[Federal Register Volume 64, Number 241 (Thursday, December 16, 1999)]
[Notices]
[Pages 70297-70307]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-32555]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42212; File No. 4-208]
RIN 3235-AH49


Adoption of Amendments to the Intermarket Trading System Plan To 
Expand the ITS/Computer Assisted Execution System Linkage to All Listed 
Securities

AGENCY: Securities and Exchange Commission.

ACTION: Adoption of amendments to national market system plan.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting amendments to the plan governing the operation of the 
Intermarket Trading System (``ITS Plan'' or ``Plan''). The amendments 
expand the ITS/Computer Assisted Execution System (``CAES'') linkage to 
all listed securities, including non-Rule 19c-3 securities.

EFFECTIVE DATE: February 14, 2000.

FOR FURTHER INFORMATION CONTACT: Katherine A. England, Assistant 
Director, at (202) 942-0154; or Christine Richardson, Attorney, at 
(202) 942-0748, Office of Market Supervision, Division of Market 
Regulation, Securities and Exchange Commission, 450 Fifth Street, NW, 
Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:

I. Background and Description

    The Commission is adopting amendments to the ITS Plan to expand the 
National Association of Securities Dealers, Inc.'s (``NASD'') ITS/CAES 
linkage to all listed securities. The Commission believes that these 
amendments, adopted by the Commission on its own initiative pursuant to 
Rule 11Aa3-2 under the Securities Exchange Act of 1934 (``Exchange 
Act'' or ``Act''),\1\ are necessary to encourage the statutory goals of 
efficient execution of securities transactions and opportunities for 
best execution of customer orders. The Commission is adopting these 
amendments only after the ITS Participants \2\ have been unable to 
reach agreement.
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    \1\ Rule 11Aa3-2 (17 CFR 240.11Aa3-2) establishes procedures for 
initiating or approving amendments to national market system plans 
such as the ITS Plan. Paragraph (b)(2) of Rule 11Aa3-2 states that 
the Commission may propose amendments to an effective national 
market system plan by publishing the text thereof together with a 
statement of purpose of the amendments. Paragraph (c)(1) requires 
the Commission to publish notice of any amendments initiated by the 
Commission and provide interested parties an opportunity to submit 
written comments. Paragraph (c)(2) of Rule 11Aa3-2 requires that 
promulgation of an amendment to an effective national market system 
plan initiated by the Commission be by rule.
    \2\ Current signatories to the ITS Plan include American Stock 
Exchange LLC (``Amex''), Boston Stock Exchange, Inc. (``BSE''), 
Chicago Board Options Exchange, Inc. (``CBOE''), Chicago Stock 
Exchange (``CHX''), Cincinnati Stock Exchange (``CSE''), NASD, New 
York Stock Exchange, Inc. (``NYSE''), Pacific Exchange, Inc. 
(``PCX''), and Philadelphia Stock Exchange, Inc. (``Phlx''), 
collectively, the ``Participants.''
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A. History of ITS

    Section 11A(a)(2) of the Exchange Act \3\ directs the Commission, 
having due regard for the public interest, the protection of investors, 
and the maintenance of fair and orderly markets, to use its authority 
under the Act to facilitate the establishment of a National Market 
System (``NMS'') for securities in accordance with the Congressional 
findings and objectives set forth in Section 11A(a)(1) of the Act. 
Among those findings and objectives is the ``linking of all markets for 
qualified securities through communication and data processing 
facilities.'' \4\
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    \3\ Section 11A(a)(2) was adopted by the Securities Acts 
Amendments of 1975 (``1975 Amendments''). Pub. L. No. 94-29 (June 4, 
1975).
    \4\ Section 11A(a)(1)(D) of the Act, 15 U.S.C. 78k-1(a)(1)(D).
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    On January 26, 1978, the Commission issued a statement on the 
national market system calling for, among other things, the prompt 
development of comprehensive market linkage and order routing systems 
to permit the efficient transmission of orders among the various 
markets for qualified securities, whether on an exchange or over-the-
counter.\5\ In particular, the Commission stated that an intermarket 
order routing system was necessary to ``permit orders for the purchase 
and sale of multiply-traded securities to be sent directly from any 
qualified market to another such market promptly and efficiently.'' \6\ 
The Commission further stated that ``[t]he need to develop and 
implement a new intermarket order routing system to link all qualified 
markets could be obviated if participation in the ITS market linkage 
currently under development were made available on a reasonable basis 
to all qualified markets and if all qualified markets joined that 
linkage.'' \7\
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    \5\ Exchange Act Release No. 14416 (January 26, 1978) (``1978 
Statement''), at 26, 43 FR 4354, 4358. Previously, on June 23, 1977, 
the Commission had indicated that a national market system would 
include those ``regulatory and technological steps [necessary] to 
achieve a nationwide interactive market system.'' See Exchange Act 
Release No. 13662 (June 23, 1977), at 20, 42 FR 33510, 33512.
    \6\ 1978 Statement, supra note 5, at 4358.
    \7\ In this connection, the Commission specifically indicated 
that ``qualified markets'' would include not only exchanges but OTC 
market makers as well. Id.
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    As requested by the Commission, in March 1978, various exchanges 
\8\ filed jointly with the Commission a ``Plan for the Purpose of 
Creating and Operating an Intermarket Communications Linkage,'' now 
known as the ITS Plan. On April 14, 1978, the Commission, noting that 
ITS might provide the basis for an appropriate market linkage facility, 
issued a provisional order, pursuant to Section 11A(a)(3)(B) of the 
Act,\9\ authorizing the filing exchanges (and any other self-regulatory 
organization (``SRO'') which agreed to become a participant in the ITS 
Plan) to act jointly in planning, developing, operating and regulating 
the ITS in accordance with the terms of the ITS Plan for a period of 
120 days.\10\
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    \8\ The exchanges involved were the Amex, BSE, NYSE, PCX (then 
called the ``PSE''), and PHlx.
    \9\ 15 U.S.C. 78k-1(a)(3)(B).
    \10\ See Exchange Act Release No. 14661 (April 14, 1978), 43 FR 
17419. In authorizing the implementation of ITS, the Commission 
urged those SROs not yet ITS participants to participate in ITS. Id. 
at 7 n.15, 43 FR 17421. On August 11, 1978, the Commission extended 
ITS authority for an additional period of one year. See Exchange Act 
Release No. 15058 (August 11, 1978), 43 FR 36732. In the interim the 
ITS Plan had been amended to include the Midwest Stock Exchange 
(``MSE'') as a participant. The MSE is now the CHX.
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    Subsequently, during the Commission's hearings regarding proposed 
Rule 19c-3 under the Act,\11\ the NASD announced plans to enhance its 
Nasdaq System to include, among other things, a computer assisted 
execution system that would enable participating firms to route their 
orders for listed securities through the system to obtain automatic 
executions against quotations of third market makers.\12\ This system 
later came to be known as CAES. The NASD also contemplated an automated 
interface between the ITS and CAES (``ITS/CAES'') to permit automated 
execution of commitments sent from participating exchanges and to 
permit market makers participating in the enhanced Nasdaq to route 
commitments efficiently to exchange markets for execution.\13\
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    \11\ Exchange Act Release No. 15769 (April 26, 1979), 44 FR 
26688. Rule 19c-3 precludes exchange off-board trading restrictions 
from applying to securities listed after April 26, 1979.
    \12\ The term third market makers refers to OTC market makers in 
listed securities.
    \13\ In its discussions with the ITS Participants, the NASD 
indicated that the enhanced Nasdaq would encompass trading of listed 
securities and that it intended to pursue an automated interface. 
See In re Off-Board Trading Restrictions, File No. 4-220, at 9-10, 
23-34.

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[[Page 70298]]

    The Commission later extended its authorization for the joint 
operation of ITS \14\ but indicated several concerns with respect to 
ITS that would require the attention of the ITS Participants during the 
extension period. In particular, the Commission indicated that, in 
order for ITS to serve as a means to achieve price protection on an 
intermarket basis, the ITS Participants should implement ``a linkage 
between the ITS and over-the-counter market makers regulated by the 
NASD. * * *'' \15\ The Commission further indicated its expectation 
that the NASD would become an ITS participant before October 1980, and 
stated that if the contemplated ITS/CAES interface was not implemented 
promptly, the Commission was prepared to take appropriate steps to 
require the inclusion of third market makers in ITS.\16\
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    \14\ The authorization for the joint operation was extended 
until January 31, 1983. See Exchange Act Release No. 16214 
(September 21, 1979), 44 FR 56069.
    \15\ Id. at 12, 44 FR 56072. The Commission also called for a 
linkage between the ITS and the CSE's National Securities Trading 
System (``NSTS'').
    \16\ Id. at 14-15, 44 FR 56072. The Commission substantially 
reiterated these views in a letter to Congress shortly thereafter. 
See letter from Harold M. Williams, Chairman, SEC, to the Honorable 
Bob Eckhardt, Chairman, Subcommittee on Oversight and Investigations 
and the Honorable James Scheuer, Chairman, Subcommittee on Oversight 
and Investigations and the Subcommittee on Consumer Protection and 
Finance, House Committee on Interstate and Foreign Commerce, dated 
November 9, 1979, included in Progress Toward the Development of a 
National Market System, Joint Hearings before the Subcommittee on 
Consumer Protection and Finance of the Committee on Interstate and 
Foreign Commerce, House of Representatives, 90th Cong., 1st Sess., 
Serial 96-89.
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    On June 11, 1980, the Commission adopted Rule 19c-3 under the Act, 
which eliminated off-board trading restrictions with respect to most 
newly-listed securities, thereby permitting member firms of the NYSE 
and Amex to make markets over-the-counter in what was then a small 
number of NYSE and Amex-listed securities.\17\ The Commission stated 
that the presence of additional market makers might: (1) Place 
competitive pressure on primary market specialists, potentially 
narrowing spreads in Rule 19c-3 securities; and (2) create incentives 
for markets to disseminate quotations of greater size, adding to the 
depth, liquidity, and continuity of the markets for those 
securities.\18\
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    \17\ See Exchange Act Release No. 16888 (June 11, 1980), 45 FR 
41125 (``Rule 19c-3 Adopting Release''). The rule, as adopted, 
essentially precludes exchange off-board trading restrictions from 
applying to securities listed after April 26, 1979 (``Rule 19c-3 
securities''). Although the Commission recognized many potential 
concerns regarding the rule, such as internalization, the Commission 
determined that they were outweighed by the benefits of the rule, 
including an opportunity for competition between the OTC and 
exchange markets, with concomitant benefits to investors. 
Internalization refers to ``the withholding of retail orders from 
other market centers for the purpose of executing them `in-house,' 
as principal without exposing those orders to buying and selling 
interest in those other market centers.'' Id. at 18, n.31, 45 FR 
41128, n.31.
    \18\ The Commission believed that off-board trading restrictions 
had anti-competitive effects because they effectively confined 
trading in listed securities to exchange markets by precluding 
exchange members from trading as principal in the OTC market. 
Adopting Rule 19c-3 limited the expansion of the anti-competitive 
effects. The Commission also announced the development of a 
monitoring program to study the issues raised by commentators and 
determined to publish monitoring reports on a periodic basis. In 
connection with the adoption of Rule 19c-3, the Commission noted the 
importance of the NASD's completion of the Nasdaq enhancements in 
order to provide ``a more efficient mechanism for over-the-counter 
market making in listed securities.'' Id. at 14-15, 45 FR 41127. See 
Rule 19c-3 Adopting Release, supra note 17, at 49-53, 45 FR 41134.
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    The Commission also indicated that achieving efficient linkages 
between traditional exchange trading floors and over-the-counter 
markets was essential to obtaining maximum order interaction between 
the various types of markets. The Commission therefore stated that it 
expected the NASD and the ITS Participants to establish an automated 
linkage between ITS and the Nasdaq system and to provide the Commission 
with formal status reports on the ITS-Nasdaq linkage.\19\
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    \19\ Id. at 15-16, 45 FR 41127. In September 1980, several 
Participants (the Amex, BSE, NYSE, Phlx, and PCX) submitted 
identical letters that indicated that they were not at that time 
willing to commit to the development of an automated interface. The 
NASD responded by reaffirming its commitment to the automated 
interface and providing the Commission and the ITS Participants with 
a functional description of the automated interface. See Description 
of NASD Market Services, Inc., Computer Assisted Execution System, 
contained in File 4-208. In its functional description, the NASD 
also committed to developing a capability to provide the ITS 
Participants with the best bid and offer among all market makers 
participating in the enhanced Nasdaq. On January 7, 1981, the NYSE 
Board of Directors approved participation in a two-step ``test'' 
linkage between ITS and the enhanced Nasdaq system.
    With respect to the actual operation of the automated interface, 
the NYSE plan contemplated an initial pilot phase in which trading 
through the automated interface would be limited to the 30 most 
active Rule 19c--3 securities. The other ITS Participants were in 
general agreement with the NYSE's position with respect to the 
automated interface. During the pilot phase, the NYSE anticipated 
that the ITS Participants and the Commission would evaluate trading 
under the preliminary rule and other policy concerns which may have 
been raised by trading Rule 19c-3 securities through the automated 
interface. The NYSE plan further anticipated that in the subsequent 
phase the automated interface would be expanded to include the 
trading of all Rule 19c-3 securities, but only after the completion 
of the pilot phase evaluation and agreement among the ITS 
Participants and the NASD on any additional measures to address 
policy concerns identified by that evaluation.
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    One year later, after the ITS Participants failed to come to an 
agreement, the Commission published a release proposing to issue an 
order requiring an automated interface between ITS and the enhanced 
Nasdaq system.\20\ In proposing the order, the Commission determined 
that ITS, because of its ability to permit market participants to send 
orders from one market to another, was consistent with national market 
system goals and, if efficiently linked with all markets, could become 
a permanent feature of a national market system.\21\ The Commission 
reiterated its belief that the absence of any established linkage 
between the exchanges and OTC market makers preserved an environment in 
which there were reduced opportunities to ameliorate market 
fragmentation,\22\ to eliminate pricing inefficiencies, to obtain best 
execution, and to promote the type of competitive market structure that 
a national market system was designed to achieve.\23\
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    \20\ See Exchange Act Release No. 17516 (February 5, 1981), 46 
FR 12379 (February 13, 1981).
    \21\ Indeed, in mandating that the Commission facilitate the 
establishment of a national market system, Congress found that the 
linking of all markets for qualified securities through 
communication and data processing facilities would foster 
efficiency, enhance competition, increase the information available 
to brokers, dealers, and investors, facilitate the offsetting of 
investors' orders and contribute to best execution of such orders. 
Section 11A(a)(1)(D) of the Act, 15 U.S.C. 78k-1(a)(1)(D).
    \22\ Fragmentation occurs when investor order flow is directed 
to several markets that are not connected. Among other things, 
fragmentation reduces the probability of matching customer buy and 
sell orders because of the smaller number of orders in each market.
    \23\ See Exchange Act Release No. 17516 (February 5, 1981), 46 
FR 12379 (February 13, 1981).
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    Finally, on April 28, 1981, the Commission issued an order \24\ 
requiring the ITS Participants to implement an automated interface 
between CAES and ITS by March 1, 1982, limited to Rule 19c-3 
securities, and to submit proposed amendments to the ITS Plan 
reflecting the inclusion of the NASD as an ITS Participant.\25\ When 
the ITS Participants failed to submit an amendment, the Commission 
adopted its own amendments to the ITS Plan on May 12, 1982.\26\ The 
Commission's

[[Page 70299]]

amendments applied to Rule 19c-3 securities initially because the 
Commission believed that the adoption of Rule 19c-3 would likely result 
in an increase in volume for these securities, thereby heightening the 
need for an efficient linkage between the exchanges and the OTC 
market.\27\ The Commission fully intended the ITS/CAES linkage 
eventually to be expanded to all listed securities.\28\ As the 
Commission stated, ``in order to achieve fully the Congressional goal 
that all markets for qualified securities be linked * * * it will be 
necessary in the future for the ITS/CAES interface to be expanded to 
include all stocks traded in the third market.'' \29\
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    \24\ See Exchange Act Release No. 17744 (April 21, 1981), 46 FR 
23856 (April 28, 1981).
    \25\ On March 11, 1982, the Commission delayed the 
implementation date of the interface until May 1, 1982, and 
published its own proposed amendments to the ITS Plan. See Exchange 
Act Release No. 18536 (March 11, 1982), 47 FR 10658.
    \26\ A majority of the amendments were non-controversial and had 
been agreed upon by the parties or reflected the parties' decision 
to defer resolution of certain issues until after a pilot phase of 
the interface. The areas where the parties could not reach agreement 
were resolved by the Commission. See Exchange Act Release No. 18713 
(May 12, 1982), 47 FR 20413. The amendments included language 
requiring the NASD to apply trade through safeguards to provide for 
a sufficient assurance of consistency with the exchanges' trade 
through rules. A ``trade through'' occurs when a transaction is 
effected at a price below the best bid, or above the best prevailing 
offer. The NASD submitted a proposed trade through rule on May 4, 
1982, which the Commission approved on an accelerated basis for six 
months. The Commission believed that the NASD rule was adequate even 
though it was not identical to the exchanges' trade through rules. 
See Exchange Act Release No. 18714 (May 6, 1982), 47 FR 20429 (May 
12, 1982). The Commission had approved the exchanges' trade through 
rules on April 9, 1981. See Exchange Act Release No. 17704 (April 9, 
1981), 46 FR 22520.
    On September 15, 1983, the pilot phase ended and all Rule 19c-3 
securities became eligible for trading through the ITS/CAES 
interface. See Exchange Act Release Nos. 19825 (May 31, 1983), 48 FR 
25043 (June 3, 1983); and 19970 (July 20, 1983), 48 FR 33103.
    \27\ See Division of Market Regulation, Market 2000: An 
Examination of Current Equity Market Developments (January 1994) 
(``Market 2000 Study''), at A.II.12.
    \28\ See Exchange Act Release No. 19456 (January 27, 1983), 48 
FR 4938 (February 3, 1983) (``Final Approval Order'').
    \29\ Id.
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    The Commission permanently approved the ITS Plan on January 27, 
1983.\30\ The Plan contains a number of market integrity provisions to 
provide for continuity of transaction prices among the various market 
centers, including a trade through rule.\31\ It also contains a block 
trade policy that provides special rights to any market displaying the 
best national bid or offer when block-size transactions are occurring 
in another market.\32\
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    \30\ See id.
    \31\ The ITS Plan promotes price continuity among the various 
markets by ensuring that all markets have the opportunity to 
interact with the best national bids and offers.
    \32\ See ITS Plan, Section 8(d)(iii).
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B. Recent Developments

    On November 12, 1991, the NASD submitted an application to the 
Commission, pursuant to Rule 11Aa3-2(e), to review the ITS Operating 
Committee's (``ITSOC'') failure to approve two NASD recommendations 
that would have amended the ITS Plan to expand the ITS/CAES linkage to 
include non-Rule 19c-3 securities.\33\ Following that submission, the 
Division of Market Regulation (``Division'') issued its Market 2000 
Study,\34\ which included the Division's findings that it was necessary 
to expand the ITS/CAES linkage,\35\ and identified several regulatory 
issues that the Commission believed the NASD needed to address prior to 
any expansion.\36\
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    \33\ The NASD has since withdrawn its application. See letter 
from Robert E. Aber, Senior Vice President and General Counsel, 
Nasdaq, to Jonathan G. Katz, Secretary, Commission, dated July 23, 
1998.
    \34\ See Market 2000 Study, supra note 27.
    \35\ Specifically, the Market 2000 Study noted that the 
possibility of execution in the OTC market of a significant 
percentage of the total volume in multiple traded securities 
increased the need to enhance interaction of orders in all market 
centers to eliminate trade throughs and to provide market makers in 
those securities the ability to compete for order flow through their 
displayed quotations. Market 2000 Study, supra note 27.
    \36\ The Division, in its Market 2000 Study, identified several 
areas where the NASD should amend its rules prior to an expansion of 
the ITS/CAES linkage. Specifically, the Division recommended that 
the NASD amend its rules to provide for: the display of customer 
limit orders that improve the existing ITS best bid or offer 
(``BBO''); customer limit order protection; fixed standards for 
queuing and executing customer orders; crossing of customers' 
orders, if possible, without dealer intervention; and compliance 
with ITS trade through and block trade policies. The Division also 
stated that the NASD should develop a program specifically designed 
to enhance oversight examination of the third market. Id.
    In February 1995, the NASD submitted a rule filing addressing 
those recommendations but subsequently withdrew that filing in light 
of the Commission's publication of its Order Handling Rules 
(Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996)), which addressed many of the topics covered by 
the NASD's proposed rules. On June 22, 1998, the NASD submitted a 
Petition for Rulemaking (``NASD Petition'') to adopt rules necessary 
to remove the limitation on access to ITS with respect to non-Rule 
19c-3 securities.
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    In addition, in 1995, in the proposing release for the Order 
Handling Rules, the Commission solicited comment on whether the ITS/
CAES linkage should be expanded to cover non-Rule 19c-3 securities.\37\ 
In the adopting release for those rules, the Commission deferred action 
on the expansion of the ITS/CAES linkage, and instead encouraged the 
ITS Participants to work jointly to expand the linkage.\38\
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    \37\ See Exchange Act Release No. 36310 (September 29, 1995), 60 
FR 52792 (October 10, 1995).
    \38\ See Order Handling Rules, supa note 36.
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    Subsequently, on May 27, 1997, the Commission sent a letter to the 
ITS Participants outlining four aspects of the ITS Plan that it 
considered anti-competitive and requesting that they develop reasonable 
recommendations to the Commission in the form of proposed ITS Plan 
amendments and proposed SRO rule changes.\39\ The responses that the 
Commission received indicated that not all the Participants would agree 
to expand the ITS/CAES linkage.\40\ Because the ITS Plan currently 
requires a unanimous vote on proposed amendments, these changes could 
not be approved by the Participants. Accordingly, in July, 1998, the 
Commission proposed, on its own initiative, to expand the ITS/CAES 
linkage.\41\ The Commission received numerous comment letters in 
response to its proposal. After careful review of those comments, the 
Commission is now amending the ITS Plan to expand the ITS/CAES linkage 
to all listed securities.
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    \39\ Preliminarily, the Commission found four elements of the 
current operation of ITS and the ITS Plan to be an unreasonable 
impediment to competition among the various markets: (1) Minimum 
increments for ITS commitments; (2) the lack of access to ITS for 
OTC market makers; (3) the unanimous vote requirement for ITS Plan 
amendments; and (4) the ITS Participants' special right of review of 
CSE proposed rule changes. See letter from Jonathan G. Katz, 
Secretary, Commission, to ITS Participants, dated May 27, 1997 
(``May 27 Letter''). The Participants have voted to eliminate the 
limitation on access to increments through ITS, and the review of 
CSE rule changes. The Commission recently approved amendments to the 
ITS Plan to eliminate the special right of review of CSE rule 
changes. See Exchange Act Release No. 40553 (October 14, 1998), 63 
FR 56278 (October 21, 1998).
    \40\ Eight of the nine Participants supported eliminating the 
ITS/CAES linkage restrictions as long as certain significant changes 
are made to the NASD's rules prior to the expansion. See letter from 
Thomas F. Ryan, Jr., President and Chief Operating Officer, Amex, to 
Jonathan G. Katz, Secretary, Commission, dated June 26, 1997 (``Amex 
Letter''); letter from Charles J. Henry, President and Chief 
Operating Officer, CBOE, to Jonathan G. Katz, Secretary, Commission, 
dated June 26, 1997 (``CBOE Letter''); letter from Robert H. Forney, 
President and Chief Executive Officer, CHX, to Jonathan G. Katz, 
Secretary, Commission, dated November 3, 1997 (``CHX Letter''); 
letter from David Colker, Executive Vice President and Chief 
Operating Officer, CSE, to Jonathan G. Katz, Secretary, Commission, 
dated July 3, 1997 (``CSE Letter''); letter from Robert E. Aber, 
Vice President and General Counsel, Nasdaq, to Jonathan G. Katz, 
Secretary, Commission (``NASD 1997 Letter''); letter from James E. 
Buck, Senior Vice President and Secretary, NYSE, to Jonathan G. 
Katz, Secretary, Commission, dated June 25, 1997 (``NYSE Letter''); 
and letter from William G. Morton, BSE, Robert H. Forney, CHX, 
Robert M. Greber, PCX, and Nicholas Giordano, Phlx, to Jonathan G. 
Katz, Secretary, Commission, dated June 23, 1997 (``Joint Letter'').
    \41\ See Exchange Act Release No. 40260 (July 21, 1998), 63 FR 
40748 (July 30, 1998) (``Proposing Release''). In the Proposing 
Release, the Commission also proposed to eliminate the requirement 
that amendments to the ITS Plan be approved unanimously. The 
Commission is deferring consideration of that proposal at this time. 
The Commission plans to deal with several larger issues relating to 
market structure in an upcoming concept release.

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[[Page 70300]]

II. Summary of Comments

    The Commission received 15 comment letters relating to the 
expansion of the ITS/CAES linkage to all listed securities.\42\ All 15 
commenters generally support the expansion, both with and without 
certain conditions. In general, most of the commenters state that 
expanding the linkage will greatly benefit the market place and public 
investors.\43\ Specifically, the commenters believe that expanding the 
linkage will: increase market efficiency and transparency, reduce trade 
throughs, and level the playing field between third market firms and 
exchanges; \44\ decrease market fragmentation and produce long-term 
benefits to the NMS; \45\ increase the liquidity and competitiveness of 
the securities markets; \46\ and increase the opportunity for investors 
to obtain the best price available in all markets for orders in 
exchange-listed securities.\47\ One commenter states that there is no 
longer any good economic reason to trade Rule 19c-3 securities 
differently from non-Rule 19c-3 securities,\48\ while another states 
that from a marketplace and economic standpoint the distinction is 
meaningless.\49\ The NYSE, on the other hand, believes that it is more 
appropriate for the ITS Participants themselves to draft the necessary 
Plan amendments, rather than for the Commission to adopt the 
amendments.\50\
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    \42\ See letters from James Angel, Associate Professor of 
Finance, Georgetown University School of Business, to Jonathan G. 
Katz, Secretary, Commission, dated August 3, 1998 (``Angel ITS/CAES 
Letter''); Adam W. Gurwitz, CSE, to Jonathan G. Katz, Secretary, 
Commission, dated August 27, 1998 (``CSE ITS/CAES Letter''); James 
E. Buck, Senior Vice President and Secretary, NYSE, to Jonathan G. 
Katz, Secretary, Commission, dated August 31, 1998 (``NYSE ITS/CAES 
Letter''); Robert H. Forney, President and Chief Executive Officer, 
CHX, to Jonathan G. Katz, Secretary, Commission, dated August 28, 
1998 (``CHX ITS/CAES Letter''); Robert Lazarowitz, Chief Operating 
Officer, Trimark Securities, to Jonathan G. Katz, dated August 28, 
1998 (``Trimark Letter''); Joanne Moffic-Silver, General Counsel and 
Corporate Secretary, CBOE, to Jonathan G. Katz, Secretary, 
Commission, dated September 1, 1998 (``CBOE ITS/CAES Letter''); 
Craig S. Tyle, General Counsel, Investment Company Institute, to 
Jonathan G. Katz, Secretary, Commission, dated September 2, 1998 
(``ICI Letter''); Kevin M. Foley, Bloomberg, to Jonathan G. Katz, 
Secretary, Commission, dated September 4, 1998 (``Bloomberg 
Letter''); Richard Ketchum, President and Chief Operating Officer, 
NASD, to Jonathan G. Katz, Secretary, Commission, dated September 8, 
1998 (``NASD ITS/CAES Letter I''); Robert W. Seijas, Co-President, 
and Joel M. Surnamer, Co-President, The Specialist Association, to 
Jonathan G. Katz, Secretary, Commission, dated September 1, 1998 
(``SA Letter''); Lon Gorman, President, Schwab Capital Markets and 
Trading Group, Charles Schwab & Co., to Jonathan G. Katz, Secretary, 
Commission, dated September 14, 1998 (``Schwab Letter''); John C. 
Katovich, Senior Vice President and General Counsel, OptiMark 
Technologies, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated September 22, 1998 (``OptiMark ITS/CAES Letter''); Andrew M. 
Brooks, Vice President and Head of Equity Trading, T. Rowe Price 
Associates, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
September 29, 1998 (``T. Rowe Letter''); James F. Duffy, Executive 
Vice President and General Counsel, Amex, to Jonathan G. Katz, 
Secretary, Commission, dated October 17, 1998 (``Amex ITS/CAES 
Letter''); Richard Ketchum, President and Chief Operating Officer, 
NASD, to Jonathan G. Katz, Secretary, Commission, dated December 17, 
1998 (``NASD ITS/CAES Letter II''); and Richard Ketchum, President 
and Chief Operating Officer, NASD, to Jonathan G. Katz, Secretary, 
Commission, dated June 3, 1999 (``NASD ITS/CAES Letter III'').
    \43\ See CSE ITS/CAES Letter; Trimark Letter; CBOE ITS/CAES 
Letter; Bloomberg Letter; NASD ITS/CAES Letter I; and OptiMark ITS/
CAES Letter.
    \44\ See Trimark Letter.
    \45\ See CBOE ITS/CAES Letter; T. Rowe Letter (reduce market 
fragmentation).
    \46\ See Bloomberg Letter; OptiMark ITS/CAES Letter.
    \47\ See NASD ITS/CAES Letter I; Schwab Letter.
    \48\ See Angel ITS/CAES Letter.
    \49\ See Trimark Letter. OptiMark states that there is no 
fundamental regulatory or functional basis for discriminating 
between Rule 19c-3 securities and non-Rule 19c-3 securities. See 
OptiMark ITS/CAES Letter.
    \50\ See NYSE ITS/CAES Letter.
---------------------------------------------------------------------------

A. Conditional Expansion

    The Commission specifically requested comment on what, if any, 
regulatory steps needed to be taken prior to expansion of the ITS/CAES 
linkage. Some commenters support the expansion outright,\51\ while 
several commenters support the linkage if the Commission removes 
certain regulatory disparities between the third market and the 
exchange community.\52\ For example, the NASD states that the expansion 
of the linkage is fully warranted at this time given that there have 
been significant changes to the third market since the link was 
originally established in 1982.\53\ On the other hand, the NYSE 
believes that three issues need to be resolved prior to any expansion 
of the linkage: (1) Enhanced NASD oversight of the third market; (2) 
the adoption of fixed standards for queuing and executing customer 
orders; and (3) the application of the ITS trade through rule and block 
policy to cover NASD members that are not registered with the NASD as 
``ITS/CAES Market Makers'' in a security.\54\
---------------------------------------------------------------------------

    \51\ See Angel Letter; Trimark Letter; Bloomberg Letter; NASD 
ITS/CAES Letter I.
    \52\ See CSE ITS/CAES Letter; CHX ITS/CAES Letter; CBOE ITS/CAES 
Letter; Schwab Letter; SA Letter; NYSE ITS/CAES Letter; Amex ITS/
CAES Letter.
    \53\ These include the requirement that: OTC market makers 
provide continuous two-sided quotations for any listed security in 
which the firm is responsible for more than 1% of the consolidated 
trading volume; all third market makers register as CQS market 
makers and participate in ITS/CAES, thereby subjecting them to the 
obligations and protections afforded Participants in the ITS Plan; 
the price and size of customer limit orders that improve the public 
quote be displayed; members be prohibited from ``trading ahead'' of 
customer orders. See NASD ITS/CAES Letter I.
    \54\ See NYSE ITS/CAES Letter. Similarly, the Specialist 
Association (``SA'') believes that certain changes to the third 
market must be implemented and proven, not just adopted, before 
expansion of the linkage (such as rules establishing fixed standards 
for queuing and executing customer orders, and assuring that 
customers' orders will be crossed, if possible, without dealer 
intervention). The SA realizes that the Commission's Order Handling 
Rules, which require all specialists and market makers to display, 
directly or through ECNs, customer limit orders that improve such 
specialists' or market makers' quotations, mean that those orders 
are available to be crossed with customer market orders on the other 
side of the market. The SA also notes that NASD Rule 6440(f) 
precludes NASD members from effecting a transaction for their own 
account ahead of customers' market and limit orders. The SA, 
however, argues that the NASD still lacks a rule requiring NASD 
members to cross customer market orders against each other, rather 
than executing them as principal for the member's own account, 
whenever it is possible to do so. The SA also states that the NASD 
must expand the application of its trade through and block trade 
policy rules to cover all third market trading in ITS securities. 
See SA Letter.
---------------------------------------------------------------------------

1. Trade Through Rule
    The Commission specifically requested comment on which, if any, 
third market participants should be subject to a trade through rule, 
and what the substance of that rule should be. In response, the NYSE 
stated that the trade through rule should apply to all ``third market 
making,'' as opposed to ``third market makers.'' The NYSE notes that 
the current NASD trade through rule already applies to all third market 
makers in ITS/CAES eligible securities, and would continue to do so 
even if the linkage were expanded. The NYSE believes that the trade 
through rule should apply not only to trades reported by ITS/CAES 
market makers, but also to all trades reported by NASD members that 
trade exchange-listed securities.\55\ Similarly, the Specialist 
Association, CSE, Amex, and CHX believe that a trade through rule 
should apply to all member firms that effect trades in ITS/CAES 
eligible securities, even those that are not registered as ITS/CAES 
market makers in those securities, and including block positioning 
firms and order entry firms.\56\
---------------------------------------------------------------------------

    \55\ See NYSE ITS/CAES Letter. The NYSE also believes that the 
approach taken by the NASD in a previous filing (SR-NASD-95-09), 
which was withdrawn, is an appropriate and acceptable means of 
addressing this issue, Id. See also NASD ITS/CAES Letter I.
    \56\ See SA Letter; Amex ITS/CAES Letter; CSE ITS/CAES Letter; 
CHX ITS/CAES Letter. Amex notes that this is what the NASD 
originally proposed in SR-NASD-95-09, which was later withdrawn.
---------------------------------------------------------------------------

    CHX states that third market makers that fall under the 1% \57\ 
threshold

[[Page 70301]]

should be bound by the trade through rules, as should block positioners 
and automated trading systems (``ATSs'').\58\ Specifically, CHX 
believes that block positioners that are not quoting two-sided 
continuous markets should have limited ITS/CAES access for the purpose 
of sending commitments when they would otherwise trade through a 
market, while third market makers who do hold themselves out as willing 
to buy and sell on a continuous basis should have complete ITS access. 
CHX also believes that ATSs that have elected to be subject to the 
display alternative should have a passive form of access to ITS (and 
should be subject to the trade through rule) but that non-display 
alternative ATSs should not have any access to ITS (but should still be 
subject to the trade through rule).\59\
---------------------------------------------------------------------------

    \57\ Under Exchange Act Rule 11Aac1-1, third market makers who 
account for less than 1% of trading volume in a security, block 
positioners who do not hold themselves out as being willing to buy 
and sell securities on a continuous basis, and ATSs that do not 
elect the display alternative do not have to display quotations 
(``1% Rule'').
    \58\ See CHX ITS/CAES Letter.
    \59\ See CHX ITS/CAES Letter.
---------------------------------------------------------------------------

    Finally, the ICI supports the adoption of a trade through rule for 
third market makers, but believes that the scope of the protection 
should be limited to displayed orders and not ``reserved'' or other 
``hidden'' orders.\60\ Schwab suggests that the NASD affix a trade 
report modifier identifying prints by NASD members that are not ITS/
CAES market makers.\61\
---------------------------------------------------------------------------

    \60\ See ICI Letter.
    \61\ Schwab states that currently the NASD's trade through and 
block trade rules apply only to ITS/CAES market makers, which can 
put specialists in the position of having to provide price 
protection against prints from NASD members that are not registered 
CAES market makers, such as block positioners who do not post quotes 
and are inaccessible through ITS/CAES. Schwab believes this 
situation could be remedied if the NASD were to affix a trade report 
modifier identifying prints by NASD members that are not ITS/CAES 
market makers (and therefore not subject to the trade through rule). 
See Schwab Letter.
---------------------------------------------------------------------------

    The NASD notes that all voluntary CQS market makers \62\ and any 
other OTC market maker accounting for more than 1% of the consolidated 
volume in a security are already subject to the NASD's trade through 
rule, Rule 5262, and that expanding the universe of ITS/CAES eligible 
securities will automatically extend the existing trade through rule to 
these participants with respect to the new securities. In response to 
many of the concerns discussed above, the NASD initially stated that it 
was willing to consider a trade through rule applicable to all members 
who would not otherwise be subject to the rule (either because they 
account for less than 1% of the volume and choose not to become CQS 
market makers or because they fit into the block positioner exception 
to the Commission's 1% Rule).\63\ More recently, however, the NASD 
stated that it does not believe that the application of a trade through 
rule to non-market makers would be fair because non-market makers do 
not have access to ITS.\64\ The NASD further believes that it can 
alleviate concerns about the trade through issue by surveilling ITS/
CAES market makers for compliance with ITS/CAES rules, including the 
trade through rule. The NASD also notes that Nasdaq, through its ITS 
Desk in its Market Operations Department, is able to determine on a 
real time basis the identity of each NASD member that reports a trade, 
and if another market center inquires regarding a perceived trade 
through of its market by an NASD member, the ITS Desk is able to 
immediately inform the inquiring market center whether the print was 
reported by a market maker subject to the rule or an NASD member not 
subject to the rule.\65\ Finally, the NASD has indicated its commitment 
to, at some point after Year 2000, develop a special trade report 
modifier that the NASD or non-CAES market maker member reporting a 
trade could append to each trade report to distinguish such trade 
report from those of CAES market makers.\66\
---------------------------------------------------------------------------

    \62\ All third market makers registered as CQS market makers in 
securities eligible for inclusion in the ITS/CAES linkage are 
required to register as ITS/CAES market makers. See NASD rule 
5210(e).
    \63\ See NASD ITS/CAES Letter I. The NASD initially stated it 
would consider a trade through rule like the one it filed with the 
Commission in 1995, consideration of which was deferred pending the 
Order Handling Rules. See NASD-95-09.
    \64\ See NASD ITS/CAES Letter III.
    \65\ See NASD ITS/CAES Letter III. The NASD further notes that 
today, if another market center sees a print from the OTC market in 
a rule 19c-3 security, the same procedure described above is 
conducted.
    \66\ The NASD does not believe that a system change is possible 
at this time given the resources being expended on Y2K preparation 
by the NASD, SIAC and the other exchanges.
---------------------------------------------------------------------------

2. Trade Reporting Rule
    Two commenters believe that, prior to expanding the linkage, the 
NASD must amend its trade reporting rules for listed securities to 
align them with exchange reporting rules.\67\ In response, the NASD 
proposed to amend its trade reporting rule for listed securities.\68\ 
Specifically, the NASD proposed to eliminate a provision of its rules 
applicable to the reporting of transactions in exchange-listed 
securities, which requires members to report transactions in a manner 
``reasonably related to the prevailing market taking into consideration 
all relevant circumstances.'' For years, the ITS Participants have 
asserted that this language provides inappropriate flexibility in the 
manner in which NASD members may report third market transactions. The 
NYSE states that the NASD's proposal addresses its concerns with the 
trade reporting issue.\69\ CHX, however, does not believe that the 
NASD's proposal solves the perceived problem with the NASD's trade 
reporting rule because it would not eliminate the discretion that the 
trade reporting rule gives to third market makers to determine the 
price at which to report a trade. CHX asserts that the proposal would 
merely eliminate the standard articulating how to calculate the markup 
or markdown on the sale.\70\ CHX further argues that the rule change 
increases the likelihood that a third market maker will be able to 
avoid a violation of the trade through rule.\71\ The NASD responds to 
this criticism by noting that concerns over the trade reporting rule 
will be effectively addressed through surveillance and enforcement of 
best execution obligations and confirmation disclosure 
requirements.\72\
---------------------------------------------------------------------------

    \67\ See CHX ITS/CAES Letter; NYSE ITS/CAES Letter.
    \68\ See Exchange Act Release No. 40360 (August 25, 1998), 63 FR 
46267 (August 31, 1998) (SR-NASD-98-61). The Commission notes that 
this proposal was approved in July 1999. See Exchange Act Release 
No. 41647 (July 23, 1999), 64 FR 41478 (July 30, 1999).
    \69\ See NYSE ITS/CAES Letter.
    \70\ See CHX ITS/CAES Letter.
    \71\ See CHX ITS/CAES Letter.
    \72\ See NASD ITS/CAES Letter II.
---------------------------------------------------------------------------

3. Surveillance of Third Market
    With regard to surveillance concerns, CHX believes that the NASD 
must implement a more thorough program for surveillance of the third 
market so that the NASD can ensure that the third market trading firms 
that provide automated routing and execution services are operating 
within their stated execution parameters.\73\ The NYSE states that it 
assumes that the Commission would not propose to expand the linkage 
unless it was satisfied that the NASD had installed an adequate 
oversight examination program for the third market.\74\
---------------------------------------------------------------------------

    \73\ See CHX ITS/CAES Letter.
    \74\ See NYSE ITS/CAES Letter. See also Amex ITS/CAES Letter.
---------------------------------------------------------------------------

4. Other Conditions
    In the CSE's view, ITS should only be opened to all listed 
securities at the same time that the securities of large, well-
capitalized companies that trade in the OTC market are included in 
ITS.\75\ CSE also believes that the Commission

[[Page 70302]]

should address the prohibition on regional markets from trading initial 
public offering securities during the first day of trading because the 
third market is not subject to such a restriction.\76\ CHX asserts that 
ATS-type regulations should be applied to third market makers that 
provide automated routing and execution facilities to other broker-
dealers in a fashion directly in competition with exchanges. CBOE 
argues that Nasdaq market makers should be required to reflect limit 
orders from options market makers or other broker-dealers in their 
displayed quotes and provide price protection to such limit orders.\77\
---------------------------------------------------------------------------

    \75\ See  CSE ITS/CAES Letter. CHX also believes that Nasdaq 
stocks should be eligible for ITS. See  CHX ITS/CAES Letter.
    \76\ See also CHX ITS/CAES Letter.
    \77\ See CBOE ITS/CAES Letter. CBOE sees this as injurious to 
the options market and investors in that market and believes it 
prevents investors in Nasdaq stocks from achieving best execution 
because they cannot see or trade with a significant source of orders 
in those stocks.
---------------------------------------------------------------------------

B. ECN Participation

    The Commission also requested comment on whether electronic 
communications networks (``ECNs,'' also known as ATSs) \78\ should be 
allowed to participate in ITS.\79\ Most commenters who discuss the 
issue support ECN participation in some form. The ICI believes that a 
truly national market requires a linkage between exchanges, market 
makers and ECNs, and therefore supports the inclusion of ECNs in 
ITS.\80\ Bloomberg agrees that ECNs should be allowed to participate in 
the ITS/CAES linkage. The NASD believes that the Commission should 
allow bilateral access between ECNs and ITS Participants, without 
restriction as to any spread parameter for a two-sided quote by the 
ECNs. The NASD also believes it would be appropriate to implement a 
formula to guard against the linkage being used as an order routing 
facility to gain access to ITS Participants.\81\ Schwab encourages the 
Commission to work with the NASD and the other ITS Participants to 
eliminate regulatory and structural impediments to ECN participation in 
ITS and the ITS/CAES linkage.\82\
---------------------------------------------------------------------------

    \78\ The term ECN is defined, with certain exceptions, as any 
electronic system that widely disseminates to third parties orders 
entered into the ECN by an exchange market maker or OTC market 
maker, and permits such orders to be executed against in whole or in 
part. See Exchange Act Rule 11Ac1-1(a)(8). The term ATS is defined 
more broadly as any organization, association, person, group of 
persons, or system: (1) That constitutes, maintains, or provides a 
market place or facilities for bringing together purchasers and 
sellers of securities or for otherwise performing with respect to 
securities the functions commonly performed by a stock exchange 
within the meaning of Exchange Act Rule 3b-16; and (2) that does 
not: (i) set rules governing the conduct of subscribers other than 
the conduct of such subscribers' trading on such organization, 
association, person, group of persons, or system; or (ii) discipline 
subscribers other than by exclusion from trading. See Regulation 
ATS, Sec. 242.300(a). Essentially, an ECN is a type of ATS.
    \79\ Under the ECN Display Alternative, an order entered by a 
market maker into an ECN that widely disseminates the order is 
deemed to be a bid or offer to be communicated to the market maker's 
association for at least the minimum quotation size required by the 
Association's rules if the priced order is for the account of the 
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. The ECN Display Alternative deems the market maker to be 
in compliance with this requirement if the ECN displays the market 
maker's order in Nasdaq. If the only option is for ECNs to link to 
the NMS through the NASD, specialists and market makers would only 
have the ECN alternative for trading rule 19c-3 securities through 
ITS. Specialists or market makers, therefore, could not use ECNs for 
non-rule 19c-3 securities because their quotes would not be 
accessible to the other ITS Participants.
    \80\ See ICI Letter.
    \81\ See NASD ITS/CAES Letter I. The NASD is also willing to 
proceed with a proposal to have ECN quotes be subject to trade 
through protection by exchange markets and accessible through the 
ITS/CAES linkage if the Commission is unwilling to support a 
formula.
    \82\ See Schwab Letter.
---------------------------------------------------------------------------

    The NYSE states that it remains flexible in considering Plan 
amendments to accommodate ECNs, and points out that the NASD has raised 
for consideration a number of potential ways in which ECNs could access 
ITS through the linkage.\83\ CHX believes that ATSs that have elected 
to be subject to the display alternative should have a passive form of 
access to ITS but that non-display alternative ATSs should not have any 
access to ITS.\84\
---------------------------------------------------------------------------

    \83\ See NYSE ITS/CAES Letter.
    \84\ See CHX ITS/CAES Letter.
---------------------------------------------------------------------------

C. Miscellaneous

    Several commenters raise additional issues regarding the expansion 
of the linkage. In the Proposing Release, the Commission noted that the 
NASD's autoquote policy would conflict with the ITS Plan, which limits 
computer-generated quotations to 100 shares, if the ITS/CAES linkage 
were expanded. The Commission requested comment on the autoquote issue. 
The NASD responds that it intends to discuss the issue with the ITSOC, 
with a view toward implementing a computer-generated quotation policy 
that could apply to all ITS/CAES eligible securities.
    The Commission also requested the NASD to consider developing 
standards for queuing and executing customer orders. The NASD does not 
believe there are any significant problems in this area. It states that 
it believes that any potential problems might manifest themselves as a 
failure to promptly display customer orders at the opening or as a 
failure to provide best execution while holding multiple orders, for 
which enhanced regulatory standards have been implemented. The NASD 
notes that it is unaware of any problems or customer complaints in 
either context. It also notes that NASD market makers generally 
guarantee customer orders the opening price of the primary market, 
thereby eliminating the potential for queuing at the open.\85\
---------------------------------------------------------------------------

    \85\ See NASD ITS/CAES Letter I. The NASD does not believe that 
the issue of queuing is directly relevant to the ITS/CAES expansion.
---------------------------------------------------------------------------

    OptiMark believes that Participants should be required to 
substantially improve the system performance and capacity of ITS, 
noting that the technology in use is an inefficient combination of 
manual and automated sub-systems within ITS. OptiMark is concerned that 
this creates capacity limitations that lead to poor or untimely 
executions of ITS commitments and delays in obtaining access to 
ITS.\86\ CSE urges the Commission to fix inefficiencies that exist 
within ITS and other national market systems, including CTA and CQS, to 
enable faster trade reporting and quote updating.\87\
---------------------------------------------------------------------------

    \86\ See OptiMark ITS/CAES Letter.
    \87\ See CSE ITS/CAES Letter.
---------------------------------------------------------------------------

    CHX believes problems exist relating to the expiration of ITS 
commitments that are not executed by the receiving market. Generally, 
CHX regards the expiration of ITS commitments as a violation of the 
firm quote rule and believes that ITS Participants should have 
liability under the ITS Plan when a market fails to act on an ITS 
commitment before it expires.\88\
---------------------------------------------------------------------------

    \88\ See CHX ITS/CAES Letter.
---------------------------------------------------------------------------

D. Replacing or Rewriting the ITS Plan

    The Commission specifically requested comment on whether the ITS 
facility itself should be replaced or the ITS Plan rewritten. CHX sees 
no reason to take such measures at this time, believing that ITS, 
although twenty years old, has served the industry well and has evolved 
over time to meet changing market conditions. CBOE also states that the 
Plan has served the NMS well in the last two decades, and believes that 
with increased automation and other improvements, it will continue to 
serve the industry into the next century.
    In contrast, the NYSE and Amex both assert that they are receptive 
to discussing alternatives to ITS.\89\ ICI believes that further 
enhancements may be necessary to realize the goals of a true NMS where 
a customer order entered anywhere can interact with the best

[[Page 70303]]

price available.\90\ Schwab believes that the Commission should 
``scrap'' ITS, and that access to prices in other markets could be 
achieved more efficiently and competitively by requiring each SRO to 
grant access to its automated order routing system--either through 
private vendors or through sponsored access by members of that SRO.\91\
---------------------------------------------------------------------------

    \89\ See NYSE ITS/CAES Letter; Amex ITS/CAES Letter.
    \90\ ICI suggests allowing any vendor to establish an 
intermarket linkage system, or that all ITS Participants should be 
required to be open to such linkages, including linkages that 
provide for the automated routing of orders. See ICI Letter.
    \91\ Schwab believes that ITS is an archaic system and that any 
number of private communications systems are faster, cheaper, more 
reliable, and more efficient. See Schwab Letter.
---------------------------------------------------------------------------

    The NYSE is open to discussing the possible replacement of the 
current ITS computer system with either existing order routing systems 
or a third-party system, but suggests that the Commission consider 
whether any linkage is necessary at all.\92\ The NYSE also has concerns 
about the legal structure that would govern any new system. Moreover, 
the NYSE believes that any new linkage should provide non-members with 
access only to superior-priced quotations.\93\ Finally, the NYSE 
believes that if the Commission did amend the Plan, it would need to 
retain the descriptions of the ITS interfaces contained in the current 
Plan, and adopt language clarifying that these descriptions are the 
only means by which the Participants can access ITS.
---------------------------------------------------------------------------

    \92\ With respect to the operation of the current ITS, the NYSE 
does not believe that any amendments are necessary to the ITS Plan. 
See NYSE ITS/CAES Letter. Amex also believes that the existing order 
routing and execution systems of the exchanges and the NASD could be 
used in place of ITS, and would support any Commission action to 
assess whether ITS could be readily replaced by other available 
access mechanisms. Amex, however, does not believe amendments to the 
current ITS Plan are necessary or appropriate at this time.
    \93\ The NYSE believes it would still be necessary to adopt 
special rules governing pre-opening procedures, trade throughs, 
block trades, and locked and crossed markets. In addition, the NYSE 
believes it would be necessary to specify that non-member trading 
interest are not ``orders'' that have the same standing in an 
exchange Participant's market as member orders. See NYSE ITS/CAES 
Letter.
---------------------------------------------------------------------------

III. Discussion and Basis for Adoption

A. Expansion of Linkage Generally

    As it originally stated in its permanent approval order for ITS, 
the Commission continues to believe that it is necessary to expand the 
ITS/CAES linkage to all listed securities in order to fully implement 
the 1975 Congressional mandate to create a national market system 
linking the exchanges and the OTC market.\94\ When the Commission 
approved the limited linkage for Rule 19c-3 securities in May 1982,\95\ 
it intended it to be the first step toward a more expansive 
linkage.\96\ The Commission's amendments applied to Rule 19c-3 
securities initially because the Commission believed that the adoption 
of Rule 19c-3 would likely result in an increase in volume for these 
securities, thereby heightening the need for an efficient linkage 
between the exchanges and the OTC market.\97\ Since that time, there 
has been a marked increase in the level of trading in the third market. 
In 1987, third market trading of NYSE listed stocks accounted for 1.9% 
of the volume and 2.05% of the trades reported to the consolidated 
tape. By 1997, third market trading of NYSE listed stocks accounted for 
7.7% of the volume and 10.49% of the trades reported to the 
consolidated tape.\98\
---------------------------------------------------------------------------

    \94\ See Final Approval Order, supra note 28. Specifically, the 
Commission noted that ``in order to achieve fully the Congressional 
goal that all markets for qualified securities be linked (Section 
11A(a)(1)(D) of the Act), it will be necessary in the future for the 
ITS/CAES interface to be expanded to include all stocks traded in 
the third market.'' Id. at 4940.
    \95\ See Exchange Act Release No. 18713 (May 12, 1982), 47 FR 
20413.
    \96\ See also Market 2000 Study, supra note 27, at AII-12; and 
Order Handling Rules, supra note 36.
    \97\ See Market 2000 Study, supra note 27, at A.II.12.
    \98\ See NYSE 1997 Fact Book at 26-27.
---------------------------------------------------------------------------

    There have been other significant improvements in the third market. 
Specifically, any NASD member that acts in the capacity of an OTC 
market maker must provide continuous two-sided quotations for any 
exchange-listed security in which that member, during the most recent 
calendar quarter, comprised more than 1% of the aggregate trading 
volume for the security as reported in the consolidated system (``1% 
Rule'').\99\ The NASD also now requires all third market makers 
registered as CQS market makers in ITS-eligible securities to register 
and participate in ITS/CAES.\100\ In addition, the NASD prohibits third 
market makers from trading ahead of their own customer limit 
orders.\101\ Finally, the Limit Order Display Rule requires third 
market makers to display customer limit orders in their quote if those 
orders improve the quote.\102\ The Commission's adoption of the Limit 
Order Display Rule eliminates the need for the NASD to implement a rule 
to require the display of customer limit orders that improve the 
existing ITS/BBO, as recommended in the Market 2000 Study.\103\ The 
Limit Order Display Rule also provides an enhanced opportunity for 
public orders to interact with other public orders without the 
intermediation of a specialist or market maker by requiring certain 
customer limit orders to be displayed in the quote.
---------------------------------------------------------------------------

    \99\ The 1% Rule applied only to Rule 19c-3 securities prior to 
being expanded in the Order Execution Rules. See Exchange Act 
Release No. 39367 (November 26, 1997), 62 FR 64242 (December 4, 
1997) (``Autoquote Order'').
    \100\ See Exchange Act Release No. 34280 (June 29, 1994), 59 FR 
34880 (July 7, 1994).
    \101\ NASD Rule 6440(f)(1)(2), which applies to listed 
securities, states that no member shall buy (or sell) (or initiate 
the purchase or sale of) any security at or above (or below) the 
price at which it personally holds or has knowledge that any person 
associated with it holds an unexecuted limited price order to buy 
(or sell) such security in the unit of trading for a customer.
    \102\ See Order Handling Rules, supra note 36.
    \103\ The Limit Order Display Rule requires all specialists and 
market makers to display customer limit orders that improve their 
quotes. See Order Handling Rules, supra note 36.
---------------------------------------------------------------------------

    In light of these changes, as discussed below, the Commission 
believes that there is no longer any need for the historical 
distinction between Rule 19c-3 and non-Rule 19c-3 securities in the 
ITS/CAES linkage. The Commission believes that expansion will increase 
a broker-dealer's ability to obtain the best price available for the 
customer, promote competition in listed securities, help ensure more 
equivalent access to the markets, and provide for additional liquidity 
and more efficient executions.
    Failure to achieve a linkage between exchange and OTC markets in 
all listed securities inhibits a broker's ability to ensure best 
execution of customer orders because orders in non-Rule 19c-3 
securities routed to exchange floors cannot be easily redirected to the 
OTC market when more favorable prices are offered by OTC market makers. 
Conversely, OTC market makers are precluded from using an efficient 
means to deliver their orders to exchange floors when the exchange has 
a more favorable price in non-Rule 19c-3 securities.\104\ The 
Commission believes that expanding the ITS/CAES linkage to non-Rule 
19c-3 securities will enable the OTC market maker and the exchange 
specialist to access more directly those superior priced quotes through 
ITS, rather than potentially executing an order at an inferior price.
---------------------------------------------------------------------------

    \104\ Non-exchange member OTC market makers presently are able 
to access exchange floors only through correspondent relationships 
with member firms.
---------------------------------------------------------------------------

    The Commission also believes that the failure to expand the ITS/
CAES linkage would impede competition among brokers and dealers and 
between exchange markets and other markets, and that competitive OTC 
markets cannot develop fully in the absence of

[[Page 70304]]

a linkage for all listed securities.\105\ Without an expanded ITS/CAES 
linkage, OTC market makers in non-Rule 19c-3 securities have little 
ability to interact with the vast majority of retail orders, which 
presently are routed to the primary exchange markets, or to attract 
additional order flow through their displayed quotations. The expansion 
of the ITS/CAES linkage should promote increased competition in non-
Rule 19c-3 securities. The Commission also believes the expansion 
should help equalize access to all the markets because OTC market 
makers and exchange specialists will have more direct access to each 
other's markets for non-Rule 19c-3 securities. Finally, the Commission 
believes that expanding the ITS/CAES linkage will reduce the occurrence 
of trade throughs because the NASD's trade through rule will apply to 
all listed securities traded in the third market, not just Rule 19c-3 
securities.\106\
---------------------------------------------------------------------------

    \105\ The Commission indicated in the Rule 19c-3 Adopting 
Release that intermarket exposure of orders in a national market 
system should maximize competition between and among markets and 
market participants, and further the efficiency and fairness of the 
securities markets. See Rule 19c-3 Adopting Release, supra note 17, 
at 10, 45 FR at 41126.
    \106\ Currently, third market makers may trade non-Rule 19c-3 
listed securities without complying with the ITS trade through rule.
---------------------------------------------------------------------------

B. Conditional Expansion

    As mentioned above, several of the commenters asserted their belief 
that certain regulatory steps were necessary prior to expanding the 
ITS/CAES linkage. Many commenters argued that the NASD should expand 
its trade through rule to apply to all NASD members. The Commission 
believes that the NASD should continue to consider modifying its 
existing trade through rule, but that it is not an essential 
precondition to approval of an expanded linkage. Currently, all third 
market makers registered as CQS market makers who trade ITS/CAES 
eligible securities must register as ITS/CAES market makers, which 
subjects them to the trade through rule. If the linkage is expanded, 
non-Rule 19c-3 securities will become ITS/CAES eligible securities. 
Therefore, any CQS market makers in those securities will be required 
to register as ITS/CAES market makers and will become subject to the 
NASD's trade through rule.
    Several commenters argued that the NASD's trade through rule should 
apply not only to ITS/CAES market makers, but to all third market 
participants. The Commission, however, recognizes the NASD's concern 
that it is not fair to apply the trade through rule to other third 
market participants that trade in listed securities, such as block 
positioners that fit within the block positioner exception to the 
Commission's 1% Rule, and market makers that account for less than one 
percent of trading volume in a security and choose not to register as 
CQS market makers because they do not have access to ITS/CAES. The 
Commission notes that the NASD has indicated its commitment to 
modifying the trade reporting process so that exchange Participants can 
distinguish a trade originating from an ITS/CAES market maker from one 
originating from another third market participant.\107\ This result 
should permit exchange participants to recognize when an NASD member 
subject to the trade through rule has executed a trade through. Until 
such time as the NASD makes the requisite systems changes to attach 
trade modifiers to trade reports, the Commission believes that the NASD 
can adequately surveil for compliance with the trade through rule.
---------------------------------------------------------------------------

    \107\ See NASD ITS/CAES Letter III. The NASD has stated that it 
will develop a special trade report modifier that an NASD or non-
CAES market maker member reporting a trade may append to each trade 
report to distinguish such trade report from those of CAES market 
makers. The NASD, however, does not expect to accomplish this goal 
in the near future because of resources aimed at Y2K issues.
---------------------------------------------------------------------------

    Commenters also expressed concerns regarding the NASD's trade 
reporting rule. The Commission believes that the issue of timely and 
accurate trade reporting of listed securities by the third market has 
already been adequately addressed. In July 1999, the Commission 
approved an NASD proposed rule change to amend NASD Rule 6420(d)(3)(A), 
the trade reporting rule for principal transactions in listed 
securities.\108\ Prior to the rule change, the NASD's rule required 
members to report transactions in a manner ``reasonably related to the 
prevailing market taking into consideration all relevant 
circumstances.'' Commenters asserted that that this language provided 
too much flexibility in the manner in which NASD members may report 
third market transactions. The NASD rule change eliminated the 
``reasonably related to the prevailing market'' language. The 
Commission recognizes that there are differences in the trade reporting 
rules of the third market and the exchange markets, but believes that 
the rule change adequately addresses some of the ambiguity in the rule 
for the purpose of expanding the ITS/CAES linkage.\109\ The Commission 
also notes that third market transactions during regular market hours 
must be reported to the consolidated tape within 90 seconds of 
execution; this is the same as the reporting of transactions on all the 
exchanges. Moreover, the Commission's confirmation rule requires 
participants in the third market to report transactions to the 
consolidated tape at the same price as they report the transactions to 
the customer.\110\ The Commission notes that the NASD must continue to 
ensure that it is actively and adequately surveilling trade reporting 
in the third market.\111\
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    \108\ See Exchange Act Release No. 41647 (July 23, 1999), 64 FR 
41478 (July 30, 1999).
    \109\ The Commission notes that NASD Rule 6420(d)(3)(A) applies 
to all listed securities, including those that already are ITS/CAES 
eligible securities.
    \110\ See Exchange Act Rule 10b-10, 17 CFR 240.10b-10. This rule 
requires that when a NASD member is acting as an agent for a 
customer, the member must confirm to the customer the gross trade 
price, which is the price that was reported to the Consolidated 
Tape, the commission equivalent, as well as the net price to the 
customer. When an NASD member is acting as principal for its own 
account, the member must include in the confirmation the price 
reported to the Consolidated Tape, the net price to the customer, 
and the difference, if any.
    \111\ In its Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market, the 
Commission noted that the NASD failed to monitor and enforce 
rigorously trade reporting compliance by NASD members trading 
exchange-listed securities in the OTC market, and that there were 
many transactions that constituted trade throughs. See U.S. 
Securities and Exchange Commission, Report Pursuant to Section 21(a) 
of the Securities Exchange Act of 1934 Regarding the NASD and the 
Nasdaq Market (August 8, 1996) (``Section 21(a) Report'') at A-44. 
Since that time, the NASD has taken various measures designed to 
comply with the undertakings contained in its settlement, one of 
which required the NASD to improve substantially the reliability of 
trade reporting through enhancement of surveillance, examination, 
and enforcement. See In the Matter of National Association of 
Securities Dealers, Inc., Exchange Act Release No. 37538 (August 8, 
1996); Administrative Proceeding File No. 3-9056 (``SEC Order''), at 
8 (Undertaking No. 9).
---------------------------------------------------------------------------

C. ECN/ATS Participation

    In the proposing release, the Commission requested comment on 
whether ECNs (or ATSs) should be required or allowed to participate in 
ITS, and if so, what form that participation should take. Most of the 
commenters who discuss the issue supported ECN and ATS access to ITS in 
some form. For example, CHX believes that ECNs that have elected to be 
subject to the display alternative should have a passive form of access 
to ITS but that non-display alternative ATSs should not have any access 
to ITS.\112\ The Commission believes that, in order to further the 
goals of the national market system, ECNs trading in listed securities 
should be linked to ITS. ITS should not prevent efficient electronic 
routing between markets. The

[[Page 70305]]

Commission notes that the Participants have begun a dialogue about the 
parameters of ECN access to ITS. The Commission strongly urges the 
Participants to continue to discuss the issue and reach a resolution.
---------------------------------------------------------------------------

    \112\ See CHX ITS/CAES Letter.
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D. NASD Autoquote Policy

    The Commission recognizes that the NASD's current autoquote policy 
may conflict with the ITS Plan if the linkage is expanded to cover all 
listed securities.\113\ However, the Commission notes that the 
Participants have been discussing this issue, and expects the 
Participants to continue to discuss how to amend the Plan to permit 
computer-generated quotations.\114\
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    \113\ See Autoquote Order, supra note 97. Currently, NASD Rule 
6330 permits computer-generated quotations in exchange-listed 
securities that generate proprietary quotes for 100 shares or more 
if such quote systems equal or improve either or both sides of the 
NBBO, add size to the NBBO, or are used to expose a customer's 
market or marketable limit order for price improvement 
opportunities. This rule applies only to non-Rule 19c-3 securities, 
because of the concern that it conflicts with the ITS Plan provision 
that currently restricts automated quotation tracking systems to 100 
shares or less. See Section 8(d)(ii) of the Plan.
    \114\ The Commission notes that on December 3, 1999, the NASD 
filed a petition for rulemaking to address this issue. The 
Commission is currently considering that petition. On a 
miscellaneous issue, one commenter argued that the unlisted trading 
privilege rule for IPOs (Rule 12f-2(a) under the Exchange Act), 
which restricts regional exchanges from trading securities subject 
to an IPO for the first day, should be amended prior to expanding 
the ITS/CAES linkage. The Commission notes that it received a study 
on this issue and is publishing a proposing release addressing this 
issue. Although two commenters argue that Nasdaq stocks should trade 
over ITS, the Commission believes that this issue is separate from, 
and not relevant to, whether or not to expand the ITS/CAES linkage 
to all listed securities. The Commission notes that it recently 
approved the expansion of Nasdaq UTP-eligible securities from 500 to 
1,000 securities. See Exchange Act Release No. 41392 (May 12, 1999), 
64 FR 27839 (May 21, 1999). Finally, the Commission believes that 
the additional issues raised by the commenters are not directly 
relevant to the expansion of the ITS/CAES linkage.
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IV. Costs and Benefits of the Proposed Amendment

    To assist the Commission in its evaluation of the costs and 
benefits that may result from the ITS amendments, commenters were 
requested to provide analysis and data, if possible, relating to costs 
and benefits associated with the proposal. No comments were received 
regarding this request.
    The Commission believes that any possible increase in costs to 
market participants are justified by the overall benefits of the 
proposed amendment. The proposed amendments will further the goals of a 
national market system under Section 11A by increasing a broker-
dealer's ability to achieve best execution of customer orders, 
promoting competition in listed securities, equalizing access to 
markets, and providing for additional liquidity and more efficient 
executions. Specifically, the Commission believes that expanding the 
ITS/CAES linkage to non-Rule 19c-3 securities will enable an OTC market 
maker and an exchange specialist to directly access superior priced 
quotes in each other's markets through ITS, rather than potentially 
executing an order at an inferior price. In addition, the expansion of 
the ITS/CAES linkage should promote competition in non-Rule 19c-3 
securities by encouraging market makers or specialists to improve their 
quotes to match or better the bid or offer in another ITS market in 
order to attract order flow from those other markets. Finally, the 
Commission believes that the proposed amendment should provide 
additional liquidity to the market in non-Rule 19c-3 securities because 
direct access (i.e., the increased ability to access a better price in 
a security) and increased competition should enable investors to 
execute transactions more efficiently.
    Any monetary costs to the Participants, including implementation 
costs and costs of expanding the linkage to include all non-Rule 19c-3 
securities, would most likely be minimal, if they exist at all, 
compared to the overall costs of ITS. The Commission consulted with the 
Securities Industry Automation Corporation (``SIAC'') as to any 
possible costs of implementing the expanded linkage.\115\ SIAC informed 
the Commission that there would not be any systems costs from expanding 
the linkage, although there may be internal administrative costs for 
the NASD.\116\ The Commission notes that the NASD fully supports the 
adoption of the Commission's amendment to expand the ITS/CAES linkage. 
The Commission also notes that most commenters supported the expanded 
linkage. The Commission further notes that the proposal may affect ITS 
order flow between the Participants, by increasing it for some 
Participants, decreasing it for others, or increasing it for all 
Participants. The Commission believes that any costs to Participants in 
the form of possible reduced order flow or decreased tape fees (from 
decreased executions) are justified by the benefits of the proposal, 
including increased liquidity, increased competition, and a better 
chance for best execution of customer orders.
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    \115\ SIAC serves as the facilities manager for ITS and is 
responsible for the operation and maintenance of ITS.
    \116\ Phone conversation between Tom Demchak, SIAC, Katherine A. 
England, Assistant Director, Market Regulation, Commission, and 
Christine Richardson, Attorney, Commission, on November 23, 1998.
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V. Effects on Competition, Efficiency and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, when 
engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider whether such action will promote efficiency, competition, 
and capital formation.\117\ In the Proposing Release, the Commission 
solicited comment on the effect on competition, efficiency, and capital 
formation. Many commenters believe that the expanded linkage will 
ultimately increase market efficiency, competition and 
transparency.\118\
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    \117\ See 15 U.S.C. 78c(f).
    \118\ See, e.g., NASD ITS/CAES Letter I; Trimark Letter; 
Bloomberg Letter; Schwab Letter; and ICI Letter.
---------------------------------------------------------------------------

    In the Commission's view, the amendment to the ITS Plan is not 
likely to impose any significant burden on competition, efficiency or 
capital formation not necessary or appropriate in furtherance of the 
Act. Indeed, the Commission believes that expansion of the ITS/CAES 
linkage to all listed securities should promote competition among 
market centers and improve efficiency in the execution of customer 
orders.
    Section 23(a)(2) of the Exchange Act requires the Commission, when 
promulgating rules under the Exchange Act, to consider the competitive 
effects of such rules and to not adopt any rule that would impose a 
burden on competition that is not necessary or appropriate in 
furtherance of the Act.\119\ The Commission has considered the proposed 
amendment to the ITS Plan to expand the ITS/CAES linkage in light of 
the standards cited in Section 23(a)(2) of the Act and believes that it 
would not likely impose any significant burden on competition not 
necessary or appropriate in furtherance of the Exchange Act. Indeed, 
the Commission believes that the proposed amendment to expand the ITS/
CAES linkage should promote competition in non-Rule 19c-3 securities 
because OTC market makers should now be able to attract orders 
typically routed to exchange specialists by disseminating a superior 
quote in all listed securities, not just Rule 19c-3 securities. In 
addition, the expansion of the ITS/CAES linkage should allow exchange 
specialists to attract orders held by OTC market makers in non-Rule 
19c-3 securities. The Commission believes that the proposed amendment

[[Page 70306]]

should help to increase efficiency and improve execution quality 
because investors will be able to access directly the exchange and OTC 
markets for all listed stocks.
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    \119\ See 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

VI. Final Regulatory Flexibility Analysis

    A Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with the provisions of the Regulatory 
Flexibility Act (``Reg. Flex. Act''), to provide a description and 
estimate of the number of small entities that would be affected by the 
ITS Plan amendment to expand the ITS/CAES linkage to all listed 
securities.\120\
---------------------------------------------------------------------------

    \120\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

    Paragraph (c)(1) of Rule 0-10 \121\ states that the term ``small 
business'' or ``small organization,'' when referring to a broker-
dealer, means a broker or dealer that: (1) Had total capital (net worth 
plus subordinated liabilities) of less than $500,000 in its prior 
fiscal year's audited financial statements or, if not required to file 
such statements, on the last business day of the preceding fiscal year; 
and (2) is not affiliated with any person (other than a natural person) 
that is not a small business or small organization. None of the 
exchanges are included within the definition of ``small entity.'' The 
Commission estimates that there are 8,300 registered broker-dealers, 
including approximately 5,000 ``small entities.'' The Commission 
requested comment on the number of small entities that could be 
affected by the proposed amendment, but did not receive any comment on 
the subject.
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    \121\  This amendment was proposed under an older, more 
expansive definition of ``small entity'' and as such is being 
adopted under the older definition. The Commission however, recently 
adopted a revised definition of ``small entity.'' See Definitions of 
``Small Business'' or ``Small Organization'' Under the Investment 
Company Act of 1940, the Investment Advisers Act of 1940, the 
Exchange Act, and the Securities Act of 1933, Exchange Act Release 
No. 40122(June 24, 1998), 63 FR 35508 (June 30, 1998). The revision, 
among other things, expanded the affiliation standard applicable to 
broker-dealers, to exclude from the definition of a small entity 
many introducing broker-dealers that clear customer transactions 
through large firms. See revised Rule 0-10(i). The Commission notes 
that, under the revised definition of ``small entity,'' 
approximately 1,100 of all registered broker-dealers are 
characterized as ``small.''
---------------------------------------------------------------------------

    As discussed more fully in the FRFA, the proposal would directly 
affect the nine ITS Participants, none of which is a small entity as 
defined by paragraph (c)(1) of Exchange Act Rule 0-10.\122\ However, 
specialists on the exchange floors who trade ITS-eligible securities, 
broker-dealers that have access to ITS through terminals located on 
exchange floors, and registered ITS/CAES market makers who trade in 
ITS-eligible securities in the third market could be indirectly 
affected.
---------------------------------------------------------------------------

    \122\ 17 CFR 240.0-10(c)(1).
---------------------------------------------------------------------------

    To the extent that a specialist or market maker does fall under the 
definition of ``small entity,'' the Commission believes that the effect 
is likely to be indirect and positive. Under the current system, an OTC 
market maker may be trading a security at a better price than an 
exchange specialist (or vice versa) and the exchange specialist (or OTC 
market maker) is not able to access directly the better quote for non-
Rule 19c-3 securities. Expanding the ITS/CAES linkage to non-Rule 19c-3 
securities should enable the OTC market maker and the exchange 
specialist to access directly those superior priced quotes through ITS, 
rather than potentially executing an order at an inferior price. 
Furthermore, the expansion of the ITS/CAES linkage to non-Rule 19c-3 
securities also would have an indirect, beneficial effect upon the 
ability of a broker with ITS access on an exchange floor to achieve 
best execution of customer orders. Finally, the ITS Plan amendment does 
not establish any new reporting, recordkeeping or compliance 
requirements for small entities.
    The Commission received no comments on the Initial Regulatory 
Flexibility Analysis prepared in connection with the Proposing Release. 
A copy of the FRFA may be obtained by contacting Christine Richardson, 
Attorney, Division of Market Regulation, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549-1001.

VII. Commission Authority

    The Commission is adopting changes to the ITS Plan as set forth 
below under Section 11A(a)(3)(B) of the Exchange Act, which authorizes 
the Commission to authorize or require SROs to act jointly with respect 
to matters as to which they share authority under the Exchange Act in 
planning, developing, operating, or regulating a national market 
system.\123\
---------------------------------------------------------------------------

    \123\ 15 U.S.C. 78k-1(a)(3)(B). This is in addition to the 
authority granted to the Commission under Section 11(A)(b)(3) to 
approve national market system facilities in response to an 
application by SROs. The possible need for commission regulatory 
compulsion in connection with the development of a national market 
system where necessary to supplement competitive forces was 
specifically recognized by the Congress in enacting the 1975 
Amendments. For example, the Committee of Conference of both Houses 
of Congress, in discussing the implementation of a national market 
system, stated:
    It is the intent of the conferees that the national market 
system evolve through the interplay of competitive forces as 
unnecessary regulatory restrictions are removed. The conferees 
expect, however, in those situations where competition may not be 
sufficient, such as the creation of a composite quotation system or 
a consolidated transaction reporting system, the Commission will use 
the power granted to it in [the 1975 Amendments] to act promptly and 
efficiently to ensure that the essential mechanisms of an integrated 
secondary training system are put into place as rapidly as possible.
    Committee of Conference, Report To Accompany S. 249, H.R. Rep. 
No. 94-249, 94th Cong., 1st Sess., at 92, reprinted in [1975] U.S. 
Code Cong. & Ad News 321, 323. See also Exchange Act Release No. 
16410 (December 7, 1979), at 13-14, 44 FR 72607, 72608-09.
---------------------------------------------------------------------------

VIII. Conclusion

    The Commission continues to believe that it is desirable for the 
industry to take the lead in the development, implementation, and 
enhancement of national market system facilities and in the formulation 
of solutions to national market system issues. Affected industry 
participants should have every reasonable opportunity to advance 
national market system goals without direct Commission intervention. In 
this instance, however, the Commission believes that change will not 
occur without Commission intervention. Therefore, the Commission has 
determined to adopt final amendments to the ITS Plan to provide for the 
expansion of the ITS/CAES linkage to all listed securities. The 
Commission finds that the final amendments are consistent with the Act, 
particularly Section 11A of the Act.

IX. Text of Amendments to the ITS Plan

    The Commission hereby adopts amendments to the ITS Plan to provide 
for the expansion of the ITS/CAES interface to non-Rule 19c-3 
securities, pursuant to Rule 11Aa3-2(b)(2) and (c)(1) and the 
Commission's authority under Sections 2, 3, 6, 11, 11A(a)(3)(B), 15A, 
17 and 23 \124\ of the Act. Below is the text of the amended ITS 
Plan.\125\ Deleted text is [bracketed] and new language is italicized.
---------------------------------------------------------------------------

    \124\ 15 U.S.C. 78b, 78c, 78f, 78k, 78k-1(a)(3)(B), 78o-1, 78q, 
and 78w(a).
    \125\ The text reflects the latest unofficial completion of the 
ITS Plan supplied by the ITSOC, including all previously 
incorporated amendments up to May 30, 1997.
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* * * * *
    Section 1. Definitions.
    (1)--(16) No Change.
    (17) ``ITS/CAES Security (stock)'' means a security (stock) (a) 
that is a System security[, (b) that is a 19c-3 security and (c)] and 
(b) as to which one or more ITS/CAES Market Makers are registered as 
such with the NASD for the purposes of Applications. When used with 
reference to a particular ITS/CAES Market Maker, ``ITS/CAES security'' 
means any such security

[[Page 70307]]

(stock) as to which the particular ITS/CAES Market Maker is so 
registered.
    (18)-(25) No Change.
    [(26) ``19c-3'' security'' means an Eligible Security that is not a 
``covered security'' as that term is defined in SEC Rule 19c-3 as in 
effect on May 1, 1982.]
    [(27)](26)
    [(27A)](26A)
    [(27B)](26B)
    [(27C)](26C)
    [(27D)](26D)
    [(27E)](26E)
    [(28)](27)
    [(29)](28)
    [(30)](29)
    [(31)](30)
    [(32)](31)
    [(33)](32)
    [(34)](33)
    [(34A)](33A)
    [(34B)](33B)
    [(35)](34)
    [(36)](35)
    [(37)](36)
    Section 2. No Change.
    Section 3. No Change.
    Section 4. No Change.
    Section 5. The System.
    (a) No Change.
    (b) General Operation. (i) No Change.
    (ii) Selection of System Securities. The System is designed to 
accommodate trading in any Eligible Security in the case of any ITS/
CAES Market Maker, trading in one or more ITS/CAES securities in which 
he is registered as such with the NASD for the purposes of the 
Applications. The particular securities that may be traded through the 
System at any time (``System securities'') shall be selected by the 
Operating Committee. The Operating Committee may add or delete System 
securities as it deems appropriate and may delay the commencement of 
trading in any Eligible Security if capacity or other operational 
considerations shall require such delay. [ITS/CAES securities may be 
traded by Exchange Participants and ITS/CAES Market Makers as provided 
in the ITS Plan and other System securities may be traded by Exchange 
Participants as provided in the ITS Plan.]
    (c)-(d) No Change.
    Section 6. No Change.
    Section 7. No Change.
    Section 8. No Change.
    Section 9. No Change.
    Section 10. No Change.
    Section 11. No Change.

* * * * *
    Dated: December 9, 1999.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 99-32555 Filed 12-15-99; 8:45 am]
BILLING CODE 8010-01-P