[Federal Register Volume 65, Number 91 (Wednesday, May 10, 2000)]
[Notices]
[Pages 30175-30180]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-11682]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42758; File No. SR-NYSE-99-48]


Self-Regulatory Organizations; New York Stock Exchange, Inc.; 
Order Approving Proposed Change To Rescind Exchange Rule 390

    On December 10, 1999, the New York Stock Exchange, Inc. (``NYSE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Exchange Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to rescind Exchange rule 390. The 
proposed rule change was published for comment in the Federal Register 
on February 28, 2000.\3\ The release publishing notice of the proposed 
rule change also included a Commission request for comment on issues 
relating to market fragmentation. The comment period relating to the 
rescission of Exchange rule 390 expired on March 20, 2000. The 
Commission has received twelve comments letters explicitly addressing 
whether Rule 390 should be rescinded. These comments are summarized in 
section II below. The comment period on issues related to market 
fragmentation has been extended for two weeks and now expires on May 
12, 2000.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 42450 (February 23, 
2000), 65 FR 10577 (``Concept Release'').
    \4\ Securities Exchange Act Release No. 42723 (April 26, 2000).
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    Off-board trading restrictions such as Rule 390 have long been 
questioned as attempts by exchanges with dominant market shares to 
prohibit competition from other market centers. On their face, such 
restrictions run contrary to the Exchange Act's objectives to assure 
fair competition among market centers and to eliminate unnecessary 
burdens on competition. The NYSE has defended Rule 390 on the basis 
that it was intended to address market fragmentation by promoting 
interaction of investor orders without the participation of a dealer, 
which also is a principal objective of the Exchange Act. Even granting 
the importance of this objective, however, Rule 390 is overbroad as a 
tool to address market fragmentation--it applies in many situations 
that do nothing to promote investor order interaction. In the after-
hours context, for example, it creates an artificial incentive for 
trades to be routed to foreign markets. Rule 390 also effectively 
restricts the competitive opportunities of electronic communications 
networks (``ECNs''), which use innovative technology to operate agency 
markets that offer investors a high degree of order interaction. To 
avoid the anticompetitive effect of the Rule, some ECONs even have 
indicated that they would accept the very substantial regulatory 
responsibilities associated with registering as a national securities 
exchange, thereby foregoing the streamlined requirements available

[[Page 30176]]

under Regulations ATS. Rescission of Rule 390 will eliminate these 
distortions of competition. The Commission will address legitimate 
concerns about assuring an opportunity for interaction of investor 
orders in the context of its ongoing review of fragmentation issues.
    In an age when advancing technology and expanding trading volume 
are unleashing powerful forces for change and new competitive 
challenges for the U.S. securities markets, both at home and abroad, 
the continued existence of regulatory rules that attempt to prohibit 
competition can no longer be justified. Such rules typically succeed 
only in distorting competition and introducing unnecessary costs. The 
NYSE operates a market of very high quality. It recognizes that success 
in the future will depend on its ability to adapt and meet competitive 
challenges by continuing to provide a market that well-serves the 
interests of investors. The NYSE's proposed rule change to rescind Rule 
390 is approved.

I. Description of Proposed Rule Change

    The proposed rule change rescinds Rule 390, which generally 
prohibits NYSE members and their affiliates from effecting transactions 
in NYSE-listed securities away from a national securities exchange. Two 
Commission rules already limit the reach of Rule 390. Exchange Act Rule 
19c-3 \5\ limits the application of Rule 390 to stocks listed on the 
NYSE as of April 26, 1979. Exchange Act Rule 19c-1 \6\ permits NYSE 
members to trade as agent in the over-the-counter market with another 
person, except when the member also is acting as agent for such other 
person. In addition, Rule 390 itself contains ten specific exceptions 
for unusual situations, such as a transaction that is part of a primary 
distribution by an issuer.\7\ Finally, an interpretation of the Rule 
permits members and their affiliates to trade as principal or agent on 
any organized foreign exchange at any time, and to trade as principal 
or agent in a foreign country's over-the-counter market after regular 
trading hours.\8\
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    \5\ 17 CFR 240.19c-3.
    \6\ 17 CFR 240.19c-1.
    \7\ NYSE Rule 290(c)(i).
    \8\ NYSE Rule 290, Supplementary Material .10, Interpretations 
of the Market Responsibility Rule.
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    The NYSE stated in its description of the proposed rule change that 
the intended purpose of Rule 390 was to maximize the opportunity for 
customer orders to interact with one another in agency auction markets 
and be executed without the participation of a dealer. The NYSE also 
discussed its concerns that broker-dealer internalization practices and 
market fragmentation would increase in the wake of Rule 390's 
rescission. It asserted that internalization--broker-dealers trading as 
principal against their customer order flow--results in the most 
objectionable of all forms of market fragmentation: the execution of 
captive customers' orders in a manner that isolates them from 
meaningful interaction with other buying and selling interest. The NYSE 
asserted that such practices not only decrease competitive interaction 
among market centers, but also isolate segments of the total public 
order flow and impede competition among orders, with no price benefit 
to the orders being internalized.
    To address these concerns, the NYSE requested the Commission to 
adopt a new market-wide rule prohibiting broker-dealers from trading as 
principal against their customer orders unless they provide a price to 
the order that is better than the national best bid or offer against 
which the order might otherwise be executed. The NYSE asserted that 
this market-wide rule would assure that investors receive the fairest 
pricing of their internalized orders and would eliminate broker-dealer 
conflicts of interest in trading against their own customer order flow 
to capture the spread. The Commission's Concept Release sets forth the 
NYSE's proposal as one of the six potential options on which comment is 
requested.\9\
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    \9\ Concept Release, note 3 above, section IV.C.2.b.
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II. Summary of Comments

    The Commission received twelve comment letters explicitly 
addressing whether Rule 390 should be rescinded.\10\ No commenter 
asserted that the Rule should be retained. Nearly all believed that the 
Rule imposed an unnecessary burden on competition. Four commenters, 
however, believed that the Commission should not approve the proposed 
rule change until it also addressed fragmentation concerns.
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    \10\ George Reichhelm, General Partner, and Andrew Schwarz, 
General Partner, AGS Specialist Partners, dated March 16, 2000 
(``AGS Letter''); Deborah A. Lamb, Chair, Advocacy Committee, and 
Maria J. A. Clark, Office of General Counsel, Association for 
Investment Management and Research, dated March 15, 2000 (``AIMR 
Letter''); Fredric W. Rittereiser, Chairman and Chief Executive 
Officer, and William W. Uchimoto, Executive Vice President and 
General Counsel, Ashton Technology Group, Inc., dated March 20, 2000 
(``Ashton Technology Letter''); George W. Mann, Jr., Senior Vice 
President and General Counsel, Boston Stock Exchange, dated March 
17, 2000 (``BSE Letter''); Craig S. Tyle, General Counsel, 
Investment Company Institute, dated March 20, 2000 (``ICI Letter''); 
John Oddie, Chief Executive Officer, Global Equities, Instinet 
Corporation, dated March 20, 2000 (``Instinet Letter''); Timothy H. 
Hosking, ITG, Inc., dated March 17, 2000 (``ITG Letter''); Kenneth 
D. Pasternak, President and Chief Executive Officer, and Walter F. 
Raquet, Executive Vice President, Knight/Trimark Group, Inc., dated 
March 21, 2000 (``Knight/Trimark Letter''); Robin Roger, Managing 
Director and Counsel, Morgan Stanley Dean Witter, dated March 27, 
2000 (``Morgan Stanley Letter''); Richard G. Ketchum, President, 
National Association of Securities Dealers, Inc., dated March 31, 
2000 (``NASD Letter''); Marc E. Lackritz, President, Securities 
Industry Association, dated March 21, 2000 (``SIA Letter''); Robert 
C. King, Chairman, and Lee Korins, President and Chief Executive 
Officer, Security Traders Association, dated March 15, 2000 (``STA 
Letter'').
    In addition, the Commission has received other letters that 
address fragmentation issues, but do not address explicitly whether 
Rule 390 should be rescinded. Copies of all comment letters are 
available for inspection and copying in File No. SR-NYSE-99-48 in 
the Commission's Public Reference Room, 450 Fifth Street, N.W., 
Washington, D.C. Electronically-submitted comment letters are posted 
on the Commission's Internet web site (http://www.sec.gov).
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    Many commenters supported rescinding Rule 390 on the ground that it 
is an unnecessary or inappropriate burden on competition.\11\The STA 
asserted that the rule is ``an anachronism that limits liquidity and 
competition and thereof constrains investors from always obtaining the 
best possible price.'' ITG stated that the rule ``imposes an 
unnecessary barrier to competition in listed securities between 
exchanges and other markets'' and ``imposes unnecessary costs on market 
participants.'' Instinet stated that ``[a]among the most significant 
factors that make such [off-board trading] rules obsolete is the 
development of electronic intermarket linkages that will ensure 
nationwide access to the best bids and offers available in any 
marketplace.'' Although supporting the rescission of the rule, AGC 
Specialist Partners stated that Rule 390 was ``not intended as an anti-
competitive initiative but as a protection for the public to ensure the 
proper exposure of their orders.''
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    \11\ AIMR Letter; Ashton Technology Letter; ICI Letter; Instinet 
Letter; ITG Letter; Knight/Trimark Letter; Morgan Stanley Letter; 
NASD Letter; SIA Letter; STA Letter.
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    Several of these commenters also noted that rescission of the Rule 
would enhance the opportunity for competition between exchange markets 
and alternative trading systems.\12\ The SIA stated that 
``technological advances and recent regulatory developments [have] led 
to the development of a host of alternative trading systems that 
provide a similar capability operating alongside the established 
markets in an intensely competitive environment,'' and that ``[t]here 
is simply no justification for regulations such as Rule 390 that 
restrict off-board trading.''

[[Page 30177]]

Morgan Stanley noted that ``the rule still may hinder the establishment 
and development of alternative OTC trading systems and markets in non-
19c-3 listed stocks.''
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    \12\ ITG Letter; Morgan Stanley Letter; SIA Letter
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    Other commenter believed that the Commission should take action to 
address possible collateral effects that could occur in the wake of 
rescinding Rule 390.\13\ Ashton Technology stated that is supported the 
rescission of the rule ``if conditioned upon adoption of the NYSE 
Proposal as modified by an order exposure alternative, applying equally 
to upstairs market makers and exchange specialists, and calling for a 
new high powered routing mechanism with auto-execution capabilities to 
access and trade against `exposed' orders.'' The ICI supported the 
NYSE's recommendation that the Commission adopt ``a market-wide 
requirement that broker-dealers not be permitted to trade as principal 
with their own customer order unless they provide for `price 
improvement,' i.e., a price to the order that is better than the 
national bid or offer against which the order might otherwise be 
executed.'' Nevertheless, ICI believed that the rescission of Rule 390 
should not be delayed while the Commission considered whether to adopt 
a price improvement requirement.
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    \13\ AGS Letter; Ashton Technology Letter; ICI Letter.
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    Other commenters did not support the NYSE's proposal. The Knight/
Trimark Group stated that the ``NYSE's'' recommendation that the 
Commission adopt a new rule requiring broker-dealers to improve on the 
NBBO if they trade with customer orders as principal is an attempt to 
replace an Exchange rule that is explicitly anticompetitive with a 
Commission rule that is implicitly anticompetitive.'' The NASD 
criticized the NYSE proposal because it believed the proposal would 
``allow NYSE specialists to match the NBBO, while requiring market 
makers to attempt to improve [the NBBO] and also to bear the risk of 
the NBBO moving away in the interim.'' The NASD stated that best 
execution and order display obligations could achieve the same 
objectives as the NYSE's proposal.
    Other commenters believed that the Commission should not approve 
the rescission of Rule 390 until it addressed market fragmentation 
issues.\14\ The AIMR noted that while it tentatively supports the 
rescission of the Rule, it ``strongly believes that the present issue 
and those surrounding market fragmentation, which the Commission 
highlighted in its official request for public comment, are so closely 
related that the Commission cannot meaningfully consider each issue in 
isolation of the others.'' It requested that the Commission delay its 
decision regarding Rule 390 until the Commission had reviewed all 
public comments addressing possible market fragmentation and related 
issues. Finally, the BSE stated that ``[a]t the very least, perhaps the 
Commission should deny the NYSE's requests to rescind Rule 390 until 
the Commission is satisfied that is rescission will not have a 
deleterious impact on the market, or until it has decided on the 
solution to any such anticipated deleterious impact''.
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    \14\ AGS Letter; AIMR Letter; Ashton Technology Letter; BSE 
Letter.
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    In contrast, other commenters did not believe that the approval of 
Rule 390 should be delayed.\15\ The STA stated that ``the question of 
internalization of customer orders touches upon a great number of 
important, compelling and interrelated issues regarding the roles of 
the exchanges, market makers, ECNs and investors,'' and that it was 
``inappropriate to link this complex and possibly contentious proposal 
with the proposal to rescind Rule 390.'' Morgan Stanley also believed 
that the Commission should not delay in its approval of the proposed 
rule change ``pending its determination of what regulatory action 
should be taken to address the fragmentation issues.'' \16\
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    \15\ ICI Letter; Morgan Stanley Letter; STA Letter.
    \16\ Morgan Stanley also recommended that the NYSE file an 
additional proposal with the Commission to rescind Exchange Rule 
393, asserting that it no longer serves ``any valid regulatory 
purpose.'' Rule 393 requires members to obtain NYSE approval prior 
to participating in an off-board secondary distribution of an NYSE-
listed security.
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III. Discussion

    The Commission finds that the proposed rule change is consistent 
with Section 6 of the Exchange Act \17\ and the rules and regulations 
thereunder applicable to a national securities exchange.\18\ In 
particular, the Commission finds the proposed rule change is consistent 
with section 6(b)(5), which requires, among other things, that the 
rules of an exchange be designed to promote just and equitable 
principles of trade, to remove impediments to and perfect the mechanism 
of a free and open market and a national market system and, in general, 
to protect investors and the public interest, and section 6(b)(8), 
which requires that the rules of an exchange not impose any burden on 
competition not necessary or appropriate in furtherance of the Exchange 
Act. The rescission of Rule 390 also is consistent with section 11A of 
the Exchange Act,\19\ which sets forth the findings and objectives that 
are to guide the Commission in its oversight of the national market 
system. Rescinding Rule 390 will help further the national market 
system objective in section 11A(a)(1)(C)(i) to assure the economically 
efficient execution of securities transactions and in section 
11A(a)(1)(C)(ii) to assure fair competition between exchange markets 
and markets other than exchange markets.
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    \17\ 15 U.S.C. 78f.
    \18\ In approving this proposal, the Commission also has 
considered its impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \19\ 15 U.S.C. 78k-1.
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    Rule 390 long has been questioned by the Commission and others 
because it directly restricts a certain type of market center 
competition--competition between exchange markets and markets other 
than exchange markets.\20\ Given the explicit national market system 
objective to assure fair competition among market centers, as well as 
the requirement that the rules of a national securities exchange not 
impose any burden on competition not necessary or appropriate in 
furtherance of the Exchange Act, Rule 390 has been suspect on its face.
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    \20\ See, e.g., Exchange Act Section 11A(c)(4), 15 U.S.C. 78k-
1(c)(4) (provision added to the Exchange Act in 1975 directing the 
Commission to review exchange rules that impose off-board trading 
restrictions); Securities Exchange Act Release no. 11628 (Sept. 2, 
1975), 40 FR 41808 (Commission commences proceedings under Exchange 
Act Section 19(c) to determine whether to amend or abrogate exchange 
rules that impose off-board trading restrictions.
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    The NYSE has defended Rule 390 on the basis that is purpose was not 
to protect the NYSE's competitive position, but to protect customer 
interests by assuring a greater opportunity for interaction of 
investors' orders without the participation of a dealer, This type of 
order interaction is also a principal objective of the national market 
system set forth in section 11A(a)(1)(C)(v) of the Exchange Act. Over 
the years, the Commission has sought to cut back on Rule 390 in ways 
that would reduce its anticompetitive nature without inappropriately 
reducing the opportunity for investor orders to interact. Exchange Act 
Rule 19c-1 allows NYSE members to execute trades in markets other than 
exchange markets as agents for their customers. Exchange Act Rule 19c-3 
systematically has reduced the scope of Rule 390 over time as more and 
more companies have listed their stocks on the NYSE in the years since 
1979. Nevertheless, the Rule still applies to securities that generate 
nearly one-half of total NYSE trading volume,

[[Page 30178]]

including many of the most active NYSE issues.\21\
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    \21\ Jeffrey Bacidore, Katharine Ross & George Sofianos, 
Quantifying Best Execution at the New York Stock Exchange: Market 
Orders, NYSE Working Paper 99-05 (December 1999) at 1 n.2 (``At the 
end of October 1999, 23 percent of NYSE issues accounting for 46 
percent of the volume were subject to Rule 390.'').
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    The Commission believes that whatever beneficial effect Rule 390 
may have in enhancing the interaction of investor orders can no longer 
justify anticompetitive nature. To the extent the Rule promotes the 
interaction of investors' orders, it does so in an undesirable way--by 
attempting a direct restriction on competition. Such attempts can never 
be wholly successful and typically succeed primarily in distorting, 
rather than eliminating, competition and introducing unnecessary costs. 
An egregious effect of Rule 390 is the artificial incentive it provides 
for NYSE members to route orders to foreign OTC markets for execution 
after regular trading hours. Such distortions can no longer be 
justified in an increasingly competitive international environment.\22\
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    \22\ The trades executed in foreign markets also are not subject 
to NYSE surveillance or the Commission's regulatory oversight.
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    In addition, Rule 390 is much too broad even when considered solely 
as a tool to address market fragmentation and to promote the 
interaction of investor orders. As noted by several commenters, the 
Rule effectively restricts NYSE members from participating in markets 
operated by ECNs or ATSs.\23\ These market centers offer their 
customers, among other things, agency limit order books that provide a 
high degree of investor order interaction. Using advanced technology 
for communicating and organizing information, ECNs can offer a number 
of advantages to investors, including low costs, fast display of limit 
orders, and fast executions against displayed trading interest.
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    \23\ For example, none of the various exceptions to, and 
limitations on, the scope of Rule 390 would generally allow an NYSE 
member to trade as principal in a U.S. market operated by an ECN.
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    These ECN limit order markets also can benefit the national market 
system as a whole by enhancing the process of public price discovery. 
Displayed limit orders are perhaps the most significant source of price 
competition in the securities markets. Limit order markets also allow 
for both investor and broker-dealer participation, but minimize 
principal-agent conflicts by adopting trading rules that establish a 
level playing field for the trading interest of both investors and 
broker-dealers--principally through price/time priority rules. Whatever 
limit order is first in line at the best price, whether submitted by 
investor or broker-dealer, such limit order has the right to trade 
first at that price. Price competition in invigorated and spreads are 
narrowed because those who improve the best bid or offer through limit 
orders know that they will be the first to trade. The price/time 
priority rules of limit order markets also can enhance depth and 
liquidity by providing an incentive for trading interest to stack up at 
prices that are at or around the best bid and offer. Because the 
second, third, and fourth orders in line at a price will be the second, 
third, and fourth to trade at that price (and so on), there is a strong 
incentive to submit limit orders even at prices that match or are 
outside the best bid or offer. The deeper a market, the less vulnerable 
it will be to excessive short-term price swings.\24\
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    \24\ See Concept Release, note 3 above, at n.26 and accompanying 
text.
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    In recent years, the Commission has taken a number of steps that 
have paved the way for ECNs to compete with established market centers 
and be integrated into the national market system. In 1996, the 
Commission adopted the Order Handling Rules,\25\ which required, among 
other things, the inclusion in the consolidated national best bid and 
offer (``NBBO'') of limit order prices and sizes that improved the 
market for a security (by either improving the price of the NBBO or 
adding significant depth to the NBBO). These rules applied to both 
customer limit orders handled by specialists and market makers, as well 
as the limit orders of specialists and market makers themselves if they 
were displayed in an ECN. In 1998, the Commission adopted Regulation 
ATS,\26\ which provides a streamlined regulatory regime for trading 
systems (including ECNs) that choose to be regulated as ATSs. In 
addition, ATSs with significant trading volume are required to display 
publicly their ``top-of-book'' trading interest in the consolidated 
national quote stream, even if such interest is not associated with a 
specialist or market maker. Most recently, the Commission approved a 
proposed rule change by the NASD that would enable ECNs to participate 
in the Intermarket Trading System that links market centers trading 
listed securities.\27\ With the rescission of Rule 390, yet another 
regulatory barrier to competition will be eliminated.
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    \25\ Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 
61 FR 48290.
    \26\ Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 
63 FR 70844.
    \27\ Securities Exchange Act Release No. 42536 (Mar. 16, 2000), 
65 FR 15401.
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    The Commission emphasizes strongly, however, that its desire to 
clear away regulatory barriers to competition from ECNs in the listed 
market should not be interpreted as an indication of whether the ECNs 
will or should attract a significant amount of listed market share. 
That will be determined by competition. Similarly, the Commission's 
criticism of Rule 390 should not be interpreted as a criticism of the 
quality of the NYSE's market. To the contrary, studies repeatedly have 
demonstrated the merits of the NYSE's market, both in terms of its 
execution quality and its public price discovery function.\28\
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    \28\ See, e.g., Hendrik Bessembinder, Trade Execution Costs on 
NASDAQ and the NYSE: A Post-Reform Comparison, 34 J. Financial & 
Quantitative Analysis 387, 389 (2999) (`` This study finds that 
trade execution costs remain larger on NASDAQ compared to the NYSE 
even after the new SEC order-handling rules are implemented, and 
that the difference in average trading costs is not attributable to 
variation in observable economic characteristics of the listed 
stocks.''); Marshall E. Blume & Michael A. Goldstein Quotes, Order 
Flow, and Price Discovery, 52 J. Finance 221, 232 (1997) (``The NYSE 
bid price equals on average the best bid price 97.1 percent of the 
time, and the NYSE ask price equals the best ask price 96.9 percent 
of the time.''); Joel Hasbrouck, One Security, Many Markets: 
Determining the Contributions to Price Discovery, 50 J. Finance 
1175, 1197 (1995) (an analysis of ``price discovery for equities 
traded on the NYSE and regional exchanges revealed that ``price 
discovery appears to be concentrated at the NYSE: the median 
information share is 92.7 percent''): Justin Schack, Cost 
Cotnainment, Institutional Investor, Nov. 1999, at 43 (worldwide 
survey of institutional investor trading costs found that ``[f]or 
the first time even NYSE-listed shares took top honors for the 
cheapest cost of execution anywhere in the world''); compare Louis 
K.C. Chan & Josef Lakonishok, Institutional Equity Trading Costs: 
NYSE verus Nasdaq, 52 J. Finance 713, (1997) (comparison of 
execution costs for institutional investors on Nasdaq and NYSE found 
that ``costs are lower on Nasdaq for trades in comparatively smaller 
firms, while costs for trading larger stocks are lower on NYSE'').
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    The NYSE offers a multi-facted trading mechanism that can 
accommodate a wide variety of participants and trading strategies. Like 
the ECNs, it offers a limit order book with price/time priority among 
orders on the book. In addition, the NYSE, through its floor, offers a 
mechanism for investors with large trading interest to be represented 
in the market. Such investors typically will not display their full 
interest in a limit order because it likely would move the market 
against them, thereby increasing their transaction costs or even 
precluding any execution at all. The NYSE floor allows the large 
trading interest to interact with trading interest of all sizes on the 
other side of the market.\29\ This enhanced

[[Page 30179]]

opportunity for interaction can benefit both large and small investors. 
Indeed, the NYSE's very substantial price improvement rate for smaller 
orders is attributable to such interaction--more than 50% of market 
orders of less than 500 shares routed to the NYSE floor in stocks with 
a quoted spread of greater than \1/16\th are executed at a price better 
than the NBBO.\30\
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    \29\ Some ECNs offer an opportunity for large trading interest 
to interact by including a reserve size feature in their limit order 
book. See Concept Release, note 3 above, at text accompanying n.27.
    \30\ See Quantifying Best Execution, note 21 above, at Table 10 
& Table 14. A market's price improvement rate is affected by the 
quality of the publicly displayed quotations that are ``price-
improved.'' The quality of the NYSE's public quotations is one of 
the issues addressed in the studies cited in note 28 above.
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    Finally, the NYSE has adopted a comprehensive set of trading rules 
that address the potential principal-agent conflicts that can arise 
when both broker-dealers and their customers trade in the same market 
center. These rules are intended to prevent NYSE members and 
professionals from obtaining unfair advantages in trading. In addition, 
the NYSE incorporates one market maker--the specialist--into its 
trading mechanism. Specialist trading is limited to help assure that it 
supplements, but does not supplant, public trading interest and thereby 
contributes to a fair and orderly market.\31\ The NYSE also monitors 
the actual performance of its specialists to assure that they comply 
with their affirmative and negative market-making responsibilities.
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    \31\ See Kenneth A. Kavajecz, A Specialist's Quoted Depth and 
the Limit Order Book, 54 J. Finance 747, 753 (1999) (comparison of 
spreads on NYSE limit order book with specialist's quoted spreads 
``suggests that the specialist plays an important role in narrowing 
the spread the market participants face when demanding liquidity, 
especially for smaller (less frequently traded) stocks.'').
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    The outcome of the competition between the NYSE and other market 
centers will depend on which market centers are most able to serve 
investor interests by providing the highest quality trading services at 
the lowest possible costs. The Commission's regulatory task is removing 
unwarranted regulatory barriers to competition between the NYSE and 
other market centers. Its approval of the rescission of Rule 390 is 
intended solely to free the forces of competition and allow investor 
interests to control the success or failure of individual market 
centers.
    Freeing of forces of competition to serve investor interests 
underlies the Commission's comprehensive review of issues related to 
market fragmentation. As discussed in the Concept Release, the 
Commission is concerned about certain broker-dealer practices that may 
substantially reduce the opportunity for investor orders to interact. 
Reduced order interaction may hamper price competition, interfere with 
the process of public price discovery, and detract from the depth and 
stability of the markets.
    Currently, brokers that handle customer orders have a strong 
financial incentive either to internalize their orders by trading 
against them as principal or to route their orders to dealers that will 
trade against them as principal and share a portion of the profits with 
the broker. Internalization and payment for order flow arrangements 
provide dealers with a guaranteed source of order flow, eliminating the 
need to compete aggressively for orders on the basis of their displayed 
quotation. Instead, the dealers can merely match the prices that are 
publicly displayed by other market centers. These prices in many cases 
will represent limit orders that are displayed by agency market centers 
(such as the NYSE or an ECN). The limit orders may be denied an 
opportunity for an execution if dealers choose not be route orders to 
the market center displaying the limit orders and instead match the 
limit order prices.\32\
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    \32\ In February 2000, the agency markets operated by ECNs 
executed approximately 19% of the share volume in Nasdaq securities, 
a drop of 3% from September 1999. See NASD Economic Research Dept., 
http://www.marketdata.nasdaq.com> (visited April 10, 2000) (In 
February 2000, ECNs that are ATSs collectively accounted for 19.2% 
of Nasdaq share volume, 25.1% of Nasdaq dollar volume, and 24.6% of 
Nasdaq trades.); NASD Economic Research Dept., http://www.marketdata.nasdaq.com> (visited Dec. 11, 1999) (In September 
1999, ECNs that are ATSs collectively accounted for 22.2% of Nasdaq 
share volume, 29.2% of Nasdaq dollar volume, and 28.0% of Nasdaq 
trades.). In calculating the market share of ATSs, the NASD adds 
orders executed internally on an ATS and the orders routed to an ATS 
for execution. Orders routed out to another market participant are 
not included.
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    Price-matching dealers thereby take advantage of the public price 
discovery provided by other market centers (which must make their best 
prices publicly available pursuant to Exchange Act price transparency 
requirements), but do not themselves necessarily contribute to the 
process of public price discovery. Moreover, if a substantial portion 
of the total order flow in a security is subject to dealer price-
matching arrangements, it reduces the ability of other dealers to 
compete successfully for order flow on the basis of their displayed 
quotations. In both cases (unfilled limit orders and disregarded dealer 
quotations), those market participants who are willing to participate 
in public price discovery by displaying firm trading interest at the 
best prices are not rewarded for their efforts. This creates 
disincentives for vigorous price competition, which, in turn, could 
lead to wider bid-asked spreads, less depth, and higher transaction 
costs. These adverse effects would harm all orders, not just the ones 
that are subject to internalization and payment for order flow 
arrangements. Consequently, a loss of execution quality and market 
efficiency may not be detectable simply by comparing the execution 
prices of orders that are subject to such arrangements with those that 
are not.
    Moreover, an agent-principal monitoring problem may tend to 
perpetuate rather than alleviate the isolation of investor orders that 
are subject to internalization and payment for order flow arrangements. 
It can be very difficult for retail customers to monitor the quality of 
execution provided by their brokers, particularly in fast-moving 
markets.\33\ Given the difficulty of monitoring execution quality, the 
most rational strategy for any individual customer may be simply to opt 
for the lowest commission possible (which may be low in part because 
the broker is receiving payment for order flow, part of which is passed 
on the customer). If many individual customers adopt this strategy, it 
could blunt the forces that otherwise would reward market centers that 
offer high quality executions.
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    \33\ See, e.g., Lawrence Harris, Consolidation, Fragmentation, 
Segmentation, and Regulation, in Modernizing U.S. Securities 
Regulation: Economic and Legal Perspectives 269, 286 (Kenneth Lehn & 
Robert W. Kamphius, Jr., eds., 1992) (``[F]ew brokerage clients--and 
probably no small clients--can observe, monitor, and measure their 
brokers' efforts at low cost. Given the high volatility of 
securities prices, the general lack of real-time market information 
available to most brokerage clients, and the high cost of processing 
that information even when it is readily available, most clients 
cannot accurately determine whether their orders are well executed 
or not. Moreover, even if they could measure their broker's 
performance, fairly evaluating that information is still more 
difficult. A fair evaluation would require that the clients compare 
the quality of service offered by at least a few different 
brokers'') (footnotes omitted). Retail investors have greater access 
to real-time market information today than in 1992. The order 
barriers to monitoring execution quality continue to exist.
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    Finally, the fragmentation concerns raised in the Concept Release 
are not limited to assuring that investors receive at least the best 
displayed prices, whatever they happen to be. Assuring that investors 
receive the best prices displayed anywhere in the national market 
system is crucial, but is not sufficient to assure that the best prices 
displayed in the system are the most efficient prices reasonably 
possible. For example, the spread between the best displayed bid and 
the best displayed offer may be wider than it otherwise would be if a

[[Page 30180]]

market structure fails to promote vigorous price competition.\34\ 
Similarly, the depth of trading interest at the best displayed prices 
may be very thin, so that prices will be more volatile than they 
otherwise would be if a market structure does not reward traders for 
displaying multiple orders (and thereby adding depth) at the best 
prices. In addition, some market centers offer investors an opportunity 
for price improvement--an execution at a price better than the best 
displayed prices. To meet their best execution responsibilities, 
brokers must take these price improvement opportunities into 
consideration in deciding where to route customers orders.
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    \34\ The spread between the best bid and offer is an indication 
of the premium that must be paid by investors seeking liquidity and 
therefore of the efficiency of the market. See Concept Release, note 
3 above, at n.20 and accompanying text.
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    Several commenters believed that the Commission should not approve 
the rescission of Rule 390 until it had addressed market fragmentation 
concerns. The Commission does not believe, however, that the potential 
fragmentation of the listed market due to an increase in 
internalization and payment for order flow arrangement warrants a delay 
in approving the proposed rule change. First, the Commission already 
has commenced its review of market fragmentation issues, and the 
comment period for the Concept Release ends on May 12, 2000. Several of 
the six potential options to address fragmentation set forth in the 
Concept Release would address internalization and payment for order 
flow arrangements.\35\ The Concept Release also requests comment on any 
additional options, or modifications of any of the six options, that 
commenters believe would be useful in addressing fragmentation.\36\ 
Second, the Commission intends to monitor any significant changes in 
the order-routing practices of NYSE members resulting from the 
rescission of Rule 390, particularly decisions to internalize their 
customer order flow. To comply with the duty of best execution owed 
their customers, brokers would need to assure that such changes further 
their customers' interests and not merely their own.
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    \35\ See Concept Release, note 3 above, section IV.C.2.b.
    \36\ After the end of the comment period, the Commission intends 
to review expeditiously the comments submitted in response to the 
Concept Release and determine what, if any, further action is 
necessary.
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IV. Conclusion

    It is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\37\ that the proposed rule change (SR-NYSE-99-48) is approved.
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    \37\ 15 U.S.C. 78s(b)(2).

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-11682 Filed 5-9-00; 8:45 am]
BILLING CODE 8010-01-M