[Federal Register Volume 62, Number 185 (Wednesday, September 24, 1997)]
[Notices]
[Pages 50036-50048]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-25319]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39086; File No. SR-PCX-97-18]


Self-Regulatory Organizations; Pacific Exchange, Inc.; Order 
Approving Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval of Amendment Numbers 1, 2 and 3 to Proposed Rule 
Change Relating to the PCX Application of the OptiMark System

September 17, 1997.

I. Introduction

    On June 11, 1997, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to establish rules for a new 
exchange facility called the PCX Application of the OptiMark System 
(``PCX Application'' or ``Application''). Notice of the proposed rule 
change appeared in the Federal Register on June 19, 1997.\3\ Fourteen 
comment letters were received in response to the proposal.\4\ On August 
1, 1997, PCX submitted an amendment (``Amendment No. 1'') to the 
proposal, as well as two letters containing supplemental 
information.\5\ On August 29, 1997, PCX submitted a second amendment 
(``Amendment No. 2'') to the proposal.\6\ On September 16, 1997, PCX 
submitted a third amendment (``Amendment No. 3'') to the proposal.\7\ 
This order approves PCX's proposal, as amended.
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    \1\ The Exchange originally submitted this filing to the SEC on 
May 20, 1997. On June 3, 1997, the Exchange submitted Amendment No. 
1 to the filing. The Exchange resubmitted the entire filing on June 
11, 1997. The resubmitted filing incorporates the substance of the 
June 3, 1997, Amendment No. 1. All subsequent references in this 
order to ``Amendment No. 1'' refer to the amendment, dated Aug. 1, 
1997, submitted as an amendment to the June 11, 1997 filing. See 
note 5, infra.
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 38740 (June 13, 
1997), 62 FR 33448 (June 19, 1997).
    \4\ Comment letters to the Commission were received from Thomas 
D. Burke, Newbridge Securities, Inc., dated July 1, 1997; Steven A. 
Denning, General Atlantic Partners, dated July 2, 1997; Theodore E. 
James, Jr., Van Kasper & Company, dated July 3, 1997; Junius W. 
Peake, University of Northern Colorado, dated July 7, 1997; Theodore 
R. Aronson, Aronson & Partners, dated July 7, 1997; Praveen K. 
Gottipalli, Symphony Asset Management, dated July 8, 1997; Robert A. 
Hill, Melvin Specialists, Inc., dated July 9, 1997; Tim McCarthy, 
Charles Schwab, dated July 10, 1997; Todd Greenberg, ProActive 
Capital Management, dated July 10, 1997; Matt Fong, Treasurer, State 
of California, dated July 10, 1997; Harold S. Bradley, American 
Century Investment Management, Inc., dated July 15, 1997; James E. 
Buck, New York Stock Exchange, Inc. (``NYSE''), dated July 15, 1997; 
Tom C. Tinsley, Baan Company, N.V., dated July 17, 1997; Bill Porter 
and Christos M. Cotsakos, E*Trade Group, Inc., dated July 21, 1997.
    \5\ Letter from John C. Katovich, Senior Vice President, General 
Counsel, and Director of Legal Affairs, PCX, to Michael Walinskas, 
Senior Special Counsel, Division of Market Regulation, SEC, dated 
Aug. 1, 1997. In Amendment No. 1, PCX made a technical amendment to 
its short sale rule, and provided clarification regarding the 
application of Rule 10a-1 under the Act to short sales in the PCX 
Application. Also in Amendment No. 1, PCX responded to comments made 
by the NYSE.
    \6\ Letter from John C. Katovich, Senior Vice President, General 
Counsel, and Director of Legal Affairs, PCX, to Michael Walinskas, 
Senior Special Counsel, Division of Market Regulation, SEC, dated 
Aug. 29, 1997. In addition to Amendment No. 2, the PCX also 
submitted two letters containing supplemental information. See 
Letter from John C. Katovich, Senior Vice President, General 
Counsel, and Director of Legal Affairs, PCX, to Michael Walinskas, 
Senior Special Counsel, Division of Market Regulation, SEC, dated 
Aug. 29, 1997 (regarding issues related to the Intermarket Trading 
System) (``PCX ITS Letter''), and Letter from John C. Katovich, 
Senior Vice President, General Counsel, and Director of Legal 
Affairs, PCX, to Michael Walinskas, Senior Special Counsel, Division 
of Market Regulation, SEC, dated Aug. 29, 1997 (regarding 
interaction of the PCX Application with the PCX floor) (``PCX Floor 
Letter'').
    \7\ Memorandum from John C. Katovich, Senior Vice President, 
General Counsel, and Director of Legal Affairs, PCX, to Michael 
Walinskas, Senior Special Counsel, Division of Market Regulation, 
SEC, dated Sept. 16, 1997. In Amendment No. 3, PCX clarified the 
manner in which Primary Market Protection (``PMP'') orders will be 
executed once the Application is implemented. The letter also 
includes several trading scenarios that illustrate the operation of 
the Application vis-a-vis PCX specialists.
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II. Description of the Proposal

A. Summary of the PCX Application and Purpose

    The Exchange proposes to establish rules for a new exchange 
facility called the PCX Application of the OptiMark System. The PCX 
Application of the ``OptiMark System'' \8\ is a computerized, screen-
based trading service intended for use by Exchange members and their 
customers. The OptiMark System would provide automatic order 
formulation, matching, and execution capabilities in the equity 
securities listed or traded on the Exchange (``PCX Securities''). The 
OptiMark System would be used in addition to PCX's traditional floor 
facilities, to buy and sell PCX Securities.\9\
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    \8\ The OptiMark System was developed by OptiMark Technologies, 
Inc. (``OTI''), a computer technology firm located in Durango, 
Colorado, based on certain patent-pending technology referred to as 
``OptiMark TM.'' OTI has represented that the PCX 
Application is expected to be one of several different trading 
services based on that technology that will be made available from 
the OptiMark System for other exchanges and markets in the future. 
OTI expects its wholly-owned subsidiary, OptiMark Servicers, Inc. 
(``OSI''), which currently plans to apply for registration as a 
broker-dealer, to be responsible for operating portions of the PCX 
Application for the Exchange and delivering the trading service to 
the Exchange's members and their customers. OTI is licensing the 
OptiMark System to OSI for purposes of the PCX Application.
    \9\ This rule filing addresses trading in PCX Securities only. 
PCX represents that if and when it proposes to extend the 
Application to options or other types of securities listed or traded 
on the Exchange, a rule change proposal will first be filed with the 
Commission.
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    Specifically, the Application would allow PCX members and their 
customers to submit anonymously from their computer terminals ranges of 
the trading interest to the OptiMark Systems. At specified times during 
the trading day, the OptiMark System would conduct certain calculations 
against such expressions of interest to identify specific orders 
capable of execution. All orders formulated by the OptiMark System 
would be automatically executed on the Exchange, except to the extent 
that they are executed on other market centers through the Intermarket 
Trading System (``ITS''). The Exchange has stated that the proposed 
facility would meet institutional investors' growing demand for a new 
trading medium. The Exchange also expects retail investors to benefit 
from the operation of the PCX Application.

B. Description of the Proposed PCX Application Operation

    The PCX Application was developed jointly by the Exchange and OTI. 
Exchange members and their customers will trade on the OptiMark System 
in the manner described below:
Proposed Method of Operation
    Two distinct operations would be involved in running the PCX 
Application: (i) The central information processing system and related 
administrative and communications

[[Page 50037]]

terminal network of the OptiMark System, which includes computers that 
collect and process data, log activities, and switch messages from and 
to other systems and carriers, as well as the communication network 
linking such computers with customer terminals; and (ii) the computer 
hardware and software needed (collectively, the ``PCX Interfaces'') for 
the OptiMark System to communicate with PCX's computerized order system 
(including any terminals in use by PCX specialists or floor brokers). 
The Exchange would continue to operate its electronic linkages with the 
ITS, Consolidated Quote System (``CQS''), and the Consolidated Tape 
System (``CTS''), as they currently exist.
    The Exchange would have direct ownership of and control over the 
PCX Interfaces. The OptiMark System would provide such electronic 
communications and information services needed for the PCX Application 
to operate. From time to time, various services provided by the 
OptiMark System would be modified to allow for system improvement and 
enhancement. The Exchange would assure that, at all relevant times, the 
material terms and conditions of the PCX Application would comply fully 
with the applicable rules of the Exchange.
Access to the PCX Application
    The PCX Application would be available to all members of PCX and, 
through them, to non-members such as institutional investors and other 
non-member broker-dealers. Each interested member and non-member 
customer would be eligible to enter into a subscription agreement 
(``User Agreement'') with OTI and also to execute an agreement with OSI 
authorizing the delivery of the trading service made available from the 
OptiMark System.
    The OptiMark System subscribers (``Users'') would log in from their 
own computer terminals and communicate with the OptiMark System over 
customary commercial information services and networks of their choice. 
Those Users that serve as specialists and floor brokers on the Exchange 
could also communicate with the OptiMark System from certain computer 
terminals located on the floor of the Exchange. Security codes and 
protocols would be required to log in to the OptiMark System. Once 
logged in, Users with authorized access to the PCX Application would be 
able to submit certain expressions of their trading interest in a PCX 
Security to the OptiMark System. Users would be responsible for all of 
such expressions and any other messages submitted to the OptiMark 
System under their passwords and security codes.
    Under PCX's proposal, each member of the Exchange would be granted 
access to the PCX Application directly as a User. Any orders formulated 
and matched by the OptiMark System based on the expressions of trading 
interest received from a member User would be automatically routed, 
executed and reported in that User's name. Each such member User would 
be responsible for all transactions resulting from the PCX Application 
for its own or customer accounts in the same way that it is currently 
responsible for transactions on the floor.
    Non-member Users would be required to designate in advance member 
firms (``Designated Brokers'') that would authorize their access to the 
PCX Application. Under a non-member's agreement with a Designed Broker 
(``Give-Up Agreement''), the Designated Broker would accept 
responsibility for that non-member User's transactions and provide a 
written statement to the Exchange to that effect. Under the Designated 
Broker's agreement with OSI (``Transmission Consent Agreement''), the 
Designated Broker would authorize any and all orders formulated and 
matched by the OptiMark System based on the expressions of trading 
interest received from the non-member User to be automatically routed, 
executed and reported in the Designated Broker's name. Both agreements 
must be in force before any non-member User may be given access to the 
PCX Application. At a minimum, the provisions in these agreements would 
include any credit limits that may be imposed by a Designated Broker 
(or its clearing broker if applicable) on a non-member User; \10\ the 
Designated Broker's undertaking that it is responsible for the non-
member User's transactions; and such other terms and conditions that 
may be agreed to from time to time.
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    \10\ A non-member User's credit limits, as they may be 
established from time to time by a Designated Broker (or its 
clearing broker if applicable), will be programmed into the OptiMark 
System. In addition, the Designated Broker will be notified as its 
potential exposure to its customers, individually or in the 
aggregate, approaches the established credit limits.
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Entry of Profiles
    Under PCX's proposal, a User would submit an expression of its 
trading interest in the form of a ``satisfaction profile'' 
(``Profile''), which would indicate the User's degree of satisfaction 
or willingness (expressed as a number between zero and one) to trade at 
each coordinate of a price/size grid. A User may depict a varying 
degree of its trading preferences, covering a range of prices and 
sizes, in a Profile.
    The price/size grid over which Profiles are entered would be 
unitized into individual coordinates. The price axis would be divided 
into the minimum trading increments in the relevant security being 
traded.\11\ The size axis would be divided into 1,000 share increments. 
A User could create a three-dimensional Profile over each coordinate in 
the desired region of the price/size grid by indicating a degree of 
willingness (a ``satisfaction value'') to trade at that coordinate. 
Such willingness to trade or satisfaction value could range from the 
most satisfactory (i.e., ``1'' satisfaction value) to a cut-off point 
at which a transaction at that price and size becomes undesirable 
(i.e., ``0'' satisfaction value).
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    \11\ PCX recently amended its rules in order to trade equity 
securities in minimum increments of \1/16\ of a dollar. See 
Securities Exchange Act Release No. 38780 (June 26, 1997), 62 FR 
36087 (July 3, 1997).
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    The delineation of the size axis into 1,000 share increments for 
purposes of defining a Profile is distinguishable from the minimum 
units of trading in the PCX Application, which are in round lots. An 
example provided in the Exchange's proposal would be a User seeking to 
submit a buy Profile for 4,100 shares that shows a 100% willingness to 
trade at the price of 20, decreasing to no willingness as the price 
reaches 22. Because of the 1,000 share increments on the size axis, the 
User's interest in excess of 4,000 shares (i.e., the 100 shares) would 
be reflected in the next available higher coordinate size--5,000. To 
draw this Profile on the grid, the User would assign the satisfaction 
value of 1 to all the coordinates with the associated size of 5,000 
shares or less and price of 20 or below. As the associated price 
increases from 20 to 22, the satisfaction value of the relevant 
coordinates would decrease steadily down to 0. According to the 
Exchange, the grid size of 5,000 shares does not mean that the User 
actually would receive a 5,000 share trade in excess of the desired 
amount, because the User could enter an instruction as part of the 
Profile to limit the transaction size to 4,100 shares.
    According to the proposal, each User may specify, with respect to 
each Profile submitted, an associated maximum quantity of shares in any 
round lot multiples starting at 1,000 shares; provided, however, those 
Profiles submitted by PCX specialists and certain system-generated CQS 
Profiles (as discussed below) would each have the associated round lot 
size reflected in the relevant limit order book or

[[Page 50038]]

quotation, which may be less than 1,000 shares. In addition, Users may, 
at their option, set boundary conditions on a Profile to restrict the 
total number of shares that may be purchased or sold within any 
particular price or size range. Similarly, Users may, at their option, 
place restrictions on any potential purchase or sale of shares through 
the ITS.
    Users would submit Profiles through their own computers or 
computers on the floor of the Exchange. All Profiles received by the 
Application from a User would be treated confidentially and would be 
viewed only by that User. Unlike orders entered on the Exchange's 
traditional floor facilities, Profiles would not be widely disseminated 
to elicit any trading interest when they are received. Instead, they 
would be logged and maintained by the OptiMark System until they are 
centrally processed. As discussed further below, Profiles would not be 
executable outside of the specified times. As trading interest 
contingent upon such periodic processing, Profiles received by and kept 
within the OptiMark System would have no standing against orders on the 
floor and no bearing on the Exchange's traditional auction-pricing 
mechanism.
    The Exchange has represented that, in accordance with its general 
audit trail requirements, all Profiles submitted by Users would be 
appropriately marked as proprietary or agency. In addition, each would 
be time-stamped with a unique serial number when received by the 
OptiMark System.\12\ Users would be able to revise or cancel their own 
Profiles at any time prior to commencement of the next scheduled 
central processing. According to the Exchange, because it would be 
important for Users to be able to adjust their outstanding Profiles in 
a timely manner in response to sudden market developments, adjustments 
would be processed in the next central processing scheduled to take 
place more than one second after receipt. Submitting a revised Profile 
would result in a new time stamp, unless the only change made is a 
reduction in the maximum quantity of shares previously specified.
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    \12\ PCX would have access to all non-member trade information 
held by a member in order to perform surveillance. Telephone 
conversation between John C. Katovich, Senior Vice President, 
General Counsel, and Director of Legal Affairs, PCX, and Michael 
Walinskas, Senior Special Counsel, Division of Market Regulation, 
SEC, Sept. 4, 1997.
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    According to the Exchange, all Users would be held responsible for 
the terms and conditions contained in their Profiles. Each User would 
assume any and all responsibility for canceling or revising its 
Profile. Users would be able to specify in advance whether to cancel 
their outstanding Profiles or to keep such Profiles active in the event 
of an unexpected interruption experienced in their own 
telecommunications linkage to the OptiMark System. If a User decided to 
keep its Profile active, it would be accountable for any and all 
transactions resulting from the PCX Application based on such Profile.
    Under PCX's proposal, the first match in a Cycle (as defined 
below), if it involves a short sale, will only be effected if it meets 
the requirements of Rule 10a-1 under the Act,\13\ i.e., if it is at a 
price above the last sale price reported on a consolidated transaction 
reporting system immediately prior to commencement of the Cycle, or at 
the last reported price if such price is above the next preceding 
different price. After the first transaction in the Cycle, short sale 
orders will only be executed at a price: (i) Above the price of the 
immediately preceding match within the Cycle, or (ii) equal to the 
immediately preceding price if such price is above the next preceding 
different price. PCX has requested an exemption from Rule 10a-1, the 
Commission's short sale rule, to permit matches within a Cycle (those 
subsequent to the initial match) to utilize the immediately prior match 
as a reference trade for determining short sale rule compliance.\14\
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    \13\ 17 CFR 240.10a-1.
    \14\ Letter from John C. Katovich, Senior Vice President, 
General Counsel, and Director of Legal Affairs, PCX, to Richard R. 
Lindsey, Director, Division of Market Regulation, SEC, dated August 
29, 1997.
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    The OptiMark System would perform the necessary credit verification 
procedures on each Profile submitted by a non-member User. Such 
procedures would ensure that the maximum absolute dollar value of each 
Profile received by the OptiMark System, when added to the non-member 
Users' current credit usage, is consistent with the applicable credit 
limits. All Profiles not meeting the credit validation requirement 
would be deactivated.
Interaction With Existing Market Interest
    According to the Exchange, the PCX Application is designed to 
provide Users with certain automated access to and interaction with 
quotations emanating from other participating market centers of the 
ITS. At the specified times during the trading day when central 
processing by the Opti-Mark System is scheduled to occur, the 
prevailing bid and offer quotations in CQS from each such market that 
may be reached by ITS, including the Intermarket Trading System/
Computer Assisted Execution System interface (``ITS/CAES''), would be 
transformed into a pair of buy and sell Profiles (``CQS Profiles''). 
Each CQS Profile would have, for the relevant limit price and size, a 
satisfaction of 1 for all the corresponding coordinates in the price/
size grid. The Exchange has represented that creation of these CQS 
Profiles and their interaction with the Profiles submitted by Users 
would ensure that the PCX Application is consistent with the 
intermarket price protection requirement under the ITS Plan.
    According to the Exchange's proposal, the PCX Application is also 
designed to serve as an additional trading service for the Exchange 
specialists and floor brokers to use in handling existing market 
interest on the floor. In their capacity as Users, the specialists and 
floor brokers would be able to submit Profiles based on their customer 
limit orders. The PCX specialists would be provided with a uniquely 
designed electronic interface at their posts that would provide simple 
retrieval instructions to facilitate designation of customer orders on 
their limit order books for inclusion as Profiles in the OptiMark 
System. Such an interface also would permit PCX specialists to revise 
and/or cancel the relevant Profile if any of the limit orders reflected 
in the Profile subsequently became executable against some other market 
interest. The Profiles created from a PCX specialist's book would be 
treated the same as any other Profiles submitted by Users of the 
OptiMark System.\15\ Similarly, floor brokers would have the ability to 
use existing terminals or designated OptiMark System terminals on the 
trading floor to submit Profiles if they wish to use the PCX 
Application to fill existing customer interest.
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    \15\ According to the Exchange, the PCX specialists may also 
submit Profiles based on their own proprietary trading strategies, 
in addition to Profiles reflecting public limit orders on their 
books. To the extent that a PCX specialist chooses to represent a 
proprietary trading interest in its designated security by 
submitting a Profile, that particular Profile will have lower time 
priority than that of the Profile submitted by any other User in the 
security, thereby preventing the specialist from trading ahead of 
any agency orders submitted by Users. Time priorities are discussed 
below.
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Central Processing
    All Profiles received by the OptiMark System (including CQS 
Profiles) for each relevant security would be centrally processed by 
computer at one or more specified times during the trading day in order 
to generate one or more orders of identified prices and sizes at which 
execution may occur immediately (``orders''). Such

[[Page 50039]]

processing would involve a series of high-speed calculations 
(``Cycle''). Cycles would be based on a computer algorithm that is 
designed to measure and rank all relevant mutual satisfaction outcomes 
by matching individual coordinates from intersecting Buy Profiles and 
Sell Profiles. The matching algorithm of the OptiMark System is 
intended to compute optimal trade results for Users based on their 
different willingness to trade across a wide range of price and size. A 
buy coordinate and a sell coordinate, each with a full satisfaction 
value of 1, would be matched, based on price, standing, time of entry, 
and size. If one or both coordinates have a partial satisfaction value 
of less than 1 (but greater than 0), they would be matched, generally 
based on the mutual satisfaction value--that is, the product of the 
specific satisfaction values associated with the buy coordinate and 
sell coordinate.
    The Exchange has represented that Profiles would be processed 
according to the following terms concerning matching eligibility 
restrictions and priority principles:
    1. Eligibility Restrictions. At commencement of a Cycle, each 
individual coordinate with a non-zero satisfaction value from all buy 
Profiles and all sell Profiles received by the OptiMark System 
(including CQS Profiles) in a given PCX Security would be grouped into 
the Buy Profile Data Base or the Sell Profile Data Base, respectively. 
Each individual coordinate, no matter how small or large in the 
corresponding size, from either Profile Data Base would be eligible to 
be matched with one or more coordinates from the other Profile Data 
Base and would result in one or more orders, provided that:

    1.1  No buy and sell coordinates could be matched in violation 
of any applicable User instructions for the respective Profiles, 
including: (a) The maximum quantity associated with the Profile, (b) 
any boundary conditions restricting the aggregate number of shares 
that may be bought or sold at a particular price or size range, and 
(c) the restrictions on any potential sale or purchase through ITS; 
and
    1.2  No buy and sell coodinates could be matched from contra CQS 
Profiles.
    1.3  No buy and sell coordinates could be matched at a price 
inferior to that of another coordinate with standing (as defined 
below) that is eligible for matching. A buy (sell) coordinate has 
Standing if: (a) It has 1 satisfaction value and (b) all coordinates 
having the same price and a smaller size, down to and including the 
minimum trading increment (100 shares), are included in the 
associated Profile at 1 satisfaction value; provided, however, that 
no coordinate from a Profile containing any boundary conditions 
restricting the aggregate number of shares that may be bought or 
sold at a particular size range has Standing. Each coordinate from a 
CQS Profile would have Standing. By contrast, no coordinate from a 
Profile submitted by a User on an ``all-or-none'' basis would have 
Standing.

    2. Priority Principles. The methods for considering potential 
matches between buy and sell coordinates in the Profile Data Bases 
would vary, depending on whether both coordinates represent 
satisfaction values of 1 or less than 1. As a result, these would be 
two separate stages of a Cycle:

    2.1  Aggregation Stage. The OptiMark System initially would 
process eligible buy and sell coordinates in the Profile Data Bases, 
each with the full satisfaction value of 1 only. At this stage of 
calculation (``Aggregation Stage''), smaller-sized coordinates may 
be aggregated to build sufficient size to be matched with larger-
sized coordinates to generate orders in accordance with the 
following rules of priority, subject to the applicable eligibility 
restrictions:
    (A) Price aggressiveness. A coordinate with a more aggressive 
price (i.e., a higher price for a buy coordinate and a lower price 
for a sell coordinate) would have priority over coordinates with 
less aggressive prices.
    (B) Standing. Among the coordinates with the same price, a 
coordinate with Standing would have priority over all other 
coordinates without Standing.
    (C) Time of entry. Among the coordinates with the same price and 
Standing, the time of the entry of the associated Profile would 
determine relative priority, with earlier submissions having 
priority. All Profiles submitted by Users would be appropriately 
time-stamped with a unique serial number when received by the 
OptiMark System; provided, however, that the effective time of entry 
for any Profile submitted by a PCX specialist representing 
proprietary trading interest in the specialist's designated security 
would fall behind that of a Profile submitted by any other User for 
that security. Because each CQS Profile would be generated from the 
relevant market's most current quotation prevailing at the time of 
commencement of a Cycle, the effective time of entry of a CQS 
Profile would be later than that of any other Profile submitted by a 
User, including a PCX specialist's proprietary trading in the 
specialist's designated security.\16\
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    \16\ See Amendment No. 3, supra, note 7.
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    (D) Size. Among the coordinates with the same price, standing 
and time of entry, priority would be determined by size, with larger 
sizes having higher priority.
    2.2  Accumulation Stage. Upon completion of the Aggregation 
Stage, the OptiMark System would consider potential matches between 
eligible buy coordinates and sell coordinates in the Profile Data 
Bases where one or both parties have less than 1 (but greater than 
0) satisfaction values. At this stage of calculation (``Accumulation 
Stage''), only those buy and sell coordinates with the same 
associated price and size would be matched to generate orders in 
accordance with the following rules of priority, subject to the 
applicable eligibility restrictions:
    (A) Mutual satisfaction. A potential match with a higher mutual 
satisfaction value (the product of the two satisfaction values) 
would take precedence over other potential matches with lower mutual 
satisfaction values.
    (B) Time of entry (based on the earlier Profile). Among the 
potential matches with the same mutual satisfaction, the match with 
the earlier time of entry, as determined initially by the effective 
time of entry assigned to the earlier of the buy and sell Profiles 
involved (the ``earlier Profile''), would have priority over other 
potential matches.
    (C) Size. Among the potential matches with the same mutual 
satisfaction and time of entry for the earlier Profile, priority 
would be given to one with a larger size.
    (D) Time of entry (based on the later Profile). Among the 
potential matches with the same mutual satisfaction, time of entry 
(for the earlier Profile), and size, the match with the earlier time 
of entry, as determined this time by the effective time of entry 
assigned to the later of the buy and sell Profiles involved (the 
``later Profile''), would have priority over other potential 
matches.
    (E) Price assignment. In regard to all remaining ties between 
potential matches, which would consist solely of the coordinates for 
a single pair of buy and sell Profiles from two Users that may be 
matched with the same mutual satisfaction, time of entry and size, 
but at different prices, priority would be given to the match at a 
price more favorable to the User whose Profile has the earlier time 
of entry. By way of example, among the last potential matches 
remaining at the price of 10 and also at 10\1/8\, if the sell 
Profile is the earlier Profile, then the match would take place at 
the price of 10\1/8\. The Commission notes that two or more Profiles 
that are entered into the OptiMark System representing the same 
number of shares may result in executions at differing prices 
depending on the other information and conditions entered into the 
System.

    The Exchange has represented that, for purposes of the PCX 
Application, the specific times at which Profiles would be centrally 
processed would vary, depending on the security involved. No Cycle, 
however, would be scheduled until after the opening of the PCX market 
for any such security. Similarly, no Cycle would be scheduled at or 
after the closing of the PCS market for that security. The maximum 
frequency with which Cycles may take place throughout the trading day 
would be every 90 seconds, while the minimum would be once a day.
    The Exchange has represented that the exact frequency of Cycles as 
to any given PCX Security would be determined by OSI, taking into 
account the general characteristics of the security (e.g., trading 
volume, price, and number of shareholders), the associated Profile flow 
over a period, and the current level of interest expressed by

[[Page 50040]]

Users. From time to time, OSI may alter the frequency of Cycles in 
response to subsequent developments. PCX has represented that OSI will 
consult with PCX prior to altering the frequency of any Cycle.\17\ Any 
change in the frequency of Cycles would be effective upon three days' 
advance notice to Users. Such notice would be provided electronically, 
using the same telecommunications linkage and protocols available to 
Users for submitting Profiles. At all relevant times, Users would be 
fully informed as to when the next Cycle in a particular PCX Security 
would take place.
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    \17\ Telephone conversation between John C. Katovich, Senior 
Vice President, General Counsel, and Director of Legal Affairs, PCX, 
and Michael Walinskas, Senior Special Counsel, Division of Market 
Regulation, SEC, Sept. 4, 1997.
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    The Exchange would assure that the frequency of Cycles remains 
commensurate with the financial community's need and demand for the 
trading service. In addition, the Exchange would assure that the PCX 
Interfaces and the OptiMark System have sufficient capacity in place to 
handle any material increase in the volume of data prior to 
implementing a change in the frequency of Cycles.
Order Execution and Reporting
    The Exchange would make available the necessary PCX Interfaces to 
permit orders in PCX Securities from the OptiMark System to be 
executed, either on the Exchange or on other market centers 
participating in ITS through the appropriate Exchange communications 
linkage. The Exchange would permit one or more pairs of orders 
resulting from intersection of the Profiles submitted by Users 
(including PCX specialists and floor brokers) to be routed and executed 
on the Exchange. Every trade resulting from the execution of a pair of 
orders on the Exchange would be appropriately reported, by way of the 
traditional Exchange linkage to the CTS processor for dissemination, in 
the sequence in which orders are generated from the Cycle. The Exchange 
would report these trades, similar to the way it currently reports 
other trades in PCX Securities to the CTS. Accordingly, consistent with 
the existing reporting practices, a series of orders generated from a 
single Cycle for the same seller with different buyers at an identical 
price would be printed on the Tape as one transaction. In general, the 
report for any transaction resulting from the PCX Application would not 
be distinguished on the Tape from the trade report of any other order 
executed on the PCX floor.
    As for one or more orders representing matched coordinates from CQS 
Profiles, and other contra Profiles, the Exchange would submit an ITS 
commitment reflecting each such order and seeking execution on market 
centers other than PCX. Every ITS commitment would be sent under the 
give-up of the relevant member User or the Designated Broker, by way of 
the traditional Exchange linkage to the ITS, in the sequence in which 
orders are generated from the Cycle. Each ITS commitment would be 
assigned a ``T-1'' (one minute) time period as specified in the ITS 
Plan. The Exchange envisions sending ITS commitments resulting from the 
PCX Application in the same way other ITS commitments are currently 
sent from the Exchange. According to the Exchange, ITS commitments 
resulting from the PCX Application would not be distinguishable from 
other ITS commitments.
    The Exchange would continue to apply all existing rules governing 
trading on its equity trading floor. For example, market orders routed 
from members to the Exchange would continue to be executed in the same 
manner. Similarly, ITS commitments received from ITS participants other 
than PCX would be executed against the Exchange's prevailing quotations 
as specified under the ITS Plan. As for limit orders, PCX specialists 
and floor brokers would be afforded an additional (but not alternative) 
opportunity to fill such interest through the PCX Application. To the 
extent that the Exchange specialists and floor brokers submit Profiles 
to the OptiMark System based on customer interest in their books, the 
handling of any such Profiles and any resulting trade executions 
through the PCX Application would be fully consistent with the 
parameters under which public limit orders are currently filled.
    Moreover, PCX specialists would remain fully responsible for 
managing their limit order books. Accordingly, if a specialist elected 
not to reflect a customer limit order in the OptiMark System, it would 
remain accountable for execution at any more favorable price that could 
have been obtained if such order were processed through the PCX 
Application. In such a case, consistent with the Exchange's existing 
floor procedures and practices, the specialist would be required to 
satisfy or cause to be satisfied the customer limit order so held, 
either at the limit price specified, or at any better price generated 
by the Application. PCX has represented that this guarantee is limited 
to customer limit orders booked prior to the commencement of a Cycle. 
Therefore, orders booked after the commencement of a Cycle would not be 
guaranteed an execution at prices obtained as a result of such Cycle.
    In Amendment No. 3 to its filing, PCX clarified that, even if the 
specialist does not submit a Profile for a limit order in its book, the 
limit order will receive ``the limit price or a better price if one 
occurred in that cycle, up to the amount of the order or orders 
executed in OptiMark.'' \18\
---------------------------------------------------------------------------

    \18\ See Amendment No. 3, supra, note 7.
---------------------------------------------------------------------------

    Specifically, after a Cycle of the Application is completed, the 
Application sends the orders to the PCX floor in a batch. The batch of 
orders, which will be automatically executed, ``will be in a specific, 
deterministic order, as defined by the Aggregation and Accumulation 
Stage'' \19\ (discussed above). According to PCX, the order of 
execution will be provided to the specialist, in the same manner as 
executions performed in another market, such as NYSE. The specialist 
will have, out of that batch of executions resulting from a Cycle, the 
prices and size of each execution. If at the beginning of a Cycle a 
specialist has a limit order in the book that was not reflected as a 
Profile in the Application, and, as a result of orders generated 
through the Application, the booked order becomes eligible for 
execution, the price that will be given to the booked order will be 
based upon the best price that occurs out of the batch of orders 
generated by the Application, up to the size of the booked order not 
entered into the Application as a Profile.
---------------------------------------------------------------------------

    \19\ Id.
---------------------------------------------------------------------------

    The Exchange presented the following example: There is a booked 
order to buy 1,000 shares with a 10 limit price, and the specialist 
does not express the order as a Profile in the Application. The 
immediately succeeding Cycle of the Application generates orders 
resulting in transactions at the following prices: 1,000 at 10\1/8\, 
500 at 10, and 1,000 at 9\7/8\. Without the existence of the 
Application, an execution in the same security on the PCX at 10 would 
trigger an execution of the booked order at 10. With the implementation 
of the Application, the batched transactions resulting from a Cycle 
would be viewed as a unit for purposes of determining the price at 
which the booked order should be filled. The specialist, therefore, 
would look for the best price resulting from the Cycle in determining 
the price at which to fill the booked order. In this case, the 
transaction resulting at a price of 9\7/8\ for 1,000 shares would be 
the determining price, and the specialist would be obligated to fill 
the order at

[[Page 50041]]

9\7/8\. If, on the other hand, the Cycle resulted in a series of 
transactions that included only 500 shares at the prices stated above, 
and the specialist nevertheless had a booked limit order for 1,000 at 
10 (which was not entered into the Application), the specialist would 
be obligated to fill the first 500 shares of the booked order at 9\7/8\ 
and the remaining 500 shares at 10, the next best price generated by 
the Cycle.
    In Amendment No. 3, PCX provided an example of how limit orders 
booked with PCX specialists would interact with the Application. In the 
example, a specialist would have two booked limit orders at buy, the 
first for 1,000 shares, and the second for 500 shares, both at a price 
of 30. The example assumes that the specialist did not enter the 1,000 
share order into the Application, but the specialist did enter the 500 
share order into the Application as a Profile. In the example, the next 
Cycle of the Application resulted in a transaction of 29\1/2\ for the 
500 share order entered into the Application as a Profile. In such a 
case, the specialist would be required to fill both orders at 29\1/2\.
    In Amendment No. 3, PCX also further clarified the manner in which 
PMP would operate in connection with the Application. Generally, 
according to the PCX,

[i]f an order is received and specifically marked PMP (primary 
market protection), this means that the firm sending the order has 
usually requested that the order only get filled if within the range 
of the designated ``primary'' market (usually the NYSE and AMEX). In 
such a case, the specialist is operating under the understanding 
that the order will not get filled outside the ``primary'' market 
range.\20\
---------------------------------------------------------------------------

    \20\ See Amendment No. 3, supra, note 7, at 2.

    In order to ensure that PMP orders can be integrated into the 
---------------------------------------------------------------------------
Application, PCX represented that:

during regular ``primary'' market trading hours, an order 
specifically marked PMP will have to be treated just like any other 
booked order when executions result from OptiMark matches, even if 
the ``primary'' market range has not traded at that price. 
Similarly, a PMP order reflected into OptiMark as a profile, which 
is matched in OptiMark and results in an execution, will require 
that the PMP limit order be filled, even if the price is out of 
range from the * * * otherwise existing ``primary'' market, however 
defined.\21\
---------------------------------------------------------------------------

    \21\ Id. PCX will codify this clarification through a rule 
amendment with the Commission. In this regard, PCX stated that the 
amendment ``will be consistent with the overall premise that under 
no circumstance can a specialist accept an execution arising out of 
orders generated from an OptiMark cycle, without first taking care 
of any eligible booked orders that were put in the book before the 
cycle began.'' Id.

    PCX will undertake to amend its rules so that the operation of the 
Application would be considered as an exception to Rule 5.32 regarding 
the execution of orders marked PMP.
    The Exchange has also represented the operation of the PCX 
Application would be consistent with the Exchange's intermarket price 
protection obligations under the ITS Plan. The OptiMark System 
incorporates existing market interest emanating from each of the ITS 
participant markets to which it is not directly linked in the form of 
CQS Profiles. Because of the rules of priority for considering 
potential matches between buy coordinates and sell coordinates from any 
Profiles (including CQS Profiles), all orders that are priced inferior 
to the quotations of another market center would be generated and 
executed on PCX only upon submission of appropriate ITS commitments 
seeking to reach such better-priced interest. As a result, the Exchange 
has represented that execution of any such orders on PCX would not 
violate the trade-through rule under the ITS Plan.
    The Exchange has represented that all Users would be informed of 
executions that take place against the Profiles that they submitted for 
their own or customer accounts promptly after the trades occur. If an 
ITS commitment resulting from the PCX Application is canceled or only 
partially filled, the OptiMark System would notify the relevant User 
and restore to the Profile the volume of the security represented by 
the unfilled order. All such reports would be sent electronically, 
using the same telecommunications linkage and protocols that were used 
to submit the Profiles initially. Unless specified otherwise by non-
member Users in advance, executions would not be reported to relevant 
Designated Brokers until after the close of the trading day in order to 
limit market impact and other such adverse effects of non-member Users' 
trading.
Clearance and Settlement
    The Exchange has represented that transactions in PCX Securities 
resulting from the PCX Application, including any ITS commitment sent 
to another market center and accepted, would clear and settle in the 
same way as other transactions occurring on the Exchange floor. All 
orders generated by the OptiMark System that are executed on PCX or 
another market center through ITS would be reported and entered into 
the comparison system on a locked-in basis. Orders generated by the 
OptiMark System on behalf of a member User and the resulting 
transactions would be cleared and settled using that member User's 
mnemonic (or its clearing broker's mnemonic). Orders generated by the 
OptiMark System on behalf of a non-member User and the resulting 
transactions would be cleared and settled using the appropriate 
Designated Broker's mnemonic (or its clearing broker's mnemonic).
    The Exchange or any operator, administrator or licensor of the 
OptiMark System would not be responsible for any User's failure to pay 
for PCX Securities purchased or to deliver PCX Securities sold. Neither 
OTI nor OSI would be deemed to be a party to or a participant in, as 
principal or as agent, any trade or transaction entered into or 
otherwise conducted by Users while using the OptiMark System for the 
purposes of clearance and settlement.
Hours of Operation
    The PCX Application would be initially available for execution of 
orders and routing of ITS commitments during the regular PCX hours 
after the opening and prior to the closing.\22\ In the event of a 
suspension in trading of a security listed or traded on the Exchange, 
the Exchange would suspend the related trading activities respecting 
that security through the PCX Application. In addition, the Chairman 
or, in the Chairman's absence, Chief Operating Officer, or other PCX 
Officer(s) as the Chairman may designate, may determine that market 
conditions warrant a market-wide halt pursuant to the Exchange's Policy 
Statement on Market Closings. Trading on the PCX Application of the 
OptiMark System would be covered by such a market-wide halt. The 
Exchange may suspend the trading activities through the PCX Application 
relating to one or more PCX Securities at any time upon consultation 
with OTI if deemed necessary and proper to preserve system capacity and 
integrity.
---------------------------------------------------------------------------

    \22\ The Exchange's hours are currently 6:30 a.m. (P.T.) to 1:30 
p.m. (P.T.).
---------------------------------------------------------------------------

Audit Trail and Surveillance
    The Exchange would maintain, or cause to be maintained, a detailed 
audit trail of each transaction resulting from the PCX Application, 
including time sequenced records of Profiles submitted to the OptiMark 
System, orders resulting from a Cycle, and their execution and 
reporting through PCX facilities. Such data would be stored and 
preserved for a period of not less than three years, the first two 
years in an easily accessible place, to assure that the Exchange has 
sufficient information for exercising its regulatory oversight.

[[Page 50042]]

The Exchange would apply appropriate equity trading surveillance 
procedures to monitor transactions resulting from the PCX Application.
System Capacity and Integrity
    The Exchange believes that the PCX Interfaces and the OptiMark 
System would provide sufficient capacity to handle the volume of data 
reasonably anticipated for the PCX Application. The Exchange would have 
in place security procedures designed to prevent unauthorized access to 
the PCX Application and to safeguard the PCX Interfaces. The Exchange 
would obtain similar assurances from OTI and OSI that reasonable 
security procedures are in place to safeguard the OptiMark System and 
to protect against threats to the proper functioning of the OptiMark 
System, including any networks used by the OptiMark System. The 
Exchange would also obtain appropriate assurances that proper system 
reliability and system capacity exists to ensure the integrity of the 
data handled and timely response of the OptiMark computers in 
connection with the PCX Application.
Fees for the PCX Application
    Transactions resulting from the PCX Application would be subject to 
the Exchange's customary assessment of transaction charges and the 
Commission's exchange transaction fee under Section 31 of the Act. As a 
sponsor of the OptiMark System within the meaning of Rule 17a-23 under 
the Act, OSI, which currently plans to apply to register as a broker-
dealer, would be compensated by way of usual and customary commissions, 
on a cents-per-share-filled basis, for transactions effected by a 
member User for its own customer accounts through the PCX Application. 
With respect to transactions effected by a non-member User, OSI would 
be paid commissions on a similar basis from the relevant Designated 
Broker.

III. Comments Received

    The Commission received fourteen comment letters in response to its 
request for comments on the PCX proposal.\23\ All of the comment 
letters, except for a letter submitted by the NYSE, supported the PCX's 
proposal. Letters in support of the proposal were submitted by 
institutions, broker-dealers (including underwriters, specialists, and 
retail and clearing brokers), the Treasurer of the State of California, 
and from academia.
---------------------------------------------------------------------------

    \23\ See supra, note 4.
---------------------------------------------------------------------------

    Those submitting letters in favor of the implementation of the 
OptiMark System provided various reasons for their support of the PCX 
proposal. For example, commenters stated that the OptiMark System would 
provide an alternative to the traditional method of order execution and 
would be the first system available to allow institutions to use 
complex trading strategies in a secure environment.
    Several commenters stated that the OptiMark System would provide 
both retail and institutional participants with an improved ability to 
buy or sell securities in a manner that matches their objectives. 
Commenters stated that both retail and institutional customers would 
benefit from better prices.
    One broker-dealer, for example, stated that the OptiMark System 
would enable its retail customers to obtain price improvement derived 
from a mixture of retail and institutional order flow between PCX floor 
brokers and specialists. Another stated that the system would be 
beneficial in allowing for anonymous interaction between retail orders 
and institutional orders.
    In addition, some commenters focused specifically on the 
confidentiality of the OptiMark System. One commenter noted that, 
currently, trading interest may be difficult to assess because of 
concerns about information integrity and the market impact cost of 
large orders. Another stated that one of the biggest problems that 
institutions face today is attempting to keep their decisions to buy or 
sell securities confidential. These and other commenters argued that 
OptiMark would provide a solution to such problems. One commenter 
stated that the system would allow a portfolio manager to add 
qualitative information to each order on a non-disclosed basis.
    Several commenters stated that the OptiMark System would promote 
liquidity, and two commenters stated that the Application would reduce 
market volatility. Several commenters stated that OptiMark would 
promote market efficiency and reduce transaction costs by lowering the 
market impact of trades.
    Commenters also argued that the OptiMark System would further the 
development of the national market system (``NMS'') envisioned in the 
Securities Acts Amendments of 1975,\24\ and as reflected in Section 11A 
of the Act.\25\ One such commenter stated that ``OptiMark represents 
precisely the kind of `new data processing and communications 
techniques' that Congress thought when it passed the 1975 Securities 
Act Amendments would create the opportunity for more efficient and 
effective market operations, and would foster efficiency, enhance 
competition, facilitate the offsetting of customer orders, and 
contribute to best execution.'' \26\ The same commenter stated that 
OptiMark's operation as a facility of an exchange, ``with the 
accompanying linkage to other markets through the ITS system, should 
ensure that OptiMark has a positive impact on the national market 
system as a whole.'' \27\
---------------------------------------------------------------------------

    \24\ Pub. L. No. 94-29, 89 Stat. 131 (1975).
    \25\ 15 U.S.C. 78k-1.
    \26\ See Letter from Tim McCarthy, Charles Schwab, supra, note 
4.
    \27\ See id.
---------------------------------------------------------------------------

    One commenter also stated that OptiMark would promote free market 
competition and would ``erod[e] the private club benefits previously 
afforded members of dominant exchanges and compel * * * limit order 
disclosure to the public markets.'' \28\
---------------------------------------------------------------------------

    \28\ See Letter from Harold S. Bradley, American Century 
Investment Management, Inc., supra, note 4.
---------------------------------------------------------------------------

    In contrast to the views of the supporting commenters, NYSE 
submitted a comment letter opposing the PCX rule filing (``NYSE Comment 
Letter'').\29\ The NYSE asked the Commission not to approve the filing, 
but to require PCX to further explain and clarify its proposal. In its 
letter, NYSE expressed several concerns about the possible 
implementation of the OptiMark System. First, NYSE contended that the 
system would have the effect of ``creating a hidden market'' within 
PCX, which it believed would be detrimental to other trading interest 
on PCX and to the NMS, and contrary to established PCX auction 
rules.\30\ NYSE argued that marketable trading interest processed 
through the Application would not be exposed to the PCX auction or to 
the NMS until after a transaction has occurred. In NYSE's view, 
OptiMark Profiles would constitute orders that should be incorporated 
into PCX's floor-based trading system. More specifically, NYSE 
contended that Profiles equal to or better than the price of the then-
disseminated PCX quotation should be quoted in the same manner as other 
orders received by PCX. In addition, NYSE argued that a trade resulting 
from use of the OptiMark System that is printed on PCX would impose new 
and additional price protection responsibilities on PCX specialists. 
NYSE claimed that the PCX filing was silent about the right or 
obligation of PCX floor brokers to ``break up,'' and provide potential 
price improvement

[[Page 50043]]

for, Profiles crossed or matched within the OptiMark System and routed 
to the PCX floor for execution.
---------------------------------------------------------------------------

    \29\ See Letter from James E. Buck, NYSE, supra. note 4.
    \30\ Id. at 2.
---------------------------------------------------------------------------

    NYSE raised concerns about the potential effect of the Application 
on PCX's relationship with the ITS with respect to access and liability 
for clearance and settlement. NYSE stated its belief that the 
Application's access to ITS would be different from that currently used 
by PCX for the sending of ITS commitments pursuant to the ITS Plan. 
NYSE argued that it would be premature for the Commission to approve 
PCX's filing until PCX has provided the ITS participant markets with a 
clear and detailed understanding of how PCX intends for OptiMark to 
access the ITS. NYSE also claimed that PCX was attempting to amend the 
terms of the ITS Plan to limit PCX's liability beyond the authority set 
forth in the ITS Plan.\31\
---------------------------------------------------------------------------

    \31\ The NYSE cited, in particular, the language in the PCX's 
filing that states:
    In no event will the Exchange or any operator, administrator or 
licensor of the OptiMark System be responsible for any User's 
failure to pay for the PCX Securities purchased or to deliver the 
PCX Securities sold. Neither OTI nor OSI will be deemed to be a 
party to or a participant in, as principal or agent, any trade or 
transaction entered into or otherwise conducted by Users while using 
the OptiMark System for the purposes of clearance and settlement.
    Letter from James E. Buck, NYSE, supra, note 4, at 5-6.
---------------------------------------------------------------------------

    Finally, NYSE stated that the PCX filing did not clearly reflect 
that all ITS price protection rules would be followed by the users of 
the Application. NYSE noted that ITS price protection rules specify the 
obligations of participant members for satisfying trade-throughs, Block 
Policy trades, and locked markets involving other ITS participant 
markets, and that these obligations include a requirement to issue ITS 
commitments to trade. Next, it highlighted that PCX's filing stated 
that users would be able to ``place restrictions on any potential 
purchase or sale of shares through ITS.'' \32\ NYSE believes this 
language suggests that a PCX member (or member's customer) could place 
restrictions on the use of ITS that would ignore the ITS price 
protection rules. Accordingly, NYSE suggested PCX's filing be amended 
to note the limitation on a user's right to place limitations on the 
use of ITS for price satisfaction purposes.
---------------------------------------------------------------------------

    \32\ ID. at 6.
---------------------------------------------------------------------------

    Further, NYSE questioned OptiMark's proposed compliance with the 
Commission's short sale rule. NYSE noted a letter sent by the PCX to 
the Commission's Division of Market Regulation in May 1997, requesting 
relief from the short sale rule.\33\ NYSE stated that an exemption 
``would not be appropriate for a system such as OptiMark which provides 
price discovery.'' \34\ NYSE also referred to PCX's proposed amendment 
to PCX Rule 5.14, which proposed that ``[t]he Exchange's short sale 
rule (Rule 5.18) shall not be applicable to any resulting transaction 
in the Exchange.'' \35\ NYSE argued that the approval of such a 
proposed rule would ``establish a clear conflict that could lead to 
inadvertent regulatory violations.'' \36\ NYSE recommended that PCX 
amend its proposal to delete both PCX Rule 5.14 and the above-quoted 
proposed language.
---------------------------------------------------------------------------

    \33\ See Letter from John C. Katovich, Senior Vice President and 
General Counsel, PCX, to Richard R. Lindsey, Director, Division of 
Market Regulation, SEC, dated May 19, 1997 (``PCX May 19 Letter'').
    \34\ See Letter from James E. Buck, NYSE, supra, note 4, at 4. 
NYSE also noted it would not generally comment on this because it 
understood that Commission staff would not grant the requested 
exemption from Rule 10a-1 under the Act. Id.
    \35\ Id.
    \36\ Id.
---------------------------------------------------------------------------

    On August 1, 1997, PCX submitted to the Commission a letter 
responding to issues raised in the NYSE Comments Letter.\37\ In 
response to NYSE's comment that the Application would create a ``hidden 
market,'' PCX stated that the Application would operate in a manner 
consistent with existing principles of the current auction market now 
in place at PCX as well as at NYSE. PCX represented that ``[b]ids or 
offers announced on the PCX floor or in the specialist's book will 
continue to be collected and disseminated by the PCX in full compliance 
with Rule 11AC1-1'' under the Act, and that PCX's continuous auction 
facilities, separate and apart from the periodic auction conducted by 
the Application, would continue to be available to members.\38\
---------------------------------------------------------------------------

    \37\ See Amendment No. 1, Supra, note 5.
    \38\ Id. at 2.
---------------------------------------------------------------------------

    PCX argued that ``[t]he fact that Profiles will not be disseminated 
as quotes does not create a hidden market'' because the Profiles are 
analogous to indications of interest, and not bids and offers.\39\ PCX 
further argued that the Application represents a periodic call market 
facility and that quotes in such market have no meaning because trading 
interest remains a generalized expression of interest until it is 
processed during the call. PCX argued that no Profile is eligible for 
execution until the time of the call, in contrast to a quote, which is 
a firm bid or offer available for execution at any time. In this 
regard, PCX believes that the display of any Profile in an open quote 
stream would contradict the desire of Users submitting Profiles and 
would impair the integrity of the quote system because individual Users 
would represent multiple and differing price values for any given buy 
or sell interest. Thus, PCX stated that it should not be required to 
display in the PCX quotation User Profiles, including those coordinates 
with a satisfaction value of 1.
---------------------------------------------------------------------------

    \39\ Id.
---------------------------------------------------------------------------

    In response to the NYSE argument that the Application would impose 
new price protection responsibilities on PCX specialists, PCX stated 
that although the Exchange would require its specialists, under PCX 
Rule 5.32(a), to honor their obligations for executions at the same or 
better prices that occur as a result of the Application, this 
requirement would not constitute a new obligation. As an example, PCX 
outlined how PCX specialists guarantee the price of executions that 
occur on the ``other city floor'' \40\ of the PCX, noting that under 
certain circumstances, a PCX specialist may be obligated to fill an 
order at a price obtained from the ``other'' PCX floor. PCX noted that 
the guarantee requirements imposed on PCX specialists regarding 
transactions effected through the Application will likely influence 
them to reflect frequently their book orders in the OptiMark system, 
although they would not be obligated to do so. Further, if a specialist 
did not honor its obligations to execute an order, based upon an 
execution that occurs in the primary market or within the PCX market, 
the specialist would be found to be in violation of existing PCX rules.
---------------------------------------------------------------------------

    \40\ The PCX has equity trading floors both in San Francisco and 
Los Angeles.
---------------------------------------------------------------------------

    PCX also disagreed with the NYSE's comment that the PCX proposal 
does not comply with PCX's crossing rules, specifically PCX Rules 5.14 
(a) and (b). According to PCX, under these rules members are 
responsible for assuring that all existing bids or offers, at or better 
than the cross price, are filled at their limits. PCX argued that 
although the OptiMark System would help a User find other trading 
interest through the central processing of Profiles, this is not the 
same as a cross transaction on the Exchange floor, where both sides of 
the trade are brought to the specialist's post by a broker. PCX 
emphasized that when coordinates from Profiles happen to match at the 
time of the call, it is fortuitous and can not be considered a cross as 
defined in either PCX or NYSE rules. PCX further stated that when two 
Profiles with overlapping coordinates give the appearance of a cross, 
the processing of these Profiles against other

[[Page 50044]]

trading interest in the PCX Application may not result in a match 
between the two Profiles. Rather, the priorities established by the 
Application could effectively ``break up'' any such potential match.
    With respect to NYSE's comment on ITS access, the Exchange argued 
that the Application would not change the method of system access in 
any manner that calls for an ITS Plan amendment. Instead, the Exchange 
stated that the Application would be an additional exchange facility, 
through which the Exchange would be able to honor its existing ITS 
commitments. The Exchange emphasized that the Application would merely 
provide more convenient electronic access for the benefit of its 
members and their customers, and as such, the Application would 
``complement one `example' of system access described in Section 6 of 
the ITS Plan through added flexibility, thereby promoting the increased 
use of ITS through information and telecommunications technology 
innovation, all as intended by the ITS Plan and as required by the 
Commission under Section 11A of the Exchange Act.'' \41\
---------------------------------------------------------------------------

    \41\ See Amendment No. 1, supra, note 5, at 4.
---------------------------------------------------------------------------

    With respect to NYSE's argument that the PCX filing would 
``effectively amend the terms of the ITS Plan to limit PCX's liability 
beyond the terms specified in the Plan,'' PCX responded that the filing 
would not have such an effect; similar limitations on liability have 
not been construed or applied so as to limit an ITS Participant's 
contractual obligations arising under Section 9 of the ITS Plan. PCX 
further stated that NYSE itself limits its liability for any damages 
sustained in connection with the use of its facilities, citing NYSE 
Constitution, Article II, Section 6.
    PCX strongly disagreed with NYSE's comment that PCX's proposed User 
restrictions on potential purchases or sales of shares through the ITS 
would have the effect of obviating the ITS price protection rules, 
stating that the Exchange ``adheres strictly to the ITS price 
protection rules.'' \42\ The Exchange stated that its filing 
``repeatedly provides that no orders may be executed on the Exchange at 
a price inferior to that of other outstanding trading interest with 
standing, which includes CQS Profiles derived from the quotes of other 
ITS Participants.'' \43\ The Exchange also stated that Users placing 
restrictions on any potential purchase or sale of shares through ITS 
would be required to forgo any potential transactions that would cause 
a trade-through. The Exchange concluded that permitting a User to place 
limitations on the use of ITS at the User's own risk is consistent with 
the ITS plan because it does not implicate the ITS price protection 
rules.
---------------------------------------------------------------------------

    \42\ Id. at 5.
    \42\ Id.
---------------------------------------------------------------------------

    The PCX letter also mentioned the PCX's May 1997 request for 
exemptive relief from the short sale rule and noted that it understood 
that such relief would not be granted. Accordingly, the PCX submitted a 
proposed amendment to PCX Rule 15.3(b), which (as modified by a 
subsequent amendment) would add the following language to the Rule:

and provided further that no Orders designated as ``sell short'' may 
be generated for execution at a price: (i) Below the price of the 
immediately preceding match (or the last sale price reported on a 
consolidated transaction reporting system immediately prior to 
commencement of the Cycle in the case of the initial match of that 
Cycle) or (ii) at such price unless such price is above the next 
preceding different price.\44\

    \44\ Id. at 1-2.
---------------------------------------------------------------------------

    On August 20, 1997, NYSE submitted to the Commission a second 
comment letter responding to issues that the PCX raised in Amendment 
No. 1.\45\ In its letter, NYSE expanded upon points raised in its 
initial comment letter. For example, NYSE again raised the ``hidden 
market'' issue. NYSE argued that the PCX was proposing ``to sponsor two 
markets (its `regular' market and the OptiMark cycles) with minimal 
interaction between the two.'' \46\ NYSE also challenged OptiMark's 
claim that the Cycles would constitute a periodic call market because 
Cycles would be as frequent as every 90 seconds. As a result, NYSE 
argued, Users could enter a priced order into a ``nearly-continuous 
auction, without disclosing the order to the regular market, even if 
the order matches or improves the national best bid and offer.'' \47\ 
NYSE argued that this activity would stand in direct conflict with 
recent Commission efforts to integrate all trading interest in the 
national market system, whether through electronic communication 
networks or otherwise.
---------------------------------------------------------------------------

    \45\ See Letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC, dated Aug. 20, 
1997 (``NYSE Second Comment Letter).
    \46\ Id. at 1.
    \47\ Id.
---------------------------------------------------------------------------

    In addition, NYSE reiterated that the Application would be 
inconsistent with PCX's own auction rules, claiming that orders and 
executions resulting from the Application would not be integrated with 
other PCX trading interest and, as such, would not be like other PCX 
executions. NYSE stated that PCX's rules require that all orders be 
integrated into the PCX auction and interact with other trading 
interest taking place on the PCX floor. NYSE argued that, contrary to 
PCX's auction rules, an order entered on the PCX after the commencement 
of a Cycle of the Application would ``not interact with an OptiMark 
`order' that is `routed and executed on the [PCX], even if the more 
recent PCX order is at a better price or has priority over the OptiMark 
`order.' '' \48\
---------------------------------------------------------------------------

    \48\ Id. at 2.
---------------------------------------------------------------------------

    In addition, NYSE argued that the PCX's proposed amendment 
regarding its intended compliance with the Commission's short sale 
rule, as explained in the PCX's Amendment No. 1, is inconsistent with 
the wording and purposes of the rule. NYSE characterized PCX's proposal 
as prohibiting short sales in the Application on minus ticks or zero 
minus ticks based on the last ``match'' in the Application, and that 
the Application would rely on the last transaction reported to the CTS 
only for the initial Cycle. NYSE argued that Rule 10a-1, by contrast, 
regulates short selling based on consolidated last sales, giving an 
exchange an option of using the last sale on that exchange. NYSE 
therefore argued that an exchange ``cannot regulate short sales based 
on sales in only one component of an exchange's trading system.'' \49\
---------------------------------------------------------------------------

    \49\ Id. at 3.
---------------------------------------------------------------------------

    NYSE also addressed the Application's access to, and liability for 
clearance and settlement through, the ITS. With respect to access, NYSE 
took issue with the PCX's statement that the Application ``will 
complement one `example' of system access'' described in the ITS Plan. 
NYSE argued that this statement ``raises serious questions of access to 
NYSE market and to the markets of the other ITS Participants.'' \50\ 
NYSE stated that PCX intends to make a detailed presentation at an ITS 
Committee meeting in September 1997, and argued that it would be 
premature for the Commission to act on the PCX's filing before the 
meeting and further consideration of the issue.
---------------------------------------------------------------------------

    \50\ Id. at 4.
---------------------------------------------------------------------------

    With respect to the PCX's proposal regarding liability for 
clearance and settlement with respect to the Application, NYSE restated 
its earlier position that the PCX's proposal is inconsistent with 
Section 9 of the ITS Plan, which requires each Participant to assume 
responsibility for settling certain uncompared ITS trades. NYSE argues 
that the PCX's proposal attempts to amend the ITS Plan to limit the 
PCX's liability beyond the terms of the Plan.

[[Page 50045]]

    On August 29, 1997, PCX submitted to the Commission two letters 
supplementing the filing and further addressing issues raised by the 
NYSE.\51\ PCX stated that it is incorrect to characterize an order 
generated by an Optimark cycle as a ``cross'' given that, under PCX 
Rule 5.14(a), a cross transaction is ``a transaction in which a member 
effects both the purchase and sale.''\52\ PCX submitted that most 
matches resulting from a Cycle would be based on trading interest 
reflected in Profiles submitted by two different members, and thus 
would not be crosses involving the same member. Although PCX conceded 
that the same member could submit both buy and sell Profiles that could 
result in a matched order, it pointed out that the member would have no 
control or influence in determining the outcome of such a match. PCX 
concluded that the presence of member intermediation and trading 
discretion is essential to the definition of ``cross'' as it is 
understood and applied in the context of continuous auction 
trading.\53\
---------------------------------------------------------------------------

    \51\ See PCX Floor, Letter and PCX ITS Letter, supra, note 6.
    \52\ PCX Floor Letter, supra, note 6, at 1.
    \53\ Id.
---------------------------------------------------------------------------

    In response to NYSE's claim that PCX floor brokers representing 
customer interest could ``miss the market'' if they chose not to use 
Optimark, PCX noted that such an outcome was no different than the 
situation where a floor broker either routes a customer order to 
another market or is not present in the trading crowd when a cross is 
announced.\54\
---------------------------------------------------------------------------

    \54\ Id. at 2.
---------------------------------------------------------------------------

    In the PCX ITS Letter, the PCX clarified its continued 
responsibility to settle trades effected through the PCX Application, 
pursuant to the terms of the ITS Plan. Specifically, PCX stated that it 
did not intend to modify any PCX members' obligations under the ITS 
Plan nor to modify the Exchange's obligation under the Plan to ensure 
settlement of trades effected via the PCX Application.\55\
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    \55\ PCX ITS Letter, supra, note 6. See also, PCX Rule 5.23.
---------------------------------------------------------------------------

IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and in 
particular, the requirements of Section 6(b) (5).\56\ The Commission 
finds that the Exchange's proposal to establish rules to implement the 
PCX Application of the Optimark System would promote the Commission's 
mandate under Section 6(b)(5) to remove impediments to and perfect the 
mechanism of a free and open market and a NMS, while protecting 
investors and the public interest. In addition, the Exchange's proposal 
with respect to the PCX Application is consistent with the Section 
6(b)(5) requirements that rules of an exchange be designed to prevent 
fraudulent and manipulative acts, to promote just and equitable 
principles of trade, and are not designed to permit unfair 
discrimination among customers, issuers, or broker-dealers.\57\
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    \56\ 15 U.S.C. Sec. 78(f)(b)(5).
    \57\ In approving the proposal, the Commission has considered 
the proposal's impact on efficiency, competition, and capital 
formation. 15 U.S.C. Sec. 78c(f).
---------------------------------------------------------------------------

    In addition, the Commission finds that the proposed rule change is 
consistent with the requirements of Section 11A of the Act.\58\ The 
Commission believes that the proposed Application of the OptiMark 
System would further the purposes of Section 11A of the Act and the 
development of a NMS by promoting economically efficient execution of 
securities transactions, fair competition among markets, the best 
execution of customer orders, and an opportunity for orders to be 
executed without the participation of a dealer. The PCX Application 
provides a new and potentially more efficient way for the Exchange to 
match and execute trading interest. The Application appears principally 
designed to meet the demands of sophisticated portfolio managers and 
other market professionals implementing complex trading strategies. 
These market participants often require instantaneous access to the 
market, and desire to minimize the market impact of their transactions 
through the expression of varied trading interests on a confidential 
basis. At the same time, the Application is designed to allow retail 
customers, through member Users, to interact with institutional trading 
interests.
---------------------------------------------------------------------------

    \58\ 15 U.S.C. Sec. 78k-1.
---------------------------------------------------------------------------

    The PCX Application is likely to promote competition among market 
centers because it has the potential to attract new market participants 
and to increase order flow to the Exchange. By attracting order flow, 
the Application may provide a new and enhanced source of liquidity for 
investors. Further, as noted in the majority of the thirteen comment 
letters that supported the proposal, both institutional and retail 
investors should benefit from the Application insofar as their 
expressions of trading interest are represented in the OptiMark System 
and are executed on the Exchange. As a result, the Application could 
enhance the ability of investors to have their orders executed on the 
PCX. Moreover, the Application would increase the ability of investors' 
orders to interact directly with other investors orders on the PCX.
    The Commission has historically encouraged exchanges to integrate 
new data communications and trade execution mechanisms into their 
markets in furtherance of the development of the NMS.\59\ The 
Commission, for example, approved the fully computerized National 
Securities Trading System (``NSTS'') of the Cincinnati Stock Exchange, 
the MAX and SuperMAX Systems of the Chicago Stock Exchange, and the 
CAES operated by Nasdaq.\60\ In fact, the PCX Application of the 
OptiMark System shares many of the characteristics of the Chicago Stock 
Exchange's Chicago Match System, which was approved by the Commission 
in 1994.\61\ Like the

[[Page 50046]]

proposed Chicago Match System, the PCX Application blends some of the 
features of a call market with the continuous auction of the PCX floor. 
The operation of such a hybird system will differ in important respects 
from the traditional structure of a trading floor. For the reasons 
discussed below, however, the Commission does not believe that these 
differences would cause the PCX Application to violate the provisions 
of the Act.
---------------------------------------------------------------------------

    \59\ In 1982, when instating the Cincinnati Stock Exchange's 
NSTS as a permanent program, the Commission stated:
    In mandating the development of a NMS, Congress expressly stated 
that ``[n]ew data processing and communications techniques create 
the opportunity for more efficient market operations.'' . . . In 
carrying out Congress' mandate, the Commission has taken an 
evolutionary approach by encouraging the securities industry to take 
the primary initiative in fashioning trading mechanisms which are 
consistent with the goals of a NMS. The Commission believes that, as 
a general matter, the industry has responded well to changing 
economic and technological demands by attempting to integrate state 
of the art data processing and communications technology to develop 
many new trading systems which have advanced the objectives of a 
NMS. In this respect, the Commission believes that ITS, the NASD's 
[National Association of Securities Dealers'] Computer Assisted 
Execution System (``CAES'') and the NSTS represent constructive 
approaches to integrating trading in physically dispersed locations. 
(citations omitted)
    Securities Exchange Act Release No. 19315 (Dec. 9, 1982), 47 FR 
56236 (Dec. 15, 1982).
    \60\ See, e.g., Securities Exchange Act Release No. 19315 (Dec. 
9, 1982), 47 FR 56236 (Dec. 15, 1982) (Commission approval to 
terminate the NSTS as an experimental program and extend its 
duration for an indefinite period of time); Securities Exchange Act 
Release No. 12451 (May 14, 1976), 41 FR 20932 (May 21, 1976) 
(Commission approval of the MAX system to operate on a permanent 
basis); Securities Exchange Act Release No. 32631 (July 14, 1993), 
58 FR 39069 (July 21, 1993) (Commission approval to operate the 
SuperMAX system on a permanent basis); Securities Exchange Act 
Release No. 17601 (Mar. 4, 1981); 46 FR 16171 (Mar. 11, 1981) 
(Commission Notice of the NASD filing of a proposed rule change for 
the establishment of CAES); Securities Exchange Act Release No. 
17744 (Apr. 21, 1981), 46 FR 23856 (Apr. 28, 1981) (Commission order 
to implement an automated interface between the ITS and CAES); and 
Securities Exchange Act Release No. 18713 (May 6, 1982), 47 FR 20413 
(May 12, 1982) (implementing ITS/CAES interface and operations).
    \61\ Securities Exchange Act Release No. 35030 (Nov. 30, 1994), 
59 FR 63141 (Dec. 7, 1994). The PCX Application differs from Chicago 
Match in that it is a periodic, rather than a unitary, call market.
---------------------------------------------------------------------------

    First, the Commission believes that the Application, operating as a 
facility of an exchange, would have the ability and capacity to carry 
out the regulatory purposes of the Act.\62\ As part of its obligations 
under the Act and pursuant to its own rules, the Exchange would conduct 
all necessary surveillance of the operation of and trading through the 
Application.\63\ The Exchange has also represented that the Application 
would have a full audit trail capability, adequate computer capacity to 
handle and process User Profiles and order flow, and adequate computer 
security to ensure the safety and confidentiality of User 
transmission.\64\
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    \62\ The PCX Application is properly regulated as a facility of 
an exchange, as defined in Section 3(a)(2) of the Act. The PCX 
Application of OptiMark would use the PCX's premises, property, and 
services for effecting and reporting transactions. For a recent 
discussion of the classification of an electronic communication and 
matching system as a facility of an exchange, see Securities 
Exchange Act Release No. 35030, supra, note 61 (concerning the 
Chicago Match System).
    OSI, which plans to register as a broker-dealer and comply with 
Rule 17a-23 under the Act, would be responsible for operating 
portions of the PCX Application for the Exchange and would receive 
commissions from Users for transactions. The Exchange has 
represented that it will submit any changes to this structure to the 
Commission as a rule filing.
    In addition, OTI expects to offer other exchanges trading 
services based on the OptiMark System technology. If another 
national securities exchange chooses to use the OptiMark System, it 
would be required to file a separate rule filing under Section 19(b) 
of the Act.
    \63\ Further, the Exchange will ensure that the Application 
complies with all trading halts and trading suspensions.
    \64\ As with any other exchange application, the Commission 
expects to conduct a full EDP review of the Application and its 
operations. See, e.g., the Commission's Automation Review Policy 
guidelines. Securities Exchanges Act Release No. 27445 (Nov. 16, 
1989), 54 FR 48703 (Nov. 24, 1989), and Securities Exchange Act 
Release No. 29185 (May 9, 1991), 56 FR 22490 (May 15, 1991).
---------------------------------------------------------------------------

    Second, contrary to the NYSE's assertion, the Exchange is not 
operating a hidden market in violation of the Firm Quote Rule.\65\ 
Specifically, the Commission does not believe that the PCX Application 
violates the Firm Quote Rule. The Firm Quote Rule, among other things, 
requires exchanges to collect bids, offers, quotation sizes and 
aggregate quotation sizes from responsible brokers or dealers for 
subject securities, and make them available to quotation vendors.
---------------------------------------------------------------------------

    \65\ 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------

    A bid or offer is defined in the Firm Quote Rule as the ``bid price 
and the offer price communicated by an exchange member or OTC market 
maker to any broker or dealer, or to any customer.'' \66\ In order to 
constitute a bid or offer, therefore, the underlying trading interest 
must have been communicated to at least one other potential 
counterparty. Bids and offers are intended to attract other parties to 
deal with the person publishing the bid or offer at the quoted price. 
For example, the Commission recently deemed the entry of priced orders 
into an electronic communications network (``ECN'') to be bids and 
offers where these orders were widely disseminated to other 
parties.\67\ In contrast, the essence of the Application is its 
anonymity. Only the Application is aware of the potential trading 
interest until trades occur. The PCX represents that the Application 
would ``not permit any interactive communication among Users whatsoever 
for any solicitation of trading interest (not even on an anonymous 
basis).'' \68\ The PCX further represented that the Application 
``differs fundamentally from any `hit or take' or `interactive' trading 
system, which allows the display of order price and size levels by a 
subscriber for others to act on.'' \69\ The Commission agrees with the 
PCX representation that the Application ``is not a mechanism by which 
system subscribers (1) broadcast prices to other system subscribers and 
(2) trade with one another at those prices,'' like an exchange or 
ECN.\70\ Accordingly, the Commission believes that the Application as 
proposed would not violate the Firm Quote Rule and would not fall 
within the status of an ECN.
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    \66\ See CFR 240.11Ac1-1(a)(4).
    \67\ The term ``electronic communications network'' means, for 
the purposes of 17 CFR 240.11Ac1-1(c)(5), ``any electronic system 
that widely disseminates to third parties orders entered therein by 
an exchange market maker or OTC market maker, and permits such 
orders to be executed against in whole or in part; except that the 
term electronic communications network shall not include: (i) Any 
system that crosses multiple orders at one or more specified times 
at a single price set by the ECN (by algorithm or by any derivative 
pricing mechanism) and does not allow orders to be crossed or 
executed against directly by participants outside of such times; or 
(ii) Any system operated by, or on behalf of, an OTC market maker or 
exchange market maker that executes customer orders primarily 
against the account of such market maker as principal, other than 
riskless principal.'' See 17 CFR 240.11Ac1-1(a)(8). Rule 11Ac1-
1(c)(5)(i) provides that the ``[e]ntry of any priced order for a 
covered security by an exchange market maker or OTC market maker in 
that security into an electronic communications network that widely 
disseminates such order shall be deemed to be: (A) A bid or offer 
under this section, to be communicated to the market maker's 
exchange or association pursuant to paragraph (c) of this section 
for at least the minimum quotation size that is required by the 
rules of the market maker's exchange or association if the priced 
order is for the account of a market maker, or the actual size of 
the order up to the minimum quotation size required if the priced 
order is for the account of a customer; and (B) A communication of a 
bid or offer to a quotation vendor for display on a display device 
for purposes of paragraph (c)(4) of this section.'' 17 CFR 
240.11Ac1-1(c)(5)(i).
    \68\ See PCX May 19 Letter, supra, note 33, at 8.
    \69\ Id. at 8-9.
    \70\ Id. at 9.
---------------------------------------------------------------------------

    Moreover, Profiles, unlike bids and offers, are conditional until 
they are processed in a Cycle. In this way, Profiles are analogous to 
indications of interest or CAP orders, neither of which are displayed 
in exchanges or on Nasdaq. The terms ``bid'' and ``offer,'' as defined 
by the Firm Quote Rule, do not include ``indications of interest.'' 
\71\ A Profile is only a generalized expression of interest with 
conditions attached and is not eligible for execution until the 
completion of the Cycle. Profiles entered into the PCX Application can 
be revised and cancelled at any time prior to commencement of the next 
scheduled Cycle.
---------------------------------------------------------------------------

    \71\ Rule 11Ac1-1(a)(4) provides that the terms ``bid and 
offer'' mean ``the bid price and the offer price communicated by an 
exchange member or OTC market maker to any broker or dealer, or to 
any customer, at which it is willing to buy or sell one or more 
round lots of a covered security, as either principal or agent, but 
shall not include indications of interest.'' (emphasis added) 17 CFR 
240.11Ac1-1(a)(4).
---------------------------------------------------------------------------

    Further, the Commission does not believe that the PCX Application 
would create a hidden market within PCX. The Commission particularly 
disagrees with NYSE's suggestion that PCX's proposed non-dissemination 
of Profiles to PCX's equity floor and other exchange markets is 
contrary to the goals of the NMS. Rather, the Commission believes that 
the unique design of the Application warrants a non-traditional 
approach in determining whether to require the dissemination of trading 
interest expressed through operation of the Application. The 
Application reflects the efforts of PCX to establish a trading system 
that blends elements of a call market with a continuous auction market, 
with anonymous Profiles being continuously entered and cancelled until 
the next scheduled periodic call market (performing a Cycle). The 
failure to disseminate Profiles does not provide any other market 
participant with an unfair market advantage as a result of seeing the 
trading interest that is not shown to others. Any User only knows its 
own Profile; it has no special access

[[Page 50047]]

to other Users' Profiles. Moreover, users have no control or influence 
in determining the outcome of a match, other than through the 
construction of their own Profiles.
    In addition, the Commission believes that dissemination of Profiles 
would likely be very difficult, given that Profiles represent 
contingent trading interest at different prices, share amounts, and 
satisfaction levels. Any accurate dissemination of Profiles, other than 
Profiles containing only a satisfaction value of one, would need to be 
expressed in a three-dimensional format, which could create confusion 
for investors.
    Third, the Commission believes that trading interest on the PCX 
floor would be adequately integrated into the PCX Application. 
Specifically, specialists and floor brokers would be able to reflect 
customer trading interest by entering Profiles into the PCX 
Application. In addition, if a specialist does not submit a limit order 
to the Application, the Exchange would require that specialist to 
guarantee the execution of the limit order at the price of an order 
derived from a Cycle that is priced at or better than the limit order's 
price, up to the amount of shares executed as a result of the 
particular Cycle.\72\ Floor brokers, similarly, would remain subject to 
best execution obligations. The NYSE has pointed out the possibility 
that, during a small window of a few seconds, if a limit order were 
sent to the Exchange immediately following the commencement of a Cycle, 
this order would not have the opportunity to interact with the Profiles 
entered into the PCX Application.\73\ Thus, once the Cycle is 
completed, resulting orders sent to the PCX for execution at such limit 
order's price or better would bypass the limit order, even though such 
limit order had priority under the PCX's current rules. The Commission 
acknowledges that there is a possibility of this scenario occurring. 
Because of the virtually instantaneous nature of the Cycles, however, 
such a scenario is likely to occur very infrequently.\74\
---------------------------------------------------------------------------

    \72\ For example, if a specialist received a customer limit 
order to buy 1,000 shares at 20 prior to the commencement of a 
Cycle, and the best priced order generated by the Cycle was assigned 
a price of 19\1/2\, involving 900 shares, with the next best priced 
order at 19\3/4\, involving 1,000 shares, the specialist would be 
obligated to fill 900 shares of the customer limit order at 19\1/2\, 
and fill the balance at 19\3/4\.
    \73\ NYSE Second Comment Letter, supra, note 45, at 2.
    \74\ Contrary to NYSE's understanding, PCX specialists would not 
be required to guarantee customer limit orders booked after the 
commencement of a Cycle at prices obtained as a result of such 
Cycle.
---------------------------------------------------------------------------

    Fourth, the Commission notes the Exchange's representations that 
the operation of the PCX Application would be consistent with the 
Exchange's and its members' obligations under the ITS Plan. 
Specifically, the Exchange represents that the PCX Application would be 
operated in a manner consistent with the Exchange's intermarket price 
protection obligations under the ITS Plan. The PCX Application would 
incorporate existing market interest from each of the ITS participant 
markets in the form of CQS Profiles. All orders priced inferior to the 
quotations of another ITS participant market would be executed on the 
Exchange only upon submission of appropriate ITS commitments seeking to 
reach such better-priced interest. For orders representing matched 
coordinates from CQS Profiles and other Profiles, the Exchange would 
submit an ITS commitment reflecting each such order for execution on 
other market centers to which the OptiMark System is not directly 
linked. Every ITS commitment would be sent under the give-up of the 
member User or the Designated Broker, by way of the traditional 
Exchange linkage to the ITS, in the sequence in which orders are 
generated from the Cycle.
    PCX has represented that it proposes to send ITS commitments 
resulting from the PCX Application in the same way as other ITS 
commitments are currently sent by the Exchange. The Commission notes 
that PCX has represented that the Application will be implemented in a 
manner fully consistent with the ITS Plan, and PCX is engaged in 
discussions with other ITS participants regarding the requirements of 
the ITS Plan.
    The Commission believes that PCX has adequately represented that 
its proposed disclaimer of liability (proposed PCX Rule 15.8) covering 
the operation of the PCX Application does not operate to change or 
modify in any way PCX's obligations for clearance and settlement of 
trades matched through the Application and submitted for execution on 
another market center pursuant to the ITS Plan.
    Fifth, the Commission also believes that the PCX will meet its 
obligation with respect to the reporting of transactions resulting from 
the Application. The Exchange has represented that transactions 
resulting from orders routed to the PCX floor from the Application 
would be reported to the CTS in the sequence in which such orders are 
generated from a Cycle. The Exchange has represented that it would 
report these trades in a manner similar to the way it currently reports 
other trades in PCX Securities to the CTS. Transaction reports 
resulting from a Cycle of the Application, moreover, would not be 
distinguishable on the CTS from the trade report of any other order 
executed on the PCX floor. Although such transaction reports may occur 
in rapid sequence, with numerous reports being generated in a short 
period of time, the individual transaction reports would still be 
reported and displayed in order of the execution of the transactions.
    Sixth, although non-members would have access to the Application, 
such access would only be through an Exchange member broker-dealer. 
Before submitting Profiles to the PCX Application, non-members would be 
required to designate a member firm that would authorize their access 
to the PCX Application and accept responsibility for these non-member 
transactions. The Exchange states that it expects the Designated 
Brokers, or the clearing brokers of the Designated Brokers, to impose 
credit limits on non-member Users of the PCX Application.\75\ Other 
exchanges have allowed non-members to access their facilities through 
member broker-dealers under similar conditions. For example, the 
Chicago Stock Exchange's Chicago Match System provided for direct non-
member access through personal computers and modems, using a member 
broker-dealer give-up. The non-member access permitted by the 
Commission with respect to the Chicago Match System is substantially 
similar to the non-member User access proposed by PCX.\76\
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    \75\ Further, Exchange members would be required to maintain 
information and records concerning non-members access for which they 
are responsible. The Exchange has represented to the Commission that 
it would require its members to make such non-member User 
information available to the Exchange upon request, so that the PCX 
can fulfill its duties regarding surveillance.
    \76\ See Securities Exchange Act Release No. 35030, concerning 
the Chicago Match System, supra, note 61. As with the PCX 
Application, the CHX required non-member users of the Chicago Match 
System to enter into several agreements to ensure that a CHX member 
had responsibility and control over the non-member's activities. 
These responsibilities, included, among other things, controlling 
and clearing the orders entered by non-members, assuming legal 
responsibility of the non-member orders entered, and ensuring 
appropriate credit limits. See id. The Commission's approval order 
for the Chicago Match System also noted that the then anticipated 
non-member use of the Chicago Match System was analogous to non-
member access to the NYSE's Designated Order Turnaround System (now 
referred to as ``SuperDOT''). The SuperDOT System is an electronic 
order-routing system that enables NYSE members and their customers 
to transmit market and limit orders in all NYSE-listed securities 
directly to the specialist post where the securities are traded, or 
to the member firm's booth. Non-member customers, however, must 
obtain the electronic means to access SuperDOT through a broker-
dealer member. Like the Chicago Match System, the NYSE's SuperDOT 
system requires NYSE members to monitor customers' electronic orders 
and to provide the NYSE with an acknowledgement indicating their 
responsibility for orders. See id.

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[[Page 50048]]

    Seventh, PCX is adopting reasonable requirements for the clearance 
and settlement of transactions resulting from the Application. In 
particular, the Commission believes it is appropriate for PCX to 
require that: (i) All orders generated by the Application that are 
executed on PCX or another market center through ITS be reported and 
entered into the comparison system on a locked-in basis; (ii) orders 
generated by the Application on behalf of a member User and the 
resulting transactions be cleared and settled using that member User's 
mnemonic (or its clearing broker's mnemonic, as applicable); and (iii) 
orders generated by the Application on behalf of a non-member User and 
the resulting transaction be cleared and settled using the appropriate 
Designated Broker's mnemonic.
    Finally, the Commission believes that PCX has established that 
short sales effected through the Application, pursuant to the requested 
exemption and in accordance with the restrictions contained in proposed 
Rule 15.3(b), would not be susceptible to the practices that Rule 10a-1 
is designed to prevent. PCX has amended its proposal to provide for 
substantial compliance with Rule 10a-1.\77\ PCX represents that the 
first match of a Cycle, if it involves a short sale, would be in 
compliance with Rule 10a-1. Subsequent matches would use the price of 
the immediately preceding match in the Cycle, rather than the last 
trade in the consolidated transaction reporting system as a reference. 
The Division of Market Regulation, by delegated authority, intends to 
grant PCX an exemption from Rule 10a-1 to permit matches within a Cycle 
(those subsequent to the initial match) to use the immediately prior 
match as a reference for determining compliance with Rule 10a-1. The 
Commission, therefore, believes that PCX has adequately addressed 
concerns arising under the short sale rule.
---------------------------------------------------------------------------

    \77\ The NYSE asserted that new Rule 15.4 proposed by PCX 
improperly stated that ``the Exchange's short sale rule (Rule 5.18) 
shall not be applicable to any resulting transaction in the 
Exchange.'' See Letter from James E. Buck, NYSE, supra, note 4, at 
4. The Commission notes that the PCX has removed this statement from 
proposed new Rule 15.4.
---------------------------------------------------------------------------

    The Commission finds that good cause exists to grant approval to 
Amendment Nos. 1, 2, and 3 to the proposed rule change on an 
accelerated basis. Collectively, these amendments reflect PCX's 
proposed handling of short sales affected through the Application and 
clarify PCX specialist obligations relating to price protection for 
orders generated by the Application. The short sale amendment narrows 
the scope of the proposed short sale exemption attendant to OptiMark 
transactions. Moreover, as stated above, the Commission has determined 
that PCX's proposed short sale restrictions substantially mirror the 
requirements of Rule 10a-1 and are designed in a manner that will not 
permit the types of short sale practices Rule 10a-1 was designed to 
prohibit. Accordingly, the Division intends to issue PCX an exemption 
from Rule 10a-1. In addition, the Commission believes that the 
amendments pertaining to specialist price protection obligations 
resulting from orders generated by the Application merely clarify and 
provide explanatory examples of how the PCX rules relating to the 
Application will ensure price protection of limit orders. The 
Commission therefore finds good cause to accelerate approval of 
Amendment Nos. 1, 2, and 3.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 1, 2, and 3. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. Sec. 552, will be available for inspection and 
copying in the Commission's Public Reference Section, 450 Fifth Street, 
N.W., Washington, D.C. 20549. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
above-mentioned self-regulatory organization. All submissions should 
refer to the file number in the caption above and should be submitted 
by October 15, 1997.

VI. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act.\78\
---------------------------------------------------------------------------

    \78\ 15 U.S.C. Secs. 78f and 78s(b)(2).
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    It therefore is ordered, pursuant to Section 19(b)(2) of the 
Act,\79\ that the proposed rule change (SR-PCX-97-18) is hereby 
approved, as amended.

    \79\ 15 U.S.C. Sec. 73s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\80\
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    \80\ CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-25319 Filed 9-23-97; 8:45 am]
BILLING CODE 8010-01-M