlying options admitted to trading on any exchange).
    (25) The term subject security shall mean:
    (i) With respect to an exchange:
    (A) Any exchange-traded security other than a security for which 
the executed volume of such exchange, during the most recent calendar 
quarter, comprised one percent or less of the aggregate trading volume 
for such security as reported in the consolidated system; and
    (B) Any other covered security for which such exchange has in 
effect an election, pursuant to paragraph (b)(5)(i) of this section, to 
collect, process, and make available to quotation vendors, bids, 
offers, quotation sizes, and aggregate quotation sizes communicated on 
such exchange; and
    (ii) With respect to a member of an association:
    (A) Any exchange-traded security for which such member acts in the 
capacity of an OTC market maker unless the executed volume of such 
member, during the most recent calendar quarter, comprised one percent 
or less of the aggregate trading volume for such security as reported 
in the consolidated system; and
    (B) Any other covered security for which such member acts in the 
capacity of an OTC market maker and has in effect an election, pursuant 
to paragraph (b)(5)(ii) of this section, to communicate to its 
association bids, offers and quotation sizes for the purpose of making 
such bids, offers and quotation sizes available to quotation vendors.
    (b) Dissemination requirements for exchanges and associations. (1) 
Every exchange and association shall establish and maintain procedures 
and mechanisms for collecting bids, offers, quotation sizes and 
aggregate quotation sizes from responsible brokers or dealers who are 
members of such exchange or association, processing such bids, offers 
and sizes, and making such bids, offers and sizes available to 
quotation vendors, as follows:
    (i) Each exchange shall at all times such exchange is open for 
trading, collect, process and make available to quotation vendors the 
best bid, the best offer, and aggregate quotation sizes for each 
subject security listed or admitted to unlisted trading privileges 
which is communicated on any exchange by any responsible broker or 
dealer, but shall not include:
    (A) Any bid or offer executed immediately after communication and 
any bid or offer communicated by a responsible broker or dealer other 
than an exchange market maker which is cancelled or withdrawn if not 
executed immediately after communication; and
    (B) Any bid or offer communicated during a period when trading in 
that security has been suspended or halted, or prior to the 
commencement of trading in that security on any trading day, on that 
exchange.
    (ii) Each association shall, at all times that last sale 
information with respect to reported securities is reported pursuant to 
an effective transaction reporting plan, collect, process and make 
available to quotation vendors the best bid, best offer, and quotation 
sizes communicated otherwise than on an exchange by each member of such 
association acting in the capacity of an

[[Page 48330]]

OTC market maker for each subject security and the identity of that 
member (excluding any bid or offer executed immediately after 
communication), except during any period when over-the-counter trading 
in that security has been suspended.
    (2) Each exchange shall, with respect to each published bid and 
published offer representing a bid or offer of a member for a subject 
security, establish and maintain procedures for ascertaining and 
disclosing to other members of that exchange, upon presentation of 
orders sought to be executed by them in reliance upon paragraph (c)(2) 
of this section, the identity of the responsible broker or dealer who 
made such bid or offer and the quotation size associated with it.
    (3)(i) If, at any time an exchange is open for trading, such 
exchange determines, pursuant to rules approved by the Securities and 
Exchange Commission pursuant to section 19(b)(2) of the Act (15 U.S.C. 
78s(b)(2)), that the level of trading activities or the existence of 
unusual market conditions is such that the exchange is incapable of 
collecting, processing, and making available to quotation vendors the 
data for a subject security required to be made available pursuant to 
paragraph (b)(1) of this section in a manner that accurately reflects 
the current state of the market on such exchange, such exchange shall 
immediately notify all specified persons of that determination. Upon 
such notification, responsible brokers or dealers that are members of 
that exchange shall be relieved of their obligation under paragraph 
(c)(2) of this section and such exchange shall be relieved of its 
obligations under paragraphs (b) (1) and (2) of this section for that 
security: provided, however, That such exchange will continue, to the 
maximum extent practicable under the circumstances, to collect, 
process, and make available to quotation vendors data for that security 
in accordance with paragraph (b)(1) of this section.
    (ii) During any period an exchange, or any responsible broker or 
dealer that is a member of that exchange, is relieved of any obligation 
imposed by this section for any subject security by virtue of a 
notification made pursuant to paragraph (b)(3)(i) of this section, such 
exchange shall monitor the activity or conditions which formed the 
basis for such notification and shall immediately renotify all 
specified persons when that exchange is once again capable of 
collecting, processing, and making available to quotation vendors the 
data for that security required to be made available pursuant to 
paragraph (b)(1) of this section in a manner that accurately reflects 
the current state of the market on such exchange. Upon such 
renotification, any exchange or responsible broker or dealer which had 
been relieved of any obligation imposed by this section as a 
consequence of the prior notification shall again be subject to such 
obligation.
    (4) Nothing in this section shall preclude any exchange or 
association from making available to quotation vendors indications of 
interest or bids and offers for a subject security at any time such 
exchange or association is not required to do so pursuant to paragraph 
(b)(1) of this section.
    (5)(i) Any exchange may make an election for purposes of paragraph 
(a)(25)(i)(B) of this section for any covered security, by collecting, 
processing, and making available bids, offers, quotation sizes, and 
aggregate quotation sizes in that security; except that for any covered 
security previously listed or admitted to unlisted trading privileges 
on only one exchange and not traded by any OTC market maker, such 
election shall be made by notifying all specified persons, and shall be 
effective at the opening of trading on the business day following 
notification.
    (ii) Any member of an association acting in the capacity of an OTC 
market maker may make an election for purposes of paragraph 
(a)(25)(ii)(B) of this section for any covered security, by 
communicating to its association bids, offers, and quotation sizes in 
that security; except that for any other covered security listed or 
admitted to unlisted trading privileges on only one exchange and not 
traded by any other OTC market maker, such election shall be made by 
notifying its association and all specified persons, and shall be 
effective at the opening of trading on the business day following 
notification.
    (iii) The election of an exchange or member of an association for 
any covered security pursuant to this paragraph (b)(5) shall cease to 
be in effect if such exchange or member ceases to make available or 
communicate bids, offers, and quotation sizes in such security.
    (c) Obligations of responsible brokers and dealers. (1) Each 
responsible broker or dealer shall promptly communicate to its exchange 
or association, pursuant to the procedures established by that exchange 
or association, its best bids, best offers, and quotation sizes for any 
subject security.
    (2) Subject to the provisions of paragraph (c)(3) of this section, 
each responsible broker or dealer shall be obligated to execute any 
order to buy or sell a subject security, other than an odd-lot order, 
presented to it by another broker or dealer, or any other person 
belonging to a category of persons with whom such responsible broker or 
dealer customarily deals, at a price at least as favorable to such 
buyer or seller as the responsible broker's or dealer's published bid 
or published offer (exclusive of any commission, commission equivalent 
or differential customarily charged by such responsible broker or 
dealer in connection with execution of any such order) in any amount up 
to its published quotation size.
    (3)(i) No responsible broker or dealer shall be obligated to 
execute a transaction for any subject security as provided in paragraph 
(c)(2) of this section to purchase or sell that subject security in an 
amount greater than such revised quotation if:
    (A) Prior to the presentation of an order for the purchase or sale 
of a subject security, a responsible broker or dealer has communicated 
to its exchange or association, pursuant to paragraph (c)(1) of this 
section, a revised quotation size; or
    (B) At the time an order for the purchase or sale of a subject 
security is presented, a responsible broker or dealer is in the process 
of effecting a transaction in such subject security, and immediately 
after the completion of such transaction, it communicates to its 
exchange or association a revised quotation size, such responsible 
broker or dealer shall not be obligated by paragraph (c)(2) of this 
section to purchase or sell that subject security in an amount greater 
than such revised quotation size.
    (ii) No responsible broker or dealer shall be obligated to execute 
a transaction for any subject security as provided in paragraph (c)(2) 
of this section if:
    (A) Before the order sought to be executed is presented, such 
responsible broker or dealer has communicated to its exchange or 
association pursuant to paragraph (c)(1) of this section, a revised bid 
or offer; or
    (B) At the time the order sought to be executed is presented, such 
responsible broker or dealer is in the process of effecting a 
transaction in such subject security, and, immediately after the 
completion of such transaction, such responsible broker or dealer 
communicates to its exchange or association pursuant to paragraph 
(c)(1) of this section, a revised bid or offer; provided, however, That 
such responsible broker or dealer shall nonetheless be obligated to 
execute any such order in such subject security as provided in 
paragraph (c)(2) of this section at its revised bid or offer in any

[[Page 48331]]

amount up to its published quotation size or revised quotation size.
    (4) Subject to the provisions of paragraph (b)(4) of this section:
    (i) No exchange or OTC market maker may make available, disseminate 
or otherwise communicate to any quotation vendor, directly or 
indirectly, for display on a terminal or other display device any bid, 
offer, quotation size, or aggregate quotation size for any covered 
security which is not a subject security with respect to such exchange 
or OTC market maker; and
    (ii) No quotation vendor may disseminate or display on a terminal 
or other display device any bid, offer, quotation size, or aggregate 
quotation size from any exchange or OTC market maker for any covered 
security which is not a subject security with respect to such exchange 
or OTC market maker.
    (5)(i) Entry of any priced order for a covered security by an 
exchange market maker or OTC market maker in that security into an 
electronic communications network that widely disseminates such order 
shall be deemed to be:
    (A) A bid or offer under this section, to be communicated to the 
market maker's exchange or association pursuant to paragraph (c) of 
this section for at least the minimum quotation size that is required 
by the rules of the market maker's exchange or association if the 
priced order is for the account of a market maker, or the actual size 
of the order up to the minimum quotation size required if the priced 
order is for the account of a customer; and
    (B) A communication of a bid or offer to a quotation vendor for 
display on a display device for purposes of paragraph (c)(4) of this 
section.
    (ii) An exchange market maker or OTC market maker that has entered 
a priced order for a covered security into an electronic communications 
network that widely disseminates such order shall be deemed to be in 
compliance with paragraph (c)(5)(i)(A) of this section if the 
electronic communications network:
    (A) Provides to an exchange or association (or an exclusive 
processor acting on behalf of one or more exchanges or associations) 
the prices and sizes of the orders at the highest buy price and the 
lowest sell price for such security entered in, and widely disseminated 
by, the electronic communications network by exchange market makers and 
OTC market makers for the covered security, and such prices and sizes 
are included in the quotation data made available by the exchange, 
association, or exclusive processor to quotation vendors pursuant to 
this section; and
    (B) Provides, to any broker or dealer, the ability to effect a 
transaction with a priced order widely disseminated by the electronic 
communications network entered therein by an exchange market maker or 
OTC market maker that is:
    (1) Equivalent to the ability of any broker or dealer to effect a 
transaction with an exchange market maker or OTC market maker pursuant 
to the rules of the exchange or association to which the electronic 
communications network supplies such bids and offers; and
    (2) At the price of the highest priced buy order or lowest priced 
sell order, or better, for the lesser of the cumulative size of such 
priced orders entered therein by exchange market makers or OTC market 
makers at such price, or the size of the execution sought by the broker 
or dealer, for the covered security.
    (d) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any responsible broker or dealer, electronic communications 
network, exchange, or association if the Commission determines that 
such exemption is consistent with the public interest, the protection 
of investors and the removal of impediments to and perfection of the 
mechanism of a national market system.
    4. Section 240.11Ac1-4 is added to read as follows:


Sec. 240.11Ac1-4  Display of customer limit orders.

    (a) Definitions. For purposes of this section:
    (1) The term association shall mean any association of brokers and 
dealers registered pursuant to Section 15A of the Act (15 U.S.C. 78o-
3).
    (2) The terms best bid and best offer shall have the meaning 
provided in Sec. 240.11Ac1-1(a)(3).
    (3) The terms bid and offer shall have the meaning provided in 
Sec. 240.11Ac1-1(a)(4).
    (4) The term block size shall mean any order:
    (i) Of at least 10,000 shares; or
    (ii) For a quantity of stock having a market value of at least 
$200,000.
    (5) The term covered security shall mean any ``reported security'' 
and any other security for which a transaction report, last sale data 
or quotation information is disseminated through an automated quotation 
system as described in section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 
78c(a)(51)(A)(ii)).
    (6) The term customer limit order shall mean an order to buy or 
sell a covered security at a specified price that is not for the 
account of either a broker or dealer; provided, however, That the term 
customer limit order shall include an order transmitted by a broker or 
dealer on behalf of a customer.
    (7) The term electronic communications network shall have the 
meaning provided in Sec. 240.11Ac1-1(a)(8).
    (8) The term exchange-traded security shall have the meaning 
provided in Sec. 240.11Ac1-1(a)(10).
    (9) The term OTC market maker shall mean any dealer who holds 
itself out as being willing to buy from and sell to its customers, or 
otherwise, a covered security for its own account on a regular or 
continuous basis otherwise than on a national securities exchange in 
amounts of less than block size.
    (10) The term reported security shall have the meaning provided in 
Sec. 240.11Ac1-1(a)(20).
    (b) Specialists and OTC market makers. For all covered securities:
    (1) Each member of an exchange that is registered by that exchange 
as a specialist, or is authorized by that exchange to perform functions 
substantially similar to that of a specialist, shall publish 
immediately a bid or offer that reflects:
    (i) The price and the full size of each customer limit order held 
by the specialist that is at a price that would improve the bid or 
offer of such specialist in such security; and
    (ii) The full size of each customer limit order held by the 
specialist that:
    (A) Is priced equal to the bid or offer of such specialist for such 
security;
    (B) Is priced equal to the national best bid or offer; and
    (C) Represents more than a de minimis change in relation to the 
size associated with the specialist's bid or offer.
    (2) Each registered broker or dealer that acts as an OTC market 
maker shall publish immediately a bid or offer that reflects:
    (i) The price and the full size of each customer limit order held 
by the OTC market maker that is at a price that would improve the bid 
or offer of such OTC market maker in such security; and
    (ii) The full size of each customer limit order held by the OTC 
market maker that:
    (A) Is priced equal to the bid or offer of such OTC market maker 
for such security;
    (B) Is priced equal to the national best bid or offer; and
    (C) Represents more than a de minimis change in relation to the 
size associated with the OTC market maker's bid or offer.

[[Page 48332]]

    (c) Exceptions. The requirements in paragraph (b) of this section 
shall not apply to any customer limit order:
    (1) That is executed upon receipt of the order.
    (2) That is placed by a customer who expressly requests, either at 
the time that the order is placed or prior thereto pursuant to an 
individually negotiated agreement with respect to such customer's 
orders, that the order not be displayed.
    (3) That is an odd-lot order.
    (4) That is a block size order, unless a customer placing such 
order requests that the order be displayed.
    (5) That is delivered immediately upon receipt to an exchange or 
association-sponsored system, or an electronic communications network 
that complies with the requirements of Sec. 240.11Ac1-1(c)(5)(ii) with 
respect to that order.
    (6) That is delivered immediately upon receipt to another exchange 
member or OTC market maker that complies with the requirements of this 
section with respect to that order.
    (7) That is an ``all or none'' order.
    (d) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any responsible broker or dealer, electronic communications 
network, exchange, or association if the Commission determines that 
such exemption is consistent with the public interest, the protection 
of investors and the removal of impediments to and perfection of the 
mechanism of a national market system.

    Dated: September 6, 1996.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-23210 Filed 9-11-96; 8:45 am]
BILLING CODE 8010-01-P