[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]]
_______________________________________________________________________
Part III
Securities and Exchange Commission
_______________________________________________________________________
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).
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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.
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\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.
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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\
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\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\
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\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.
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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\
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\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).
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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.
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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.
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\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.
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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.
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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
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\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).
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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.
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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.
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\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.
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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.
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\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
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\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.
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\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).
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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
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\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.
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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
---------------------------------------------------------------------------
\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.
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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).
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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.
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\143\ See, e.g., Dillon Letter; HHG Letter; Merrill Letter;
PaineWebber Letter; Schwab Letter.
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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.
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\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.
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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).
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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
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\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.
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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
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\156\ See, e.g., Bear Stearns Letter; Lehman Letter; Merrill
Letter; NASD Letter; SIA Letter.
\157\ SIA Letter.
\158\ PSE Letter.
\159\ Ricker Letter.
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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
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\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.
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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
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\162\ See description of the phase-in at section III.A.3.d.,
infra.
\163\ See, e.g., Amex Letter.
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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
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\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.
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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
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\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.
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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
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\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.
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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
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\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.
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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
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\174\ CSE Letter.
\175\ Dean Witter Letter.
\176\ See, e.g., Amex Letter; CHX Letter; Schwab Letter.
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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
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\177\ Any SRO may set more stringent display requirements
through its own rules.
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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.
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\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).
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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
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\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.
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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.
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\182\ Section 240.11Ac1-4(c)(1).
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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.
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\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.
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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.
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\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.
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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
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\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.
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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).
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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.
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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.
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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.
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\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
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\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.
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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.
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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
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\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.
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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.
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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.
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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.
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\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
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\250\ See DOJ Letter; SIA Letter; Instinet Letter; Schwab
Letter; STI Capital Letter; Sutro Letter.
\251\ See, e.g., Instinet letter.
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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.
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\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.
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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.
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\254\ See Proposing Release and e.g., NASD Letter.
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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.
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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.
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\259\ See, e.g., Instinet Letter.
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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.
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\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.