[Federal Register Volume 65, Number 151 (Friday, August 4, 2000)]
[Proposed Rules]
[Pages 47918-47936]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-19728]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-43085; File No. S7-17-00]
RIN 3235-AH96


Firm Quote and Trade-Through Disclosure Rules for Options

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``SEC'' or 
``Commission'') is proposing to amend Rule 11Ac1-1 under the Securities 
Exchange Act of 1934 (``Exchange Act''), to require options exchanges 
and options market makers to publish firm quotes. The Commission also 
is proposing new Rule 11Ac1-7 under the Exchange Act to require a 
broker-dealer to disclose on its customer's confirmation statement when 
the customer's order for listed options was executed at a price 
inferior to a better published quote and what that better quote was, 
unless the transaction was effected on a market that is a participant 
in an intermarket options linkage plan approved by the Commission.

DATES: Comments should be submitted on or before September 18, 2000.

ADDRESSES: All comments should be submitted in triplicate and addressed 
to Jonathan G. Katz, Secretary, U.S. Securities and Exhange Commission, 
450 Fifth Street, N.W., Washington, D.C. 20549-0609. Comments also may 
be submitted electronically at the following E-mail address: [email protected]. All comment letters should refer to File No. S7-17-
00; this file number should be included on the subject line if E-mail 
is used. Comment letters will be available for inspection and copying 
in the Commission's Public Reference Room at the same address. 
Electronically submitted comment letters will be posted on the 
Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Deborah Flynn, Senior Special Counsel, 
at (202) 942-0075, Kelly Riley, Attorney, at (202) 942-0752, John 
Roeser, Attorney, at (202) 942-0762, Terri Evans, Special Counsel, at 
(202) 942-4162, and Heather Traeger, Attorney, at (202) 942-0763, 
Division of Market Regulation, Securities and Exchange Commission, 450 
Fifth Street, NW., Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Executive Summary
    A. Proposed Trade-Through Disclosure Rule
    B. Proposed Amendments to the Quote Rule
    C. Approval of Linkage Plan
II. Background
III. Discussion of Proposed Rulemaking
    A. Proposed Trade-Through Disclosure Rule
    1. Background
    2. Proposed Trade-Through Disclosure Rule
    a. Proposed Disclosure Requirement
    b. Proposed Exception to Disclosure Requirement
    c. Proposed Definition of Trade-Through
    d. Rejection of Absolute Prohibition on Trade-Throughs
    B. Proposed Amendments to the Quote Rule
    1. Background
    2. Proposed Amendments to the Quote Rule
    a. Proposed Amendments to Defined Terms
    b. Quotation Size
    c. Proposed Thirty Second Response Requirement
IV. General Request for Comment
V. Paperwork Reduction Act
    A. Summary of Collection of Information
    B. Proposed Use of Information
    C. Respondents
    D. Total Annual Reporting and Recordkeeping Burden
    1. Proposed Trade-Through Disclosure Rule
    a. Capital Costs
    b. Burden Hours
    2. Proposed Amendments to the Quote Rule
    a. Capital Costs
    b. Burden Hours
    E. General Information about the Collection of Information
    F. Request for Comment
VI. Costs and Benefits of Proposed Rules
    A. Costs and Benefits of the Proposed Trade-Through Disclosure 
Rule
    1. Benefits
    2. Costs
    B. Costs and Benefits of Proposed Amendments to the Quote Rule
    1. Benefits
    2. Costs
VII. Consideration of the Burden on Competition, and Promotion of 
Efficiency, Competition and Capital Formation
VIII. Initial Regulatory Flexibility Analysis
    A. Reasons for the Proposed Action
    B. Objectives and Legal Basis
    C. Small Entities Subject to the Rules
    D. Reporting, Recordkeeping, and other Compliance Requirements

[[Page 47919]]

    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    G. Solicitation of Comments
IX. Statutory Authority

I. Executive Summary

    Recent increases in the multiple listing of options classes 
previously listed on a single exchange have intensified the competition 
among the option exchanges and the need to further integrate the 
options markets into the national market system. The marked increase in 
multiple trading is indicative of the dynamic environment in which the 
options markets currently operate. For example, in August 1999, only 32 
percent of equity options classes were traded on more than one 
exchange. By the end of June 2000, the number of equity options classes 
that were multiply-traded had risen to 48 percent, a 50 percent 
increase.
    While the growth in multiple trading has increased the competition 
between markets, it also has dramatically altered the environment in 
which options market participants conduct their trading. In particular, 
multiple trading raises new best execution challenges for broker-
dealers.\1\ When an option is listed on only one exchange, broker-
dealers do not have to decide where to route an order, and 
consequently, satisfying their best execution obligations is less 
rigorous than when they must consider the relative merits of routing 
orders to two or more market centers. With as many as five options 
exchanges currently trading certain options classes, broker-dealers are 
increasingly required to regularly and rigorously evaluate the 
execution quality available at each options exchange.
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    \1\ In accepting orders and routing them to an exchange for 
execution, brokers act as agents for their customers and owe them a 
duty of best execution. A broker's duty of best execution is derived 
from common law agency principles and fiduciary obligations. It is 
incorporated both in self-regulatory organization's rules and, in 
the antifraud provisions of the federal securities laws through 
judicial and Commission decisions. This duty requires a broker to 
seek the most favorable terms reasonably available under the 
circumstances for a customer's transaction. As a result, broker-
dealers must periodically assess the quality of competing markets. 
See Securities Exchange Act Release No. 37619A (September 6, 1996), 
61 FR 48290 (September 12, 1996).
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    Directly relevant to a broker's ability to obtain best execution 
for its customers is the ability to get the best price available. The 
considerable growth in the number of options classes traded on more 
than one exchange has significantly increased the likelihood that an 
order may be executed at a price that is inferior to a quoted price 
available on another exchange (``intermarket trade-through''). 
According to preliminary data analyzed by the Commission's Office of 
Economic Analysis during the week of June 26, 2000, 5% of all trades in 
the 50 most active multiply-listed equity options were executed at 
prices inferior to the best price quoted on a competing market. 
Currently, it is difficult to ensure that a customer order sent to one 
exchange will receive the best available price because of the absence 
of fair access and an efficient mechanism allowing a market participant 
at one exchange to reach a better price published by another exchange. 
As a result, better prices quoted on another exchange do not always 
receive price priority, and customer orders may receive inferior 
executions.
    Because of its concerns about the increasing likelihood of 
intermarket trade-throughs in the options markets, the Commission, on 
October 19, 1999, issued an Order directing the options exchanges to 
act jointly to file a national market system plan within 90 days for 
linking the options markets.\2\ On January 19, 2000, the options 
exchanges submitted three separate linkage plans,\3\ a detailed summary 
of which was published for comment in the Federal Register on March 2, 
2000.\4\ The Commission received comments on the proposed linkage plans 
from 24 market participants.\5\ A thorough review of the comment 
letters received on the proposed linkage plans has led the Commission 
to consider alternate ways in which to accomplish its goal of 
protecting price priority and minimizing intermarket trade-throughs of 
customer orders.\6\
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    \2\ See Securities Exchange Act Release No. 42029, 64 FR 57674 
(October 26, 1999) (``October 19, 1999 Order''). The October 19, 
1999 Order directed the American Stock Exchange LLC (``Amex''), 
Chicago Board Options Exchange, Inc. (``CBOE''), Pacific Exchange, 
Inc. (``PCX''), and Philadelphia Stock Exchange, Inc. (``Phlx'') to 
act jointly in discussing, developing, and submitting for Commission 
approval an intermarket linkage plan for multiply-traded options. 
The Commission's Order also requested the International Securities 
Exchange LLC (``ISE'') to participate with the options exchanges in 
the development of an intermarket linkage plan. The ISE was 
subsequently registered as a national securities exchange for 
options trading on February 24, 2000. See Securities Exchange Act 
Release No. 42455, 65 FR 11387 (March 2, 2000).
    \3\ Amex, CBOE, and ISE submitted identical plans and PCX and 
Phlx each submitted separate plans.
    \4\ See Securities Exchange Act Release No. 42456 (February 24, 
2000), 65 FR 11402. At the same time, the full text of each of the 
plans was made available to interested persons on the Commission's 
website.
    \5\ A summary of comments received on the proposed linkage plans 
is available in the Commission's Public Reference Room (File No. 4-
429).
    \6\ In its proposed release issued today on Disclosure of Order 
Routing and Execution Practices, the Commission states that it 
``recognizes that fair and efficient linkages to market centers 
publishing quotes are important to encouraging priced competition 
and strengthening price priority * * * At the same time, the 
Commission believes that wherever possible, market-based incentives, 
not government imposed systems, should determine the connections 
between markets.'' See Securities Exchange Act Release No. 43084 
(July 28, 2000).
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    In assessing the best way to encourage fair access and linkage 
among the options markets, the Commission has carefully evaluated not 
only the comment letters submitted by interested persons, but also the 
impact of the recent increases in multiple trading and the availability 
of new technologies. This review has raised concerns that mandating a 
single linkage system in which all of the options exchanges must 
participate may have inherent limitations. The linkage plans proposed 
by the options markets offer significant advantages by reducing 
barriers to access between the markets. Nonetheless, the Commission is 
reluctant to mandate one single form of linkage, which may fail to 
adapt over time to changes in the markets and may impede the entry of 
new participants with different business models.
    Moreover, a mandatory linkage plan may not maintain up-to-date 
technology. For example, one commenter expressed concern that any 
linkage system technology would become obsolete before or soon after 
the system was implemented.\7\ The Commission believes that the growth 
of electronic routing systems may enable the options exchanges to 
access one another's markets directly through agreed-upon methods, or 
indirectly through broker-dealers. As a result, there may well be a 
variety of equally effective, or indeed more effective, ways in which 
technology may be employed by the markets to encourage price priority 
and decrease the likelihood of intermarket trade-throughs in the 
options markets.
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    \7\ See letter to Jonathan G. Katz, Secretary, Commission, from 
Peter Hajas, Chief Executive Officer, Knight Financial Products LLC, 
dated April 3, 2000.
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    Consequently, the Commission's proposals today are purposely 
limited in scope. The Commission's proposals are intended to facilitate 
the ability of market participants to obtain the best price for 
customer orders without mandating a specific linkage. As described 
below, in conjunction with its approval of an options intermarket 
linkage plan (``Amex/CBOE/ISE plan''),\8\ the Commission today is 
proposing a new rule and amendments to an existing rule designed to 
provide customers with

[[Page 47920]]

more information with which to evaluate the quality of executions 
achieved by their brokers and to require market makers to be firm for 
their quotes. Together these rules would provide incentives for the 
markets and their members to develop mechanisms to reduce the frequency 
of intermarket trade-throughs, and would allow market participants to 
choose the form of mechanism employed.
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    \8\ See Securities Exchange Act Release No. 43086, (July 28, 
2000).
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    In addition, some commenters have argued, in the context of the 
Commission's review of the linkage plans submitted by the exchanges, 
that the Commission's approval of a linkage plan should be viewed as an 
opportunity to mandate, among other things, the protection of customer 
limit orders and price/time priority.\9\ The Commission concluded, 
however, in its Order approving the Amex/CBOE/ISE plan that it does not 
have sufficient information to satisfy itself that the potential 
benefits of a mandatory price/time priority requirement clearly justify 
the potential drawbacks, and that it would be premature at this time to 
mandate cross-market priority rules as elements of a linkage between 
the options markets.
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    \9\ Price/time priority generally requires that if an exchange 
receives an order but was not the first exchange to display the best 
price, that exchange must route the order to the exchange that first 
displayed the best price.
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A. Proposed Trade-Through Disclosure Rule

    To begin, the Commission is proposing a new rule, Exchange Act Rule 
11Ac1-7 (``Trade-Through Disclosure Rule''),\10\ to require a broker-
dealer to disclose to a customer when the customer's order to buy or 
sell a listed option was executed at a price inferior to the best quote 
published at the time of execution of the customer's order.
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    \10\ Proposed 17 CFR 240.11Ac1-7.
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    The proposed Trade-Through Disclosure Rule is intended to better 
inform customers about the implications of their brokers' execution 
decisions. If the fact of a trade-through was disclosed, along with the 
better available price, customers would have additional information 
with which to evaluate the quality of executions achieved by their 
brokers. The proposed new rule is not an absolute prohibition on trade-
throughs. To the contrary, the Commission recognizes that, in certain 
circumstances, an execution at a price inferior to a quote displayed by 
another market may be consistent with an investor's particular 
investment strategy. For example, it is possible that a customer would 
prefer to receive an immediate execution at one price rather than 
pursue the opportunity to obtain a superior price. By requiring 
disclosure of executions at inferior prices when they occur, the rule 
is intended to ensure that the decision not to pursue publicly-
displayed superior prices is rooted in the interests of customers, not 
intermediaries. Nonetheless, the Commission anticipates that an 
effective disclosure requirement would minimize the likelihood that a 
customer order does not receive an execution at the best available 
published quote.
    In addition, as an incentive for markets to cooperate in developing 
effective means to access other markets to avoid trade-throughs, the 
Commission's proposal would except broker-dealers from the proposed 
disclosure requirements if they effect orders on options markets that 
participate in an intermarket linkage plan that has explicit provisions 
reasonably designed to limit trade-throughs. In such instances, the 
Commission expects that the value in requiring a broker-dealer to 
disclose the rare trade-through that may occur would be substantially 
reduced. The proposed Trade-Through Disclosure Rule would not, however, 
mandate that options exchanges participate in a specific linkage plan. 
Instead, the proposal contemplates that there ultimately may be 
multiple linkage plans approved by the Commission that contain 
provisions to effectively limit intermarket trade-throughs.

B. Proposed Amendments to the Quote Rule

    The proposed Trade-Through Disclosure Rule would not be meaningful 
if the market publishing a better quote is not firm for a specified 
number of contracts at that quote. In particular, members of an 
exchange cannot develop effective means of access to displayed quotes 
of another exchange if those quotes are not firm. To that end, the 
Commission proposes to amend Exchange Act Rule 11Ac1-1 (``Quote Rule'') 
\11\ to require options exchanges and options market makers to publish 
firm quotes.\12\ As discussed in greater detail below, the proposed 
amendments to the Quote Rule include certain accommodations to reflect 
the fact that the Options Price Reporting Authority (``OPRA'') does not 
have the ability to disseminate quotes with size at this time. These 
accommodations require quotes to be firm for the size specified, but 
not displayed by, the options markets. The Commission also proposes, as 
an alternative, rule language that would allow options exchanges to be 
firm for their quotes in different sizes for orders from customer 
accounts than for orders from broker-dealer accounts. The Commission is 
proposing this alternative because options market makers may otherwise 
be inclined to limit their exposure to other professionals by widening 
their spreads or limiting their firm quote size, which would be to the 
detriment of public customers.
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    \11\ 17 CFR 240.11Ac1-1.
    \12\ The Quote Rule has, to date, applied only to equity markets 
and market makers. See Securities Exchange Act Release No. 1445 
(January 26, 1978), 43 FR 4342 (February 1, 1978), as amended in 
Securities Exchange Act Release Nos. 37619A (September 6, 1996), 61 
FR 48290 (September 12, 1996); and 40760 (December 8, 1998), 63 FR 
70844 (December 22, 1998).
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C. Approval of Linkage Plan

    As noted above, the Commission today, in a separate release, 
approved the options market linkage plan proposed by the Amex, CBOE, 
and ISE, the Amex/CBOE/ISE plan.\13\ This plan is an important step 
forward in linking the options markets and, if implemented, would 
eliminate many existing barriers to access between the participating 
markets and would provide members of those markets with better methods 
of access than exist today. Ultimately, it may prove to be the 
preferred means of linking the options exchanges. Nonetheless, the 
Commission's approval of the Amex/CBOE/ISE plan does not require those 
options exchanges that are not participants in the plan to become 
participants.\14\ This approach is premised on the Commission's belief, 
discussed above, that there may be a number of means of achieving the 
Commission's goal of encouraging price priority and limiting 
intermarket trade-throughs of customer orders. The Commission's 
approval of the Amex/CBOE/ISE plan, coupled with the proposed new 
Trade-Through Disclosure Rule and amendments to the Quote Rule, is 
designed to encourage access to, and linkage among, the

[[Page 47921]]

competing options markets, without mandating the means to achieve this 
goal. The Commission is today soliciting comment on this flexible 
approach.
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    \13\ See supra note 8. The Commission's approval of the Amex/
CBOE/ISE plan should not be construed as a rejection on the merits 
of either the Phlx or PCX submissions. Neither of those submissions 
could be approved as a national market system plan pursuant to 
Exchange Act Rule 11Aa3-2, 17 CFR 240.11Aa3-2, because neither plan 
was filed by two or more sponsors as required by the rule. In fact, 
the Commission would consider approving other national market system 
plans relating to intermarket linkage between the options markets 
submitted by two or more markets.
    \14\ The plan does, however, include express provisions pursuant 
to which other options exchanges may become participants by 
executing the plan, paying a fee applicable to new participants, and 
obtaining the Commission's approval of the plan as amended to 
reflect the new participant. See Amex/CBOE/ISE plan Sections 4(c) 
and 5(c)(ii).
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II. Background

    Section 11A of the Exchange Act,\15\ enacted as part of the 
Securities Act Amendments of 1975,\16\ sets forth Congress' findings 
concerning the establishment of a national market system. Congress 
found, among other things, that it was in the public interest, and 
appropriate for the protection of investors and the maintenance of fair 
and orderly markets to assure the availability to brokers, dealers, and 
investors of quote and transaction information, and the practicability 
of brokers executing investors' orders in the best market.\17\ Congress 
asserted that linking all of the markets for qualified securities 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.'' \18\
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    \15\ 15 U.S.C. 78k-1.
    \16\ Pub. L. No. 94-29, 89 Stat. 97 (1975) (``1975 
Amendments''). In the 1975 Amendments, Congress directed the 
Commission to oversee the development of a national market system. 
Congress granted the Commission broad, discretionary powers to 
oversee the development of a fully integrated national system for 
the processing and settlement of securities transactions. See also 
infra note 19.
    \17\ Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C).
    \18\ Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C).
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    The national market system was intended by Congress to potentially 
encompass ``all segments of corporate securities including all types of 
common and preferred stocks, bonds, debentures, warrants, and 
options.'' \19\ Congress included all types of securities because it 
believed that many of the goals of a national market system, such as 
the availability of information with respect to price, volume, and 
quotations, would be universally beneficial, although perhaps 
implemented through subsets of a national market system. \20\
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    \19\ Senate Committee on Banking, Housing, and Urban Affairs, 
Report to Accompany S. 249, S. Rep. 94-75, 94th Cong., 1st Sess. 7 
(1975) (``Senate Report''). See also Committee of Conference, Report 
to Accompany S. 249, H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 2 
(1975) (``Conference Report'').
    \20\ Id.
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    Congress did, however, recognize the differences between the 
markets and granted the Commission broad powers to implement a national 
market system without forcing all securities markets into a single 
mold. \21\ Accordingly, Congress granted the Commission the authority 
to implement the objectives of the 1975 Amendments,\22\ while allowing 
the Commission to recognize and classify markets, firms, and securities 
in any manner appropriate or necessary in the public interest or for 
the protection of investors.\23\
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    \21\ See Senate Report. See also Conference Report. The 
Committee of Conference stated that the unique characteristics of 
securities other than common stocks may require different treatment 
in a national market system.
    \22\ The two primary objectives of the 1975 Amendments were (1) 
``the maintenance of stable and orderly markets with maximum 
capacity for absorbing trading imbalances without undue price 
movements,'' and (2) ``the centralization of all buying and selling 
interest so that each investor will have the opportunity for the 
best execution of his order, regardless of where in the system it 
originates.'' See Senate Report.
    \23\ Section 11A(a)(2) of the Exchange Act authorizes the 
Commission to designate, by rule, securities qualified for trading 
in the national market system. 15 U.S.C. 78k-1(a)(2).
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    Many of the national market system initiatives were implemented in 
the equities markets at a time when standardized options trading was 
relatively new.\24\ Therefore, the Commission deferred applying many of 
the national market system initiatives to options to give options 
trading an opportunity to develop.
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    \24\ The trading of standardized options on securities exchanges 
began in 1973 with the organization of the CBOE as a national 
securities exchange. See Securities Exchange Act Release No. 9985 
(February 1, 1973) 1 S.E.C. Doc. 11 (February 13, 1973). Currently, 
Amex, CBOE, ISE, PCX, and Phlx are the only national securities 
exchanges that trade standardized options.
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    In October 1977, in response to allegations of wide-spread 
manipulation in the market for exchange-traded options, the Commission 
initiated an investigation and special study of the options 
markets.\25\ In the Options Study, the Commission acknowledged that 
Congress had intended to include options in a national market system, 
and set forth a number of issues to be explored before the options 
markets could be fully integrated into the national market system.\26\ 
Subsequently, the Commission approved a national market system plan 
that collects and disseminates consolidated quotes and trades for the 
options markets.\27\ Today, the options markets continue to operate 
with limited market integration facilities. \28\
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    \25\ The result of the Commission's investigation was The Report 
of the Special Study of the Options Markets, issued on December 22, 
1978 (``Options Study''). Report of the Special Study of the Options 
Markets to the Securities and Exchange Commission, 96th Cong., 1st 
Sess. (Comm. Print No. 96-IFC3, December 22, 1978) (examining the 
major issues of market structure in standardized options markets, 
including multiple trading).
    \26\ Options Study at 1029-1030. The Commission stated that it 
had ``not begun to consider whether standardized options are 
appropriate for inclusion as qualified securities or whether it 
would be more appropriate to design a `subsystem' of a national 
market system to comprehend standardized options trading.'' The 
Options Study delineated the following as among the issues to be 
explored in the options market: (1) A comprehensive quotation system 
for the dissemination of firm quotes; (2) market linkage and order 
routing systems to enable the best execution of orders; (3) 
nationwide limit order protection to ensure that agency orders 
receive auction-type trading protections; and (4) off-board trading 
restrictions.
    \27\ Currently, the options exchanges report their respective 
quotes and trades of OPRA, which operates pursuant to a national 
market system plan, approved by the Commission pursuant to Section 
11A of the Exchange Act and Rule 11Aa3-2 thereunder. See Securities 
Exchange Act Release No. 17638 (March 18, 1981). Quote and trade 
reporting are integral components of a national market system. See 
Section 11A(a)(1)(C)(iii) of the Exchange Act. 15 U.S.C. 78k-
1(a)(1)(C)(iii). See also infra Section III.B.1.
    \28\ The Commission has repeatedly called for increased national 
market system initiatives in the options markets. See Securities 
Exchange Act Release No. 16701 (March 26, 1980), 45 FR 21426 (April 
1, 1980) (deferring expansion of multiple trading to afford the 
options exchanges an opportunity to consider the development of 
market integration facilities); Securities Exchange Act Release No. 
22026 (May 8, 1985), 50 FR 20310 (May 15, 1985) (urging options 
market participants to consider the development of market 
integration facilities); Directorate of Economic and Policy 
Analysis, ``The Effects of Multiple Trading on the Market for OTC 
Options'' (November 1986); Office of the Chief Economist, 
``Potential Competition and Actual Competition in the Options 
Market'' (November 1986); and Securities Exchange Act Release No. 
26871 (May 26, 1989), 54 FR 24058 (June 5, 1989) (requesting comment 
on three measures, including an intermarket linkage). In 1989, the 
Commission adopted Exchange Act Rule 19c-5, which generally 
prohibits any exchange from adopting rules limiting its ability to 
list any stock options class because that options class is listed on 
another exchange. See Securities Exchange Act Release No. 26870 (May 
26, 1989), 54 FR 23963 (June 5, 1989). In 1990, then Chairman 
Breeden requested that the options exchanges develop an intermarket 
linkage plan. See letter from Chairman Breeden to the Registered 
Options Exchange dated January 9, 1990.
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    With the onset of widespread multiple trading in options, the 
Commission is increasingly concerned about customer orders that are 
sent to one exchange being executed at prices inferior to quotes 
published by another market. The Commission believes further action is 
necessary at this time to encourage the removal of barriers to access, 
and the use of efficient vehicles to reach, better prices on another 
market. At the same time, the Commission believes that wherever 
possible, market-based incentives, not government-imposed systems, 
should determine the connections between the markets. For this reason, 
the Commission is today proposing an alternative to a government-
imposed single intermarket linkage that would remove certain barriers 
to access and create incentives for options market

[[Page 47922]]

participants to develop access arrangements with each other.

III. Discussion of Proposed Rulemaking

A. Proposed Trade-Through Disclosure Rule

1. Background
    In the 1975 Amendments, Congress declared that, ``[i]t is in the 
public interest and appropriate for the protection of investors and the 
maintenance of fair and orderly markets to assure * * * the 
practicability of brokers executing investor's orders in the best 
market  * * * '' \29\. In accordance with these principles, the 
Commission determined that trade-throughs--that is, the execution of 
orders at prices inferior to prices offered on other markets--are 
``inconsistent with the goals of a national market system.'' \30\ 
Consequently, the Commission has consistently sought to protect orders 
displayed at a better price from being traded through at inferior 
prices by encouraging executions of customer orders at the best prices. 
Further, the Commission has repeatedly emphasized a broker-dealer's 
duty of best execution of customer orders, which includes seeking the 
best price reasonably available. In the equity markets, the Intermarket 
Trading System (``ITS'') Plan includes a trade-through rule protecting 
displayed bids and offers for ITS-eligible exchange-listed 
securities.\31\ In conformance with the ITS Plan, each participating 
exchange and the National Association of Securities Dealers (``NASD'') 
has adopted rules that limit trade-throughs in exchange-listed 
securities.\32\ In the options markets, the Commission has repeatedly 
encouraged the exchanges to implement mechanisms to limit trade-
throughs from occurring.\33\ For a variety of reasons over the years, 
however, none of these efforts has been wholly successful.
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    \29\ See Section 11A(a)(1)(C)(iv) of the Exchange Act, 15 U.S.C. 
78k-1(a)(1)(C)(iv). In fact, as early as 1973, the Commission had 
indicated that the facilities of a national market system should 
provide a broker-dealer with the ability to ensure that ``his 
customer's order is executed in the best market available.'' SEC, 
Policy Statement on the Structure of a Central Market System, at 17 
(March 29, 1973), reprinted in [1973] Sec. Reg. & L Rep. (BNA) No. 
196 at D-1, D-4.
    \30\ See Securities Exchange Act Release No. 22127 (June 21, 
1985), 50 FR 26548 (June 27, 1985) (soliciting comment on issues 
relating to the designation of securities as national market system 
securities).
    \31\ See Securities Exchange Act Release No. 17703 (April 9, 
1981), 22 S.E.C. Doc. 707.
    \32\ See Securities Exchange Act Release No. 17704 (April 9, 
1981), 46 FR 22520 (April 17, 1981). The NASD submitted a proposed 
trade-through rule for exchange-listed stocks, which the Commission 
approved on May 6, 1982. See Securities Exchange Act Release No. 
18714, 47 FR 20429 (May 12, 1982). On June 21, 1985, the Commission 
requested comment on, among other things, the extent to which 
securities listed on The Nasdaq Stock Market, Inc. (``Nasdaq'') 
should be subject to trade-through rules. See Securities Exchange 
Act Release No. 22127 (June 21, 1985), 50 FR 26584 (June 27, 1985). 
In addition, in recently adopting amendments to the ITS Plan to 
expand the linkage to all listed securities, the Commission 
concluded that the NASD should continue to consider modifications to 
its existing trade-through rule to cover non-ITS participants, but 
that such modifications were not a precondition to approval of the 
expanded linkage. See Securities Exchange Act Release No. 42212 
(December 9, 1999), 64 FR 70297 (December 16, 1999).
    \33\ See supra note 28.
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    In 1980, at the time the Commission ended the voluntary moratorium 
on expansion of standardized options trading, it asked for comment on 
several approaches to more fully integrate the options markets into the 
national market system, including a market linkage system similar to 
ITS, requiring brokerage firms to route retail orders on an order-by-
order basis to the market center showing the best quotation, and an 
order exposure system for options public limit orders.\34\
---------------------------------------------------------------------------

    \34\ See Securities Exchange Act Release No. 16701 (March 26, 
1980), 45 FR 21426 (April 1, 1980) (``Moratorium Termination 
Release'')
---------------------------------------------------------------------------

    The Commission's adoption of Exchange Act Rule 19c-5 in 1989 \35\ 
created the need for some mechanism to ensure that customers' orders 
for multiply-traded options could be executed at the best available 
price. Accordingly, in 1990, the CBOE, New York Stock Exchange 
(``NYSE''), \36\ Amex, and PCX filed with the Commission a proposed 
Joint Industry Plan providing for the creation and operation of an 
Options Intermarket Communications Linkage (``Linkage Plan'').\37\ The 
Commission sought comment on the Linkage Plan,\38\ but neither the 
Linkage Plan nor its Model Trade-Through Rule was adopted, in part, 
because the options exchanges could not reach a consensus on several 
critical elements.
---------------------------------------------------------------------------

    \35\ 17 CFR 240.19c-5. See Securities Exchange Act Release No. 
26870, supra note 28.
    \36\ The NYSE has since sold its options business to the CBOE. 
See Securities Exchange Act Release No. 38542 (April 23, 1997), 62 
FR 23521 (April 30, 1997).
    \37\ The filing was amended on April 29, 1991, when the 
signatories to the Linkage Plan submitted a Model Option Trade-
Through Rule as Exhibit A to the Linkage Plan. The Model Trade-
Through Rule would have been incorporated into each of the options 
exchanges' rules. The Model Rule provided that, absent reasonable 
justification or excuse, a member in a participant market should 
avoid initiating a trade-through when purchasing or selling an 
options contract permitted to be transmitted through the proposed 
linkage.
    \38\ See Securities Exchange Act Release No. 30187 (January 14, 
1992), 57 FR 2612 (January 22, 1992).
---------------------------------------------------------------------------

    During the comment period on the Linkage Plan, an alternative plan 
was considered that involved the gradual phase-in of multiple trading, 
along with the adoption of exchange rules and operational enhancements 
linking the markets non-electronically (``Phase-In Plan'').\39\ 
Specifically, the Phase-In Plan would have provided for the re-routing 
of orders received through automated systems to other execution 
facilities, in conjunction with a trade-or-fade rule.\40\ Again, 
however, the exchanges did not agree to the Phase-In Plan and it was 
not adopted.
---------------------------------------------------------------------------

    \39\ The Phase-In Plan was put forth by the Securities Industry 
Association (``SIA'') and endorsed by the Committee on Options 
Proposals (``COOP''). See letters to Jonathan G. Katz, Secretary, 
SEC, from Thomas P. Hart, Chairman, SIA Options and Derivative 
Products Committee, dated March 10, 1992; and Michael Schwartz, 
Chairman, COOP, dated March 11, 1992.
    \40\ Id. See also letter from Richard C. Breeden, Chairman, SEC, 
to Aleger B. Chapman, Chairman & CEO, CBOE, dated June 30, 1992 
(setting forth the Commission's understanding of the elements of the 
Phase-In Plan).
---------------------------------------------------------------------------

    In 1994, the markets adopted trade-or-fade rules, which require a 
market maker to revise its quote if it is unwilling to trade at its 
published quote with an order sent to it by a market maker from another 
exchange.\41\ The trade-or-fade rules do not provide efficient means of 
access between the markets. They also provide little incentive to try 
to reach a better quote in another market, because that quote need not 
be firm when reached. Thus, the trade-or-fade rules have done little to 
promote price priority or discourage intermarket trade-throughs.
---------------------------------------------------------------------------

    \41\ See Securities Exchange Act Release Nos. 34431, 34432, 
34444, 34434, and 34435 (July 22, 1994), 59 FR 38994 (August 1, 
1994) (orders approving proposed rule changes filed by Amex, CBOE, 
NYSE, Phlx, and PCX, respectively). See also Amex Rule 958A, 
Commentary 01; CBOE Rule 8.51(b); PCX Rule 6.37(d); and Phlx Rule 
1015(b).
---------------------------------------------------------------------------

    To provide investors with better information on the quality of the 
executions they are receiving and to provide incentives to market 
participants to develop means of access to the competing markets, 
without mandating a single linkage mechanism, the Commission today is 
proposing the Trade-Through Disclosure Rule, described below.
2. Proposed Trade-Through Disclosure Rule
    a. Proposed Disclosure Requirement. Generally, proposed Exchange 
Act Rule 11Ac1-7 would require a broker-dealer to disclose to a 
customer when the customer's order is executed at a price inferior to a 
better published quote on another exchange and what that better 
published quote was.\42\ A broker would

[[Page 47923]]

be required to make this disclosure on the customer's confirmation 
delivered pursuant to Exchange Act Rule 10b-10.\43\ To satisfy this 
disclosure requirement, the Commission would expect such disclosure to 
be as prominent as the transaction price disclosed to the customer 
under Exchange Act Rule 10b-10.
---------------------------------------------------------------------------

    \42\ Proposed Exchange Act Rule 11Ac1-7(b)(1). The Commission 
believes that a broker-dealer should be allowed to rely on the 
market of execution to notify the broker-dealer of when a trade-
through has occurred and the best quote at that time.
    \43\ 17 CFR 240.10b-10. Exchange Act Rule 10b-10 requires 
information to be delivered in writing (including electronically) at 
or before completion of the transaction. It does not require that 
all information be included in a single document.
---------------------------------------------------------------------------

    A broker-dealer would not be required to provide such disclosure to 
its customer if it effects a transaction for a customer on an exchange 
that participates in an approved linkage plan that includes provisions 
reasonably designed to limit customers' orders from being executed at 
prices that trade through a better published price.\44\ Importantly, 
the proposed rule's disclosure requirement would not prohibit trade-
throughs, but is intended to provide customers with important 
information about the quality of their executions. The Commission 
believes that the proposed rule would provide the individual customer 
with important information and facilitate an individual investor's 
ability to actively monitor whether his or her order routing firm is 
fulfilling its best execution obligations. It also would encourage 
broker-dealers to develop effective means of accessing better quotes 
published by other markets. The Commission notes, however, that the 
proposed Trade-Through Disclosure Rule would not replace the well-
established duty that broker-dealers must provide best execution to 
their customers. To the contrary, broker-dealers remain obligated to 
seek the most favorable terms possible under the circumstances for 
their customers.\45\
---------------------------------------------------------------------------

    \44\ Proposed Exchange Act Rule 11Ac1-7(b)(2).
    \45\ See supra note 1.
---------------------------------------------------------------------------

    The Commission solicits comment on whether there are any special 
considerations that should be taken into account in light of the fact 
that options trades are settled the day after the transaction.
    b. Proposed Exception to Disclosure Requirement. As noted above, 
the proposed Trade-Through Disclosure Rule provides an exception from 
the customer disclosure requirements if the broker-dealer effects its 
customers' orders on an options exchange that participates in an 
effective national market system options linkage plan that includes 
provisions reasonably designed to limit intermarket trade-throughs. 
Preliminarily, the Commission believes that, at a minimum, to be 
reasonably designed to limit trade-throughs, a plan should contain 
provisions to: (1) Limit participants from trading through not only the 
quotes of other linkage plan participants, but also the markets of 
exchanges that are not participants in the plan; (2) require plan 
participants to actively surveil their markets for trades executed at 
prices inferior to those publicly quoted on other exchanges; and (3) 
make clear that the failure of a market with a better quote to complain 
within a specified period of time that its quote was traded-through may 
affect potential liability, but does not signify that a trade-through 
has not occurred.\46\
---------------------------------------------------------------------------

    \46\ The Commission, in a separate release, is approving a 
national market system options linkage plan that generally requires 
members of participating markets to avoid initiating trade-throughs. 
See supra note 8. The Commission notes, however, that if the 
proposed Trade-Through Disclosure Rule is adopted as proposed, the 
Amex/CBOE/ISE plan approved today would have to be amended before 
broker-dealers effecting transactions on exchanges participating in 
the plan would be excepted from the disclosure requirements of the 
proposed Trade-Through Disclosure Rule.
---------------------------------------------------------------------------

    In addition, to comply with these standards, a participating 
exchange, generally, would have to adopt rules that would allow the 
exchange to sanction firms that repeatedly trade-through better prices 
of other exchanges, maintain policies and procedures that would limit 
the occurrence of trade-throughs, and maintain records that would 
identify trade-throughs and any review or remedial action taken by the 
exchange in response to such trade-throughs.
    As stated above, to be reasonably designed to limit trade-throughs, 
the Commission preliminarily believes that a plan should limit trade-
throughs of all markets displaying quotes in the consolidated quote 
system. The Commission recognizes that because of barriers to access 
and order routing obstacles, limiting trade-throughs of quotes on 
markets not participating in a linkage plan would be more difficult 
than limiting trade-throughs of quotes published by linked markets. The 
Commission seeks comment on potential approaches that could be employed 
in linkage plans to adequately limit trade-throughs of non-linked 
markets. The Commission also requests comment on whether instead of 
requiring the limitation of trade-throughs of non-linked markets, the 
exception from disclosure of trade-throughs should be limited only to 
trade-throughs of markets that participate in the linkage plan.
    The Commission believes exchange linkage agreements are a 
straightforward method of removing barriers to access between 
exchanges. Because a linkage plan satisfying the proposed rule would 
provide for a mechanism to access superior quotes on another market and 
rules limiting such trade-throughs, the Commission believes there would 
be little value in requiring order routing firms to develop a 
disclosure process to deal with the unlikely event that there was a 
trade-through. Moreover, such an exception would provide an incentive 
for exchanges to enter into linkage agreements to limit trade-throughs, 
without mandating participation in a linkage or the method of linkage.
    The Commission requests comment on the propriety of the proposed 
exception to the proposed Trade-Through Disclosure Rule for orders 
effected on exchanges that are participants in an effective national 
market system options linkage plan that includes provisions reasonably 
designed to limit customer orders from trading through better published 
prices. The Commission also seeks comment on what provisions such a 
linkage plan should be required to include and whether the minimum 
requirements identified by the Commission above are sufficient. 
Commenters are also invited to express their views as to whether an 
options exchange that is not a participant in an approved linkage plan 
should be required to provide to broker-dealers information about 
intermarket trade-throughs occurring on its market.
    In response to the linkage plan proposals, several commenters 
suggested that the Commission require broker-dealers to route 
customers' orders on an order-by-order basis to the best quote.\47\ The 
Commission does not currently believe that it is appropriate to mandate 
such a routing requirement, but would like commenters' views on whether 
it would be appropriate to except broker-dealers from the Commission's 
proposed disclosure requirements in new Rule 11Ac1-7 \48\ if broker-
dealers systematically route customer orders on an order-by-order basis 
to the exchange with the best price at the time the order is routed.
---------------------------------------------------------------------------

    \47\ See e.g., letters to Jonathan G. Katz, Secretary, 
Commission, from Douglas J. Engmann, President and Chief Executive 
Officer, ABN-AMRO, dated March 24, 2000; and Thomas Petterffy, 
Chairman, and David M. Battan, Vice President and General Counsel, 
Interactive Brokers, the Timber Hill Group, dated April 3, 2000 and 
April 10, 2000.
    \48\ Proposed Exchange Act Rule 11Ac1-7.
---------------------------------------------------------------------------

    c. Proposed Definition of Trade-Through. The proposed Trade-Through 
Disclosure Rule would define a trade-through as occurring when a 
customer

[[Page 47924]]

order for listed options is executed at a worse price than the best 
quote published pursuant to a national market system plan for reporting 
quotations in listed options at the time of execution.\49\ The proposal 
identifies seven circumstances in which a trade executed at a price 
inferior to a published price on another market would nevertheless not 
be considered a trade-through for purposes of the rule.\50\ These 
circumstances are, in large part, the same as those exceptions proposed 
by the options exchanges in each of their linkage plan proposals.
---------------------------------------------------------------------------

    \49\ Proposed Exchange Act Rule 11Ac1-7(b)(3).
    \50\ Proposed Exchange Act Rule 11Ac1-7(b)(4).
---------------------------------------------------------------------------

    In particular, because a broker-dealer should not be required to 
disclose to its customer that its order was executed at a price 
inferior to a ``stale'' quote, a trade would not be considered a trade-
through if it occurs while OPRA is experiencing queuing. In the past, 
the aggregate message traffic generated by the options exchanges has, 
at times, surpassed OPRA's systems capacity,\51\ which could result in 
the dissemination of quotes that are no longer accurate or accessible. 
Similarly, the definition of trade-through would exclude a trade 
executed at a price inferior to a price published by another exchange 
that has determined, for example, that as a result of unusual market 
conditions, it is incapable of accurately collecting and disseminating 
quotes, and thus would not require disclosure in such 
circumstances.\52\
---------------------------------------------------------------------------

    \51\ See, e.g., Securities Exchange Act Release No. 42849 (May 
26, 2000), 65 FR 36180 (June 7, 2000) (approving a temporary 
capacity allocation plan). There are a number of events, such as the 
conversion to decimal pricing, that may result in an increase of 
peak message traffic, which could result in delayed quotes.
    \52\ 17 CFR 240.11Ac1-1(b)(3). Currently, each options exchange 
has rules that allow the exchange to suspend its firm quote 
requirements, for example, if a systems malfunction or other 
circumstance impairs the exchange's ability to disseminate or update 
market quotes in a timely and accurate manner. See Amex Rule 958A; 
CBOE Rule 8.51(a); PCX Rule 6.86(d); Phlx Rule 1015(a)(ix); and ISE 
Rule 804(d). The options exchanges may have to amend these rules to 
conform to the Quote Rule's exception for unusual market conditions. 
See supra note 70 and accompanying text.
---------------------------------------------------------------------------

    In addition, a trade would not be considered a trade-through under 
the proposed rule when it occurs at a price inferior to a quote 
published by another market conducting a trading rotation for that 
options class, or when a customer order is executed as part of a 
trading rotation in that options class. During a trading rotation, each 
options series or class may not be open on all markets at the same time 
and may not be accessible. Moreover, two options exchanges have 
automated openings where their respective systems determine a single 
opening price and then automatically cross customer orders.\53\ As a 
result, orders that are on the book prior to the opening do not have a 
chance to interact with better quotes or orders published by other 
markets.
---------------------------------------------------------------------------

    \53\ See CBOE Rule 6.2A and PCX Rule 6.64.
---------------------------------------------------------------------------

    The Commission also is proposing that it not be considered to be a 
trade-through in the event that an exchange member attempts to access a 
better published quote for a customer order, but the market publishing 
the better quote fails to respond to the order routed to it within 30 
seconds of receiving the order, or the market publishing the better 
price experiences systems malfunctions that result in inaccessible 
quotes. In either case, the broker-dealer has attempted to access the 
superior published quote and has been unsuccessful. The Commission is 
proposing these exceptions because it does not believe that there is 
any value in requiring a broker-dealer to repeatedly attempt to access 
a clearly inaccessible quote.
    Finally, the Commission is proposing to exclude transactions 
executed as part of a complex trade from the proposed Trade-Through 
Disclosure Rule. A complex trade involves two or more transactions that 
are contingent on each other, such as a spread \54\ or a straddle.\55\ 
The Commission is proposing to exclude such trades from the 
requirements to disclose trade-throughs because it believes that 
customers using these complex-trading strategies understand that 
inherent in executing the component parts of such strategies is the 
possibility that they may not receive the best-published price for each 
component part of the trade.
---------------------------------------------------------------------------

    \54\ A spread is an investment strategy that generally involves 
the simultaneous purchase or sale of options on the same underlying 
stock with different strike prices or expiration dates or both.
    \55\ A straddle is an investment strategy that generally 
involves the simultaneous purchase and sale of an equal number of 
calls and puts on the same underlying security with identical strike 
prices and expiration dates.
---------------------------------------------------------------------------

    The Commission seeks comment on the propriety of the proposed 
exceptions to the proposed Trade-Through Disclosure Rule, and on 
whether there are any other circumstances in which a trade executed at 
a price inferior to a price offered on another market should 
nevertheless not be considered a trade-through for purposes of the 
proposed rule.
    The Commission also seeks comment on whether a trade-through 
disclosure requirement should apply to all trade-throughs, or only to 
trade-throughs of a material price or amount. This question is 
particularly important in a decimals trading environment, where quotes 
may be for a smaller size, and trade-throughs for smaller amounts, and 
with respect to large orders, where the quote size may be small in 
relation to the order. One possible response would be to allow broker-
dealers to include the size of the quote as part of the disclosure, so 
investors can better assess whether the size of the quote traded-
through is meaningful compared to the size of their orders. Another 
response would be to exempt large block orders from the disclosure 
requirement because of their size in relation to the quote, their 
special handling need, and the awareness by customers with block orders 
of the quality of executions they receive.
    d. Rejection of Absolute Prohibition on Trade-Throughs. The 
Commission considered whether to mandate a flat prohibition on trading 
at an inferior price. The Commission, however, was concerned, in part, 
that mandating a flat prohibition on trading at an inferior price would 
preclude investors from choosing to trade at an inferior price for 
reasons of better speed, size, or liquidity. The proposed rule would, 
instead, require that inferior executions be disclosed to investors, 
who would then be better informed and therefore better able to 
determine whether the quality of executions they receive are 
satisfactory.

B. Proposed Amendments to the Quote Rule

1. Background
    One of the first national market system initiatives implemented by 
the Commission in the equity markets was the Quote Rule, Exchange Act 
Rule 11Ac1-1.\56\ The Quote Rule requires all national securities 
exchanges and associations to establish procedures for collecting from 
their members bids, offers, and quotation sizes with respect to 
reported securities, and for making such bids, offers, and sizes 
available to quotation vendors. It also requires that quotation 
information made available to vendors be ``firm,'' subject to certain 
exceptions.
---------------------------------------------------------------------------

    \56\ See supra note 11.
---------------------------------------------------------------------------

    The reliability and availability of quotation information are basic 
components of a national market system \57\ and are needed so that 
broker-dealers are able to make best execution decisions for their 
customers' orders, and customers are able to make order

[[Page 47925]]

entry decisions. Quotation information has significant value to the 
marketplace as a whole because a quotation reflects the considered 
judgment of a market professional as to the various factors affecting 
the market, including current levels of buying and selling 
interest.\58\ Both retail and institutional investors rely on quotation 
information to understand the market forces at work at any given time 
and to assist in the formulation of investment strategies.
---------------------------------------------------------------------------

    \57\ See Securities Exchange Act Release No. 12670 (July 29, 
1976), 41 FR 32856 (1976) (proposing Exchange Act Rule 11Ac1-1).
    \58\ See Securities Exchange Act Release No. 11288 (March 11, 
1975), 40 FR 15015 (1975) (letter sent from the Commission to the 
registered national securities exchanges requesting that the 
exchanges eliminate rules that restrict their access to, or use of, 
quotation information that is provided by an exchange to a quotation 
vendor).
---------------------------------------------------------------------------

    By its terms, the Quote Rule currently does not apply to options. 
At the time the Quote Rule was adopted in 1978, standardized options 
had been listed and traded on the options exchanges for only a few 
years, and the Commission had imposed a moratorium that restricted the 
expansion of options trading.\59\ However, while the Commission 
intentionally excluded options from the requirements of the Quote Rule 
at that time, the Commission always thought that firm quotes ultimately 
should be required in the options markets. In 1980, when the Commission 
lifted the moratorium on options listings, it also set forth its vision 
on the future of options multiple trading, including the feasibility of 
firm quotes.\60\ Successful implementation of a linkage among the 
markets was thought to depend upon the quality and reliability of 
quotation information disseminated by each market center. At that time, 
however, the Commission believed that the imposition of a firm quote 
requirement was unworkable.\61\
---------------------------------------------------------------------------

    \59\ See supra notes 24 and 25 and accompanying text.
    \60\ See Moratorium Termination Release, supra note 34.
    \61\ In 1980, quotes were updated manually; thus, the options 
exchanges argued that it would be virtually impossible for a market 
maker to update its quotes in a timely fashion each time the 
underlying stock price moved.
---------------------------------------------------------------------------

    In conjunction with the Commission's adoption in 1989 of Rule 19c-5 
\62\ on multiple trading of options, the Commission published a Staff 
concept release that discussed options market structure issues 
associated with multiple trading, and outlined suggestions for possible 
market structure enhancements. At that time, the release emphasized 
that the availability and reliability of comprehensive quotation 
information for options are important elements in considering the 
concerns traditionally associated with multiple trading.\63\
---------------------------------------------------------------------------

    \62\ See Securities Exchange Act Release No. 26870, supra note 
28.
    \63\ See Securities Exchange Act Release No. 26871, supra note 
28.
---------------------------------------------------------------------------

    The release discussed whether the then-existing quote and trade 
reporting mechanism for options needed to be adapted for multiple 
trading by requiring that equity options quotes be firm. Market 
participants had, in the past, argued against a firm quote requirement 
in the options markets for a number of reasons.\64\ These concerns, 
however, were recognized as largely moot due to the development of 
autoquote \65\ and automatic execution \66\ systems, which indicated 
that firm quotes were, at the very least, possible.\67\
---------------------------------------------------------------------------

    \64\ One major concern of market participants was that due to 
the derivative nature of options, and the need to adjust quotes in 
numerous series in response to a single price change in the 
underlying security, it would be impossible, or at least 
impractical, to require options market makers to honor their 
disseminated quotes. Further, it was thought to be difficult for an 
exchange to identify which member of a trading crowd was responsible 
for a quote and to provide a mechanism for quotes to be modified or 
withdrawn.
    \65\ The autoquote systems enable options market professionals 
to update their quotes in numerous options series simultaneously.
    \66\ The automatic execution systems provide, in effect, firm 
quotes for public customer orders.
    \67\ See Securities Exchange Act Release No. 26871, supra note 
28.
---------------------------------------------------------------------------

    Today, each options market requires its market makers to have firm 
quotes for some types of orders.\68\ Therefore, the Commission believes 
that imposing a market-wide firm quote obligation on the options market 
participants should not be unduly burdensome. While the exchanges' firm 
quote rules and automatic execution systems provide their public 
customers with firm quote guarantees, these rules currently do not 
extend to other market participants. As described below, the 
Commission's proposal would modify the Quote Rule to require that 
options quotes be firm to both customers and other market participants.
---------------------------------------------------------------------------

    \68\ See generally Amex Rule 958A (requiring a specialist to 
sell/buy at least 10 contracts at the offer/bid displayed when the 
order reaches the trading post); CBOE Rule 8.51 (requiring a trading 
crowd to sell/buy at least the RAES contract limit applicable to a 
particular options class at the offer/bid displayed when a customer 
order reaches the trading station); PCX Rule 6.86 (requiring a 
trading crowd to provide a depth of 20 contracts for all non-broker-
dealer orders at the bid/offer disseminated at the time an order is 
announced at the trading post); Phlx Rule 1015 (requiring that 
public customer orders be filled at the best market for a minimum of 
10 contracts); and ISE Rule 804 (requiring a market maker to enter 
the number of contracts it is willing to buy or sell at in its quote 
and prohibiting a market maker from entering a bid or offer for less 
than 10 contracts).
---------------------------------------------------------------------------

    The Commission is proposing a firm quote rule for options in 
conjunction with the proposed Trade-Through Disclosure Rule to ensure 
that the published quotes of options exchanges are accessible to orders 
from both customers and broker-dealers.\69\ Currently, the options 
exchanges' quotes need not be firm for broker-dealer orders. Therefore, 
market markers on an exchange may not be able to trade with quotes on 
competing exchanges even when these market makers are representing 
customer orders. Yet market makers are expected to match the prices on 
competing exchanges or to trade with those quotes, before trading at an 
inferior price. The proposed Trade-Through Disclosure Rule is intended 
to reinforce efforts to honor the best-displayed price, and should 
encourage the development of improved methods to access better prices 
in other markets. A firm quote requirement for options is needed to 
ensure that these quotes will, in fact, be honored when orders are 
routed from other markets.
---------------------------------------------------------------------------

    \69\ Section 11A(c)(1) of the Exchange Act grants the Commission 
the authority to prescribe, among other matters, rules and 
regulations to assure accurate and reliable quotations ``with 
respect to any security other than an exempted security.'' 15 U.S.C. 
78k-1(c)(1). The Commission believes that extending the requirements 
of the Quote Rule to listed options will further these interests.
---------------------------------------------------------------------------

2. Proposed Amendments to the Quote Rule
    The Quote Rule currently requires that the best bid, best offer, 
and size for each market quoting any security covered by the Quote Rule 
be collected and publicly disseminated.\70\ These quotations must be 
firm, and a market maker, specialist, or other responsible broker or 
dealer generally is obligated to execute an order at a price at least 
as favorable as its published bid or offer up to the size of its 
published bid or offer.\71\

[[Page 47926]]

In addition, the Quote Rule requires responsible broker-dealers to 
supply quotations to their exchange or association for dissemination to 
quotation vendors.\72\ The Commission is proposing to expand the 
application of the Quote Rule to options traded on national securities 
exchanges.
---------------------------------------------------------------------------

    \70\ Exchange Act Rule 11Ac1-1(b) requires exchanges to 
establish and maintain procedures and mechanisms for collecting 
bids, offers, quotation sizes and aggregate quotation sizes from 
responsible brokers or dealers who are members of such exchange or 
association, processing such bids, offers and sizes, and making such 
bids, offers, and sizes available to quotation vendors. 17 CFR 
240.11Ac1-1(b). An exchange is relieved of its obligations to 
collect and disseminate quotation data if it determines pursuant to 
rules approved by the Commission that the level of trading 
activities or the existence of unusual market conditions is such 
that the exchange is incapable of collecting and disseminating 
quotation data and it notifies specified persons of that 
determination. 17 CFR 240.11Ac1-1(b)(3)(i). The Commission expects 
that each exchange would submit to the Commission for its approval 
proposed rule changes necessary to comply with the requirements of 
paragraph (b)(3) of Exchange Act Rule 11Ac1-1.
    \71\ This is referred to as the broker-dealer's ``firm quote'' 
obligation. The firm quote obligation under Exchange Act Rule 11Ac1-
1(c) requires a responsible broker-dealer to: (i) communicate to its 
exchange, pursuant to procedures established by that exchange, its 
best bids, offers and quotation sizes for any subject security; and 
(ii) execute any order to buy or sell a subject security presented 
to it by another broker-dealer at its published bid or offer in any 
amount up to its published quotation size, unless an exception 
applies. 17 CFR 240.11Ac1-1(c).
    \72\ Id.
---------------------------------------------------------------------------

    a. Proposed Amendments to Defined Terms. Exchanges, associations, 
and responsible broker-dealers have obligations under the Quote Rule 
only with respect to subject securities. The Commission is proposing to 
expand application of the Quote Rule to include transactions in listed 
options by amending the definition of the term ``reported security.'' 
As proposed, the term ``reported security'' would be modified to 
include any security or class of securities for which transaction 
reports are collected, processed, and made available pursuant to an 
effective transaction reporting plan \73\ or an effective national 
market system plan for reporting transactions in listed options.\74\ By 
proposing to broaden the definition of the term ``reported security'' 
to include listed options, \75\ the proposal would also include listed 
options within the definitions of ``covered security,'' \76\ 
``exchange-traded security,'' \77\ and ``subject security.'' \78\ Thus, 
options exchanges and market makers would be obligated to publish their 
quotes and, as importantly, be firm for those quotes.
---------------------------------------------------------------------------

    \73\ All national securities exchanges and national securities 
associations must file with the Commission a transaction reporting 
plan regarding transactions in listed equity and Nasdaq securities. 
See Exchange Act Rule 11Aa3-1(b)(1), 17 CFR 240.11Aa3-1(b)(1).
    \74\ Currently, the OPRA Plan is the only effective national 
market system plan that collects, processes, and makes available 
transaction reports for listed options.
    \75\ The Commission is proposing to define the term ``listed 
option'' in the Quote Rule by reference to Exchange Act Rule 15c3-
1(c)(2)(x)(B)(1), which defines ``listed option'' as any option 
traded on a registered national securities exchange or automated 
facility of a registered national securities association. 17 CFR 
240.15c3-1(c)(2)(x)(B)(1). See Proposed Exchange Act Rule 11Ac1-
1(a)(27).
    \76\ The term ``covered security'' is defined as any reported 
security and any other security for which a transaction report, last 
sale data or quotation information is disseminated through an 
automated quotation system as described in Section 3(a)(51)(A)(ii) 
of the Exchange Act, 15 U.S.C. 78c(a)(51)(A)(ii). See Exchange Act 
Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1(a)(6).
    \77\ The term ``exchange-traded security'' is defined as any 
covered security or class of covered securities listed and 
registered, or admitted to unlisted trading privileges, on an 
exchange. See Exchange Act Rule 11Ac1-1(a)(10), 17 CFR 240.11Ac1-
1(a)(10).
    \78\ Under the Quote Rule, the term ``subject security'' is 
defined to include any exchange-traded security other than a 
security for which the executed volume of such exchange, during the 
most recent calendar quarter, comprised one percent or less of the 
aggregate trading volume for such security as reported in the 
consolidated system. See Exchange Act Rule 11Ac1-1(a)(25), 17 CFR 
240.11Ac1-1(a)(25).
---------------------------------------------------------------------------

    In addition, the Commission is proposing to amend the definition of 
``consolidated system'' under Rule 11Ac1-1(a)(5) \79\ to include a 
transaction reporting system operating pursuant to an effective 
national market system plan. The effect of this proposed amendment is 
to make clear that listed options would only be ``subject securities'' 
with respect to an exchange or association if, during the most recent 
calendar quarter, the aggregate trading volume on such exchange or 
association is more than 1% of the aggregate trading volume as reported 
by OPRA.
---------------------------------------------------------------------------

    \79\ 17 CFR 240.11Ac1-1(a)(5).
---------------------------------------------------------------------------

    b. Quotation Size. Under the Quote Rule, each responsible broker or 
dealer is required to communicate to its exchange quotation sizes for 
any subject security,\80\ and exchanges are required to collect and 
make available to quotation vendors quotation sizes and aggregate 
quotation sizes for subject securities.\81\ Broker-dealers responsible 
for the quote must be firm up to its published size.\82\
---------------------------------------------------------------------------

    \80\ See supra note 71.
    \81\ See supra note 70.
    \82\ Each responsible broker or dealer, subject to certain 
exceptions, must execute any order to buy or sell a subject 
security, other than an odd-lot order, presented to it by another 
broker or dealer, or any other person belonging to a category of 
persons with whom such responsible broker or dealer customarily 
deals, at a price at least as favorable to such buyer or seller as 
the responsible broker's or dealer's published bid or offer in any 
amount up to its published quotation size. See Exchange Act Rule 
11Ac1-1(c)(2), 17 CFR 240.11Ac1-1(c)(2). This obligation is subject 
to certain exceptions. See Exchange Act Rule 11Ac1-1(c)(3), 17 CFR 
240.11Ac1-1(c)(3). In addition to the existing exceptions, the 
Commission is proposing to except responsible brokers or dealers 
from the firm quote requirements of proposed paragraph (d)(3)(i) if 
the order for the purchase or sale of a listed options is presented 
during a trading rotation in that listed option. Alternatives A and 
B, Proposed Exchange Act Rule 11Ac1-1(d)(3)(ii)(B).
---------------------------------------------------------------------------

    Because the options markets do not disseminate to quotation vendors 
the size associated with their bids and offers,\83\ the Commission is 
proposing two alternative amendments to the Quote Rule so that, at this 
time, broker-dealers and options exchanges would not be required to 
publish on a quote-by-quote basis the size associated with each 
quotation in listed options. Exchanges would, however, be required to 
establish by rule and periodically publish the size for which its best 
bid or offer in each options series \84\ that is listed on the exchange 
is firm. The Commission is proposing these exceptions to the Quote Rule 
because of the existing limitations of the options exchanges' systems 
and of the OPRA system. Instead, market participants would be furnished 
by the exchanges with information relating to the size associated with 
the quotes in a particular series, as they are today. While the 
proposal, as drafted, permits each exchange to determine the size 
associated with quotes on its market, the Commission seeks comment as 
to whether the Commission should establish a minimum number of 
contracts for which quotes must be firm.
---------------------------------------------------------------------------

    \83\ Currently, OPRA does not have the systems capability to 
collect and disseminate quotes with size. OPRA is, however, 
scheduled to have this capability by January 2001. Some options 
markets may, however, choose to continue not to disseminate quote 
size.
    \84\ The Commission is proposing to define the term ``option 
series'' in the Quote Rule. Under proposed Exchange Act Rule 11Ac1-
1(a)(28), the term ``option series'' means contracts in an options 
class that have the same unit of trade, expiration date, and 
exercise price, and other terms or conditions.
---------------------------------------------------------------------------

    Commenters should also address whether the Commission should 
mandate that size be disseminated with each quotation. Comment on this 
issue was solicited at the time the Commission published for comment 
linkage plans submitted by the options markets. In response, the 
majority of commenters that addressed this issue favored the 
development of a system to provide the dissemination of quotes with 
size.\85\ Some of those commenters, however, stated that quotations 
with size should not be required as part of a linkage plan.\86\ Two of 
these commenters noted the desirability of disseminating quotes with 
size, but questioned whether existing options quotation systems would 
be able to handle quotes with size in the near future.\87\
---------------------------------------------------------------------------

    \85\ Donahue Letter; Ianni Letter; Amex Letter; Susquehanna 
Letter; Pershing Letter; SIA Letter; CBOE Letter; and Charles Schwab 
Letter.
    \86\ Amex Letter; Susquehanna Letter; Pershing Letter; SIA 
Letter; and CBOE Letter.
    \87\ Susquehanna Letter and SIA Letter.
---------------------------------------------------------------------------

    Under both alternatives being proposed, if the rules of the 
exchange do not require its members to communicate to it quotation 
sizes for listed options, a responsible broker or dealer that is a 
member of that exchange would be relieved of its obligations under the 
Quote Rule to communicate to such exchange its quotation sizes for any 
listed option that is a subject security. Instead, each responsible 
broker or dealer would satisfy its firm quote obligation by executing 
any order to buy or sell a listed option that is a subject

[[Page 47927]]

security, in an amount up to the size established by the exchange's 
rules.\88\
---------------------------------------------------------------------------

    \88\ Alternatives A and B, Proposed Exchange Act Rule 11Ac1-
1(d)(2).
---------------------------------------------------------------------------

    The two alternatives differ, however, in the flexibility that 
exchanges would have to establish the size for which its bid and offer 
is firm. Under proposed Alternative A, the size for which an exchange's 
best bid or offer is firm, as established by exchange rule, would have 
to be the same for orders received from customers as for orders 
received from broker-dealers.\89\ Under proposed Alternative B, 
however, an exchange could establish different firm quote sizes for 
customer orders than for broker-dealer orders.\90\
---------------------------------------------------------------------------

    \89\ Alternative A, Proposed Exchange Act Rule 11Ac1-1(d)(1).
    \90\ Alternative B, Proposed Exchange Act Rule 11Ac1-
1(d)(1)(ii).
---------------------------------------------------------------------------

    The Commission is soliciting comment on the circumstances under 
which it is appropriate for exchanges to be permitted to establish 
rules that allow options market makers to be firm for broker-dealer 
orders in a size different than that for which they are firm for 
customer orders. In particular, should the Commission establish a 
minimum size for which options market makers' quotes must be firm for 
broker-dealer orders? The Commission would also like commenters views 
on whether the size for which options market makers' quotes are firm 
for customer orders should be the same, regardless of whether the 
orders are executed through an exchange's automatic execution system or 
otherwise.
    c. Proposed Thirty Second Response Requirement. As discussed above, 
under the proposed Trade-Through Disclosure Rule, if a responsible 
broker or dealer fails to respond to an incoming order within the 30 
seconds required pursuant to the Quote Rule, the routing broker or 
dealer may execute its customer's order at its own inferior quote and 
would not be required to disclose the unresponsive quote to its 
customer as a trade-through.\91\ The Commission's 30-second proposal is 
based on the trade-through provisions of the Amex/CBOE/ISE plan, under 
which broker-dealers are excepted from trade-through liability when a 
receiving market fails to respond to an incoming linkage order within 
30 seconds.\92\
---------------------------------------------------------------------------

    \91\ Proposed Exchange Act Rule 11Ac1-7(b)(4)(vii).
    \92\ See Amex/CBOE/ISE plan Section 8(c)(iii)(B).
---------------------------------------------------------------------------

    As a complement to this provision, the Commission is proposing to 
require each responsible broker or dealer to respond to an order to buy 
or sell a listed option within 30 seconds by either: (i) Executing the 
entire order; or (ii) executing at least that portion of the order 
equal to the applicable firm quote size and revising its bid or 
offer.\93\ A responsible broker's or dealer's applicable firm quote 
size would be its published quote size or, if a responsible broker or 
dealer has been relieved of the obligation to publish quote size, the 
minimum firm quote size established by its exchange's rules. If, as 
provided in Alternative B, an exchange is permitted to set different 
firm quote sizes for orders received from customers than for orders 
received from broker-dealers, a responsible broker's or dealer's 
applicable firm quote size could be different for customer orders than 
for broker-dealer orders.\94\
---------------------------------------------------------------------------

    \93\ Alternatives A and B, Proposed Exchange Act Rule 11Ac1-
1(d)(3).
    \94\ Alternative B, Proposed Exchange Act Rule 11Ac1-
1(d)(1)(ii).
---------------------------------------------------------------------------

    For example, if Market Maker A is not required to publish a 
quotation size but Market Maker A's exchange requires Market Maker A to 
be firm for customer orders up to 20 contracts, Market Maker A must 
respond within 30 seconds to a customer order for 30 contracts by 
filling the order for an amount equal to at least 20 contracts. If 
Market Maker A executes the entire order for 30 contracts, Market Maker 
A would not be obligated to move its quote. If Market Maker A executes 
only the part of the order representing its firm quote guarantee (i.e., 
20 contracts), Market Maker A would be required to move its quote to an 
inferior price.
    The Commission preliminarily believes that it is appropriate to 
establish a time limit in which a broker-dealer that routes an order to 
another broker-dealer's quote must wait before being able to execute 
its customers' orders at its own inferior quote without being required 
to disclose the subsequent execution as a trade-through. If a market 
that is displaying a quote fails to respond to an incoming order that 
seeks execution at the displayed quote, the Commission believes it 
would be unreasonable to require a broker that executes its customer 
order at its own inferior quote to incur trade-through disclosure 
responsibility. Further, the Commission does not want to unduly delay 
the execution of orders by requiring a broker-dealer to wait an 
unreasonable amount of time for a response from an away market before 
it can execute the order without incurring disclosure responsibility. 
Thus, any time period that is established must balance the need for 
price priority against the need for efficient execution of orders.
    Commenters should address the propriety of the proposed 
modification to the Quote Rule that would require a response within 30 
seconds from a market that has published the best quote. Specifically, 
is it appropriate to have a specified time frame? If so, is 30 seconds 
appropriate, or is there another time frame, such as 15 seconds, or 45 
seconds, that would be more appropriate?

IV. General Request for Comment

    The Commission seeks comment on the proposals described in this 
release. In addition to the specific requests for comment throughout 
the release, the Commission asks commenters to address whether the 
proposed amendments to the Quote Rule and proposed Trade-Through 
Disclosure Rule would further the national market system goals set out 
in Section 11A of the Exchange Act,\95\ and, in particular, the goals 
of assuring ``the practicability of brokers executing investors' orders 
in the best market.'' Commenters are also asked to address whether 
disclosure to customers about the execution of their orders at a price 
that trades through another market is an adequate substitute for 
requiring that all customers' orders receive trade-through protection 
by mandating a linkage among the options markets.
---------------------------------------------------------------------------

    \95\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

    In addition, the Commission seeks comment on whether it should 
order the options exchanges to become participants in the Amex/CBOE/ISE 
plan or any other linkage plan.
    Commenters may also wish to discuss whether there are any legal or 
policy reasons why the Commission should consider a different approach. 
For purposes of the Small Business Regulatory Enforcement Fairness Act 
of 1996,\96\ the Commission is also requesting information regarding 
the potential impact of the proposed amendments and rules on the 
economy on an annual basis. If possible, commenters should provide 
empirical data to support their views.
---------------------------------------------------------------------------

    \96\ Pub. L. No. 104-121, 110 Stat. 857.
---------------------------------------------------------------------------

V. Paperwork Reduction Act

    Certain provisions of the proposed rules contain ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995,\97\ and the Commission has submitted them to the 
Office of Management and Budget (``OMB'') for review in accordance with 
44 U.S.C. 3507(d) and 5 C.F.R. 1320.11. The Commission is proposing 
amendments

[[Page 47928]]

to the collection of information titled ``Rule 11Ac1-1, Dissemination 
of Quotations'' (OMB Control Number 3235-0461). The Commission is also 
proposing to create a new information collection entitled ``Rule 11Ac1-
7, Trade-Through Disclosure Rule.'' An agency may not conduct or 
sponsor, and a person is not required to respond to, a collection of 
information, unless it displays a currently valid OMB control number.
---------------------------------------------------------------------------

    \97\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collection of Information

    The proposed Trade-Through Disclosure Rule, proposed Exchange Act 
Rule 11Ac1-7, would require a broker-dealer to disclose to a customer 
when its order is executed at a price inferior to a better published 
price on another market, as well as the better price. However, a 
broker-dealer would not be required to provide such disclosure to its 
customer if it effects the customer's transaction on a market that 
participates in an approved linkage plan that includes provisions 
reasonably designed to limit customers' orders from being executed at 
prices that trade through a better published price.
    The Quote Rule, Rule 11Ac1-1, was adopted pursuant to Exchange Act 
Sections 2, 3, 5, 6, 9, 10, 11A, 15, 15A, 17, and 23. The proposed 
amendment to Exchange Act Rule 11Ac1-1 would require markets to 
establish procedures for collecting their members' bids, offers, and 
quotation sizes for options traded on a national securities exchange or 
an automated facility of a registered national securities association. 
The proposed amendment also would require that the quotation 
information made available to vendors be firm, subject to certain 
exceptions.

B. Proposed Use of Information

    The proposed Trade-Through Disclosure Rule information would be 
used by customers to evaluate the quality of the trade executions they 
receive. It would also be used by broker-dealers to evaluate and make 
determinations related to their best execution obligations. The 
Commission and options markets would use the information collected 
pursuant to the proposed rule for enforcement inquiries or 
investigations and trading reconstructions, as well as for inspections 
and examinations.
    Customers of broker-dealers, as well as other market participants, 
would use the firm quote information to determine the best prices 
available for, and level of trading interest in, listed options 
trading. The Commission and options markets would use the firm quote 
information for enforcement inquiries or investigations and trading 
reconstructions, as well as for inspections and examinations of broker-
dealers.

C. Respondents

    While the proposed Trade-Through Disclosure Rule generally would 
apply to all of the approximately 7,500 broker-dealers that were 
registered with the Commission as of December 31, 1999, of which 
approximately 3,800 broker-dealers conduct business with the general 
public, most provisions would apply only to the less than 330 broker-
dealers that clear customer accounts pursuant to Exchange Act Rule 
15c3-3.\98\ The proposed amendments to the Quote Rule would apply to 
the approximately 1,044 broker-dealers registered with the Commission 
that function as options market makers or specialists.\99\
---------------------------------------------------------------------------

    \98\ 17 CFR 240.15c3-3.
    \99\ The number of specialist and market makers was determined 
by counting the number of registered broker-dealers that report non-
zero market making profits or losses in their FOCUS reports.
---------------------------------------------------------------------------

D. Total Annual Reporting and Recordkeeping Burden

1. Proposed Trade-Through Disclosure Rule
    a. Capital Costs. If a broker-dealer effects trades on a market 
that participates in a linkage plan with provisions reasonably designed 
to limit trade-throughs, including trade-throughs of prices on unlinked 
markets, the broker-dealer has no paperwork capital costs under the 
proposed Trade-Through Disclosure Rule.
    However, the proposed Trade-Through Disclosure Rule would require 
broker-dealers to make certain disclosures to customers if the broker-
dealer effects trades on markets that do not participate in a linkage 
plan. Broker-dealers would incur paperwork costs to modify systems to 
permit them to receive information about when a trade-through has 
occurred and the price that was traded through. Further, broker-dealer 
systems would have to be modified to ensure that information about 
trade-throughs is matched with correct customer accounts, thus 
permitting broker-dealers to disclose to customers when trade-throughs 
occur.
    Because broker-dealer processes, systems capability, and customer 
bases vary so widely, it is difficult to provide an estimated cost with 
which all parties will agree. Nevertheless, the Commission estimates 
that it would take a computer programmer at an hourly rate of 
approximately $50 \100\ between 500 and 1,000 hours \101\ to modify the 
average broker-dealer's systems to receive trade-through information, 
at a cost of between $25,000 and $50,000 for each broker-dealer. There 
are approximately 7,500 broker-dealers that were registered with the 
Commission as of December 31, 1999. Of those, approximately 3,800 
broker-dealers conduct business with the general public. Most 
introducing firms, however, rely on their clearing firms to generate 
confirmation statements for customers.\102\ As a result, fewer than 330 
broker-dealers would actually have to modify their systems, should any 
systems modifications be necessary. However, if all 330 registered 
broker-dealers that clear customer accounts pursuant to Exchange Act 
Rule 15c3-3 \103\ were required to make these systems modifications, 
the one-time paperwork cost is estimated to be between $8,250,000 and 
$16,500,000.
---------------------------------------------------------------------------

    \100\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See Report on 
Management and Professional Earnings in the Securities Industry 
1999, published by the SIA (``SIA Report'').
    \101\ The Commission estimates that it would take each broker-
dealer that provides confirmation statements to customers between 
500 and 1,000 hours to complete the required systems modifications.
    \102\ The Commission estimates that none of the 41 small broker-
dealers who do not have a relationship with a clearing firm 
regularly represent customer options orders.
    \103\ 17 CFR 240.15c3-3.
---------------------------------------------------------------------------

    The Commission notes, however, that it is quite possible that the 
participants in the approved linkage plan would amend the plan to 
adequately limit trade-throughs, and that the Phlx and PCX would choose 
to join the linkage plan or submit their own linkage plan for 
Commission approval. If all options markets participate in a linkage 
plan that includes provisions reasonably designed to limit trade-
throughs, no systems modifications would be necessary and broker-
dealers would incur no paperwork costs.
    b. Burden Hours. If a broker-dealer effects trades on a market that 
participates in a linkage with provisions reasonably designed to limit 
trade-throughs, including trade-throughs of prices on non-linked 
markets, the broker-dealer would have no paperwork burden under the 
proposed Trade-Through Disclosure Rule.
    However, the proposed Trade-Through Disclosure Rule would require 
broker-dealers to make certain disclosures to customers if the broker-
dealer effects trades on markets that do not participate in a linkage 
that has provisions reasonably designed to limit

[[Page 47929]]

trade-throughs. Specifically, if a customer order was traded-through, a 
broker-dealer would be required to disclose the trade-through to the 
customer. Currently, approximately 21,000,000 trades in multiply-listed 
options classes occur each year.
    If the Amex, CBOE, and ISE amend their linkage plan to comply with 
the proposed Trade-Through Disclosure Rule's alternative to disclosure 
of trade-throughs, and the Phlx and PCX choose not to join the Amex/
CBOE/ISE plan and also choose not to submit for Commission approval 
another linkage plan, the Commission estimates that approximately one-
third of all trades annually, or 7,000,000 trades, in multiply-listed 
options classes would be subject to the disclosure requirement of the 
proposed Trade-Through Disclosure Rule. Of those 7,000,000 trades, the 
Commission estimates that as many as 5%, or 350,000 trades, would 
involve intermarket trade-throughs. For each trade-through, it is 
assumed that broker-dealers' systems would have already been 
reprogrammed to receive information about trade-throughs and to 
appropriately disclose such trade-throughs to their customers on the 
customer confirmation statements. Therefore, the Commission estimates 
that the paperwork burden of the disclosure for broker-dealers would be 
nominal because it would merely require a small amount of additional 
information on customer confirmation statements.
    The Commission notes, however, that it is quite possible that the 
participants in the approved linkage plan would amend the plan to 
adequately limit trade-throughs, and that the Phlx and PCX will choose 
to join the linkage plan or submit their own linkage plan for 
Commission approval. If all options markets participate in a linkage 
plan that is reasonably designed to limit trade-throughs, there may 
ultimately be no paperwork burden associated with the proposed Trade-
Through Disclosure Rule.
2. Proposed Amendments to the Quote Rule
    a. Capital Costs. Applying the Quote Rule to options trading would 
require options self-regulatory organizations (``SROs'') to collect 
bids and offers from their members. However, SROs generally are 
obligated already, pursuant to their participation in the OPRA plan, to 
collect bids and offers, and send them to OPRA for dissemination. To 
comply with the amended Quote Rule, SROs would be required to 
periodically publish the size (or sizes, if different categories are 
used) for which a quote must be firm. In addition, under the amended 
Quote Rule, SROs would be required to file proposed rule changes to 
identify unusual market conditions. The options markets would incur 
one-time costs to file and obtain approval of these rule changes, as 
well as other related rules. The Commission estimates that the five 
options SROs would need to file two rule changes initially to comply 
with the proposed amendments to the Quote Rule, for a total of 10 rule 
changes. The Commission estimates that a routine rule change requires 
approximately 25 hours of legal review at an hourly cost of 
$98.25,\104\ plus one hour of secretarial time at an hourly cost of 
$30.40,\105\ for a total cost of $2,487 per proposed rule change 
submitted for Commission approval. Therefore, the Commission estimates 
that the aggregate cost of two proposed rule changes filed by each of 
the five options SROs would total approximately $24,867.
---------------------------------------------------------------------------

    \104\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See SIA Report 
supra note 100.
    \105\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See Report on 
Office Salaries in the Securities Industry 1999.
---------------------------------------------------------------------------

    Broker-dealers that are market-makers or specialists have existing 
obligations under SRO rules to communicate their bids and offers to 
their SROs, and already do so. Therefore, broker-dealers would incur no 
additional paperwork costs from the amended Quote Rule beyond those 
related to systems changes, discussed below, to comply with the amended 
Quote Rule. Specifically, market makers and specialists may, to comply 
with the amended Quote Rule, change their quote-setting practices by 
changing the factors used to establish quotes through automated quoting 
systems (i.e., resetting the parameters). The Commission notes that 
almost all option quotes are currently set by automated quoting 
systems. The Commission estimates broker-dealer systems changes made to 
comply with the amended Quote Rule would require changes estimated to 
take approximately three to five minutes per options class. As there 
are approximately 3,000 options classes eligible for multiple listing, 
the Commission estimates that the total burden for one market could 
range from 180 to 250 hours. For all five markets, the total burden 
could range from 900 to 1,255 hours. The hourly rate of an exchange 
clerk that would make the required system changes is $32.50; \106\ 
therefore, the total cost for these changes could range from $29,250 to 
$40,787.
---------------------------------------------------------------------------

    \106\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See SIA Report 
supra note 100.
---------------------------------------------------------------------------

    b. Burden Hours. SROs may amend their rules to comply with the 
Quote Rule from time to time. The Commission estimates that the five 
options SROs would amend their respective rules at most once per year, 
for a total of five proposed rule changes. The Commission estimates 
that a routine proposed rule change takes 25 hours of legal review at 
an hourly cost of $98.25 \107\ plus one hour of secretarial time at an 
hourly cost of $30.40,\108\ for a total cost of $2,487 per proposed 
rule change. Therefore, the total annual cost of five SRO proposed rule 
changes would impose a burden of $12,433.
---------------------------------------------------------------------------

    \107\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See SIA Report 
supra note 100.
    \108\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See Report on 
Office Salaries in the Securities Industry 1999.
---------------------------------------------------------------------------

    Broker-dealers would not incur any additional paperwork cost from 
the Quote Rule beyond the systems changes discussed above. Market-
makers and specialists are already required to make and provide quotes 
in options to their SROs. As a result, amending the Quote Rule to 
include options would require only that market makers and specialists 
be firm for their quotes, which would impose no additional paperwork 
burden on them.

E. General Information about the Collection of Information

    Any collection of information pursuant to the proposed rules would 
be mandatory. Market centers that are national securities exchanges or 
national securities associations would be required to retain the 
collections of information required under the proposed Trade-Through 
Disclosure Rule and the amended Quote Rule for a period of not less 
than five years, the first two years in an easily accessible place. 
Broker-dealers would be required to retain the collections of 
information for a period of not less than three years, the first two 
years in an easily accessible place.
    The information collected pursuant to the Quote Rule would be held 
by the broker-dealers and markets. The Commission and other securities 
regulatory authorities would obtain possession of the information only 
upon request. The information collected pursuant to the proposed Trade-
Through Disclosure Rule would be sent

[[Page 47930]]

to customers and also retained by the broker-dealers. The Commission, 
SROs, and other securities regulatory authorities would obtain 
possession of the information only upon request. Any collection of 
information that is received by the Commission, SROs and other 
securities regulatory authorities, would not be disclosed under the 
terms of the proposal, subject to the provisions of the Freedom of 
Information Act, 5 U.S.C. 552.

F. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to: (1) Evaluate whether the proposed collection of 
information is necessary for the proposed performance of the functions 
of the agency, including whether the information shall have practical 
utility; (2) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collection of information; (3) enhance the 
quality, utility, and the clarity of the information to be collected; 
and (4) minimize the burden of collection on those who are to respond, 
including through the use of electronic or automated collection 
techniques or other forms of information technology.
    Persons wishing to submit comments on the collection of information 
requirements should direct them to the following persons: (1) Desk 
Officer for the Securities and Exchange Commission, Office of 
Information and Regulatory Affairs, Office of Management and Budget, 
Washington, D.C. 20503; and (2) Jonathan G. Katz, Secretary, Securities 
and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 
20549-0609, with reference to File No. S7-17-00.
    The Commission has submitted the proposed collection of information 
to OMB for approval. Members of the public should direct any general 
comments to both the Commission and OMB within 30 days. OMB is required 
to make a decision concerning the collection of information between 30 
and 60 days after publication in the Federal Register, so a comment to 
OMB is best assured of having its full effect if OMB receives it within 
30 days of publication of this release. Requests for the materials 
submitted to OMB by the Commission with regard to this collection of 
information should be in writing, refer to File No. S7-17-00, and be 
submitted to the Securities and Exchange Commission, Records 
Management, Office of Filings and Information Services, 450 Fifth 
Street, N.W., Washington, D.C. 20549-0609.

VI. Costs and Benefits of Proposed Rules

    As discussed above, the Commission is proposing a new rule--the 
Trade-Through Disclosure Rule--and amendments to the Quote Rule to 
provide customers with more information with which to evaluate the 
quality of executions achieved by their broker-dealers and to require 
that quotes for listed options be firm. Together, these rules would 
provide incentives for the options exchanges and their members to 
develop mechanisms to reduce the frequency of intermarket trade-
throughs, but would not mandate the form of mechanism employed.
    The Commission has identified below certain costs and benefits to 
the proposed Trade-Through Disclosure Rule and the proposed amendments 
to the Quote Rule. The Commission requests comment on all aspects of 
this cost-benefit analysis, including identification of additional 
costs or benefits of the proposed changes. The Commission encourages 
commenters to identify or supply any relevant data concerning the costs 
or benefits of the proposed amendments.

A. Costs and Benefits of the Proposed Trade-Through Disclosure Rule

    The proposed Trade-Through Disclosure Rule would require a broker-
dealer to disclose to its customer (on the confirmation statement) when 
a trade-through has occurred. A broker-dealer would not be required to 
make this disclosure if the trade was effected on a market that is a 
participant in a Commission-approved intermarket linkage plan that 
contains provisions reasonably designed to limit trade-throughs.
1. Benefits
    A trade-through is costly to an investor primarily because the 
investor receives an execution at a price that is not the best price 
available. A trade-through also has potential costs for the broker-
dealer or customer responsible for the best quote because that quote or 
customer order does not receive the execution it would have if the 
order that was executed at a price inferior to the best quote were 
instead routed to it. Consequently, trade-throughs may increase the 
incidence of unexecuted customer limit orders.
    The staff estimates that approximately 5% of all trades (or 7,964 
trades for a total of 156,403 contracts) in the 50 most active 
multiply-listed option classes took place at prices inferior to the 
best price quoted on a competing exchange during the week of June 26, 
2000.\109\ To better describe the execution quality of small customer 
orders, the staff also estimates that 1% of all automatic execution 
trades (or 464 automatic execution trades for a total of 2,336 
contracts) in the 50 most active multiply-listed option classes took 
place at prices inferior to the best price quoted on a competing 
exchange during the week of June 26, 2000.\110\
---------------------------------------------------------------------------

    \109\ The staff relied on data from OPRA for this analysis. All 
trades marked as spreads, straddles, late or stopped were excluded 
from the sample. To determine the quote in effect at the time of the 
trade, the highest offer and lowest bid on each competing exchange 
for a period of one minute prior and two minutes after the reported 
execution were identified. Quotes from an exchange that indicated it 
was experiencing fast market conditions during the time when the 
trade was executed were not included. Quotes that indicated that an 
option class was in rotation were also excluded. The staff 
recognizes that not all these trades in the sample could be fully 
executed at the best available quoted price because of size or other 
factors.
    \110\ Trades executed through automatic execution systems 
account for about 36% of all trades and about 12% of all contracts 
traded in the 50 most active multiply-traded options classes during 
the week of June 26, 2000. The procedure used for the analysis of 
automatic execution trades is similar to that described for all 
trades, except only automatic execution trades are included.
---------------------------------------------------------------------------

    Investors would benefit from the proposed Trade-Through Disclosure 
Rule because they would be informed of whether their orders were 
executed at a price inferior to the best available price. With that 
information, investors would have the opportunity to reduce the 
likelihood that their orders would be executed at a price inferior to a 
price displayed by another market, by selecting broker-dealers that 
effect their transactions on markets that are participants in a linkage 
plan with provisions reasonably designed to limit trade-throughs. If 
all orders executed through automatic execution systems were executed 
at the best-published quote (i.e., trade-throughs of automatic 
execution trades were eliminated), the estimated annual savings to 
investors trading through exchanges' automatic execution systems would 
be approximately $11,000,000 each year.\111\ If all trades were 
considered, the elimination of trade-throughs would result in 
substantially higher annual savings to investors.\112\
---------------------------------------------------------------------------

    \111\ The annual benefit estimate is obtained by applying the 
staff's trade-through findings for automatic execution trades in the 
50 most active multiply-traded options classes to all multiply-
listed classes and extending the results from one week to a full 
year.
    \112\ The Commission estimates the benefits of executing a 
maximum of 20 contracts at the best-quoted price for those trades 
identified as trade-throughs could total several hundred million 
dollars per year.
---------------------------------------------------------------------------

    The Commission requests comment on whether there is a better 
measure for

[[Page 47931]]

determining the benefits of the proposed rule than the evaluation of 
the trades currently executed at a price inferior to the best published 
quote. Commenters are also invited to express their views on the 
estimate of the number of trades executed at inferior prices. Would 
options exchanges' audit trail data, rather than OPRA data, provide a 
better estimate of the number and cost of trade-through executions? Is 
it possible to estimate the price and number of contracts that an order 
would have received had it been routed to an exchange showing a 
superior price? Is the week of June 26, 2000 representative of general 
trading patterns? Finally, the Commission would like commenters' views 
on investors' likely response to order confirmation statements 
disclosing that their orders were executed at prices inferior to the 
best prices available in the market, and the impact of such response.
2. Costs
    The proposed rule may require broker-dealers and markets to incur 
capital costs, such as one-time costs to modify existing systems. For 
example, the proposal could impose one-time costs on markets and 
broker-dealers that must modify systems to determine when trade-
throughs have occurred and to issue notifications to customers of 
trade-throughs. Further, to identify when an order trades through a 
posted quote, information systems would need to be developed that could 
identify the displayed quotes at the time of execution. Because the 
Commission would allow broker-dealers to rely on notifications from the 
markets when trade-throughs occur and the quote at that time, the costs 
of such information systems may be borne by the options markets. The 
Commission seeks comment on the costs of implementing such systems. The 
Commission requests commenters' views on whether the current OPRA feed 
is adequate to identify quotes from options markets. Would information 
in addition to the quote need to be made available to broker-dealers by 
the options markets? If so, the Commission requests comment on the 
anticipated costs of providing such information.
    In addition, implementing the proposed rule could require broker-
dealers to change the content of customer confirmation statements, 
issued in either electronic or paper form. The Commission requests 
estimates of the costs of changing customer confirmation statements. An 
alternative to changing confirmation statements would be for broker-
dealers to route orders to exchanges participating in an approved 
linkage plan. Although the proposed rule does not require the 
implementation of such a plan, it does envision that an approved plan 
could be implemented.
    Thus, one possible cost to the options markets of the Trade-Through 
Disclosure Rule could be a one-time cost to establish a linkage. In 
addition to the capital costs of establishing the linkage, costs could 
include regulatory costs, such as obtaining Commission approval of a 
linkage and of SRO rule changes necessary to implement a linkage. 
Further, there may be economic implications if a market chooses to 
participate in an approved linkage plan, because members may then be 
more likely to route orders to other exchanges that are quoting a 
better price.
    The Commission estimates that capital costs for a linkage plan 
range from $1,000,000 to $1,500,000 initially, and yearly costs could 
range from $300,000 to $1,000,000. The Commission requests comment on 
the costs of developing a linkage between the markets, as well as the 
costs for individual markets to integrate their systems into such a 
plan.

B. Costs and Benefits of Proposed Amendments to the Quote Rule

    The Commission proposes to amend the Quote Rule so that it applies 
to trading in listed options. The proposal makes certain accommodations 
for the fact that options markets do not currently disseminate to 
quotation vendors the size of their quotes. The Commission also 
proposes an alternative that would allow broker-dealers to be firm in 
different sizes for customer and broker-dealer orders. Finally, the 
proposal would require a broker-dealer to respond to an incoming order 
within 30 seconds by either: (1) Executing the order in full; or (2) 
partially executing the order up to the firm quote size and updating 
its quote.
1. Benefits
    Amending the Quote Rule would eliminate discrepancies between the 
treatment of quotes in the options markets and the equity markets. 
Although options trading is not currently covered by the Commission's 
Quote Rule, each exchange's rules require their members' quotes to be 
firm up to a certain minimum size and establish the process for 
handling orders in excess of the exchange's firm quote size. Exchange 
rules also establish whether members' quotes must be firm for all 
orders or only some orders, such as only for public customer orders.
    The Commission believes that applying the Quote Rule to options 
trading would provide a number of benefits. Firm quotes reduce 
uncertainty surrounding order routing decisions for broker-dealers that 
are seeking to fill customer orders at the best available price. If 
broker-dealers are confident that quotes are firm, investor orders may 
be routed to the market with the best price and receive an execution at 
that price. Under current practices, because broker-dealers cannot be 
confident that a price on another market is firm (due to existing 
market rules, including trade-or-fade rules), orders do not always 
receive the best available price. As discussed above, the staff 
estimates that 5% of all trades in the 50 most active multiply-listed 
classes took place at prices inferior to the best price quoted on a 
competing market during a one-week period in June 2000. Broker-dealers 
often state that such trade-throughs occur when market makers trade at 
inferior prices because they believe the better price on the other 
market may not be firm and the quote may ``fade'' if the broker-dealer 
were to attempt to execute against it. By requiring that posted prices 
be firm, a great deal of uncertainty about order execution quality 
could be reduced. This would be true even if the quote were permitted 
to be firm for different sizes for customer orders than for broker-
dealer orders. The Commission is unable to quantify these benefits, and 
therefore requests comment and estimates.
    In addition to providing certainty to broker-dealers making order 
routing decisions and seeking to fill orders at the best available 
price, extending the Quote Rule to the options markets may benefit 
broker-dealers by enhancing their ability to satisfy their regulatory 
obligations, including best execution. The Commission is unable to 
quantify these benefits, and therefore requests comment and estimates.
    The Commission also believes that the proposed amendments to the 
Quote Rule would bolster investor confidence in the options markets by 
ensuring that quotes made by market participants are available for a 
specified number of options contracts, thus providing greater certainty 
for investors. In addition, by requiring the quotations in listed 
options to be firm, the proposed amendments may also lead to better 
informed investors, also increasing investor confidence in the market. 
The Commission requests comment and estimates on any other benefits 
that would result from applying the Quote Rule to options trading.
    Specifically, the Commission requests comment on whether investors 
(including broker-dealers) have

[[Page 47932]]

experienced problems with the execution of their orders because options 
quotes have not proven to be firm. If so, how widespread are these 
problems and to what extent do they presently occur? Do these problems 
encourage broker-dealers to route orders to markets displaying inferior 
prices? The Commission also requests any data or information on the 
number of trades executed at inferior prices. Is it possible to 
estimate the price and quantity that a trade would have received had it 
been routed to a market showing a superior price?
    Another benefit of applying the Quote Rule to options trading is 
that it would likely increase competition between markets. Because all 
quotes would be firm, a market participant would know that a posted 
quote that is superior to the best-published quote would be recognized 
as firm. Therefore, the posted quote may attract order flow. The 
ability to attract order flow with a market-improving quote encourages 
intermarket price competition, which benefits investors. The Commission 
requests comment on whether firm quotes would affect order routing 
decisions, including information and data about the impact, if any.
    Currently, options markets do not disseminate quotes with size. 
Options markets determine the size for which their market makers or 
specialists must be firm. The proposed amendment to the Quote Rule 
would require each market to establish and periodically publish the 
sizes for which market makers or specialists must be firm. The 
Commission requests comment on the costs and benefits of permitting 
options markets to require different minimum sizes for customer orders 
than for broker-dealer orders. Would this help avoid market makers 
widening their spreads to protect themselves from other market 
professionals? Is it possible to quantify the benefits of having 
different minimum size requirements for customer and broker-dealer 
orders? What is the current experience with differential treatment for 
customer and broker-dealer orders, with particular regard to the 
markets' minimum size and auto-execution eligibility rules?
    The Commission believes the proposed amendments to the Quote Rule 
will benefit investors whose orders, upon arrival at the options 
market, are either: (1) delayed, but then executed, or (2) delayed and 
never executed. The Commission further believes that its proposal would 
result in (1) fewer unexecuted investor orders due to quote changes 
after order arrival, or (2) fewer orders executed at prices less 
favorable to the investor than those prevailing at the time of order 
arrival. The Commission requests comment on the extent to which order 
execution is delayed following order arrival at a market, particularly 
for orders requiring manual execution. What execution prices do delayed 
orders receive relative to the quotes at order arrival? How many orders 
are cancelled due to delays incurred prior to exposure to the market?
    Finally, the proposed rule would provide a similar standard for 
firm quotes in both equity and option markets. Does the current 
regulatory environment create confusion for investors experiencing 
different firm quote rules in different markets? If such confusion 
exists, what are the benefits that would be achieved by eliminating the 
confusion? Do investors have incorrect expectations about the nature of 
quotes in options markets? If so, do these incorrect expectations have 
a cost?
2. Costs
    Applying the Quote Rule, as proposed, to options trading would 
require markets to collect bids and offers from their members. This 
would not impose a significant burden on markets because bids and 
offers generally are collected already by the markets and sent to (and 
disseminated through) OPRA. Currently, each of the options markets has 
rules that establish the maximum size of orders that its automatic 
execution system will execute. Markets would, however, be required to 
periodically publish the size (or sizes, if different categories are 
used) for which their quotes must generally be firm. There are likely 
to be expenses incurred by the markets related to periodically 
publishing their firm quote sizes. The Commission requests comment on 
the cost associated with the proposed requirements.
    Amendment of the Quote Rule to include options may require markets 
to incur one-time costs. For example, options markets will need to 
enhance surveillance and enforcement mechanisms to ensure that SRO 
members are complying with the Quote Rule. Further, options market 
makers and specialists may need to reevaluate and change their quotes 
in light of the obligation to be firm that would be imposed by the 
proposed amendment to the Quote Rule. As the Commission is unable to 
quantify these costs, comment and estimates on the costs described 
above is requested.
    Commenters are invited to express their views about the costs 
associated with the proposed 30-second response time for orders larger 
than the firm quote size. What are the costs, including opportunity 
costs, to investors in waiting 30 seconds for a report on such orders? 
What are the costs related to enabling the markets to respond to such 
an order within 30 seconds? Will options markets be able to respond 
within 30 seconds if both markets involved are not participants in the 
same linkage plan? The Commission seeks estimates for the costs to 
market makers of executing orders that they currently decline to fill 
at their displayed quote. If firm quotes were extended to broker-
dealers as well as customers, would there be an increase in the risk to 
market makers from executing orders against other market professionals? 
What costs are currently incurred by SROs and other regulators in 
investigating market maker complaints that broker-dealers are 
misidentifying their trades as those of public customers? Would these 
costs be reduced if the amended Quote Rule were adopted? How would a 
difference in firm quote size between customer orders and broker-dealer 
orders affect the costs incurred by market makers and specialists?
    In order to minimize costs, the Commission is proposing to amend 
the Quote Rule to conform as closely as possible to existing options 
market requirements and practices. The Commission seeks comment and 
supporting data on these and any other costs of the proposed amendments 
to the Quote Rule.

VII. Consideration of the Burden on Competition, and Promotion of 
Efficiency, Competition and Capital Formation

    Exchange Act Section 23(a) \113\ requires the Commission, when 
adopting rules under the Exchange Act, to consider the anti-competitive 
effects of any rule it adopts. Because both the proposed amendments to 
the Quote Rule and the proposed Trade-Through Disclosure Rule would 
apply equally to all relevant market participants, the Commission does 
not believe that the proposals would have any anti-competitive effects. 
The Commission requests comment on any anti-competitive effects of the 
proposals.
---------------------------------------------------------------------------

    \113\ 15 U.S.C. 78w(a).
---------------------------------------------------------------------------

    In addition, Exchange Act Section 3(f) \114\ 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 the action will promote efficiency, 
competition, and capital formation. The Commission believes that the 
proposed

[[Page 47933]]

Trade-Through Disclosure Rule would bolster investor confidence in the 
options markets by better informing customers about the quality of 
their executions and the implications of their broker-dealers' 
execution decisions. This increased investor confidence should promote 
market efficiency and capital formation. The proposed disclosure 
requirement likely would help minimize the number of customer orders 
that do not receive an execution at the best available published quote. 
Further, the proposed Trade-Through Disclosure Rule would assist 
broker-dealers in evaluating and complying with their best execution 
obligations. Finally, it would provide an incentive for securities 
markets to develop an effective means to access quotes on other markets 
to avoid trade-throughs. This should increase the efficiency of the 
markets.
---------------------------------------------------------------------------

    \114\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    The proposed amendments to the Quote Rule would also bolster 
investor confidence in the options markets by ensuring that quotes made 
by market participants are available for a specified number of options 
contracts, thus providing greater certainty for investors. Similarly, 
the increased investor confidence should promote market efficiency and 
capital formation. The proposed amendments to the Quote Rule also would 
assist broker-dealers in making their best execution determinations. 
Further, it would provide information to the market as a whole as to 
the various factors affecting the market, including the current levels 
of buying and selling interest. This should promote market efficiency, 
competition, and capital formation.
    Finally, the Commission anticipates that any impact of these 
proposals on competition would be to promote competition. The 
Commission requests comment on all of these matters.

VIII. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis (``IRFA'') has been 
prepared in accordance with the Regulatory Flexibility Act. \115\ It 
relates to proposed Exchange Act Rule 11Ac1-7 and proposed amendment to 
Exchange Act Rule 11Ac1-1.
---------------------------------------------------------------------------

    \115\ 5 U.S.C. 601. Pursuant to 5 U.S.C. 603 when an agency is 
engaged in a proposed rulemaking, ``the agency shall prepare and 
make available for public comment an initial regulatory flexibility 
analysis.''
---------------------------------------------------------------------------

    The proposed Trade-Through Disclosure Rule, proposed Rule 11Ac1-7, 
would require a broker-dealer to disclose when a customer order is 
executed at a price inferior to a price published by another market. 
However, a broker-dealer would not be required to provide such 
disclosure to its customer if it effects the customer transaction on a 
market that participates in an approved linkage plan that includes 
provisions reasonably designed to limit customers' orders from being 
executed at prices that trade through a better published price, even if 
the better price is on a market that is not part of the linkage plan.
    The Quote Rule, Rule 11Ac1-1, currently requires markets to 
establish procedures for collecting from their members bids, offers, 
and quotation sizes for certain equity securities available to 
quotation venders. It also requires that the quotation information made 
available to vendors be firm, subject to certain exceptions. The 
proposed amendments to the Quote Rule would apply the Quote Rule to 
options trading on a national securities exchange or an automated 
facility of a national securities association.

A. Reasons for the Proposed Action

    The significant increase in multiple trading that has occurred 
during the past year has dramatically altered the options trading 
environment and raised a number of issues, including new best execution 
challenges for broker-dealers. When an option is listed on only one 
market, broker-dealers do not have to decide where to route the order, 
and, consequently, satisfying their best execution obligations with 
respect to such options orders is less complex than when they must 
consider the relative merits of executing orders on several markets. 
Directly relevant to a broker's ability to get best execution for its 
customers is the ability to get the best price available. Currently, it 
is difficult to ensure that a customer order sent to one market will 
receive the best available price because there is no effective 
mechanism that allows broker-dealers on one market to access a better 
price displayed on another.
    Therefore, the Commission is proposing the Trade-Through Disclosure 
Rule and the proposed amendments to the Quote Rule to help address this 
situation. The proposed Trade-Through Disclosure Rule would require a 
broker-dealer to disclose to its customer when the customer's order was 
executed at a price inferior to the best published quote. A broker-
dealer would not be required to make this disclosure when the broker-
dealer transacts the customer order on a market that participates in a 
Commission-approved linkage plan that has rules reasonably designed to 
limit trade-throughs, even when the better price is displayed by a non-
linked market. Amending the Quote Rule to apply to the options markets 
would provide greater certainty about both options quotes and pricing 
generally in the options markets. The proposed amendments to the Quote 
Rule, along with the proposed Trade-Through Disclosure Rule, would 
assist broker-dealers in making their best execution evaluations.

B. Objectives and Legal Basis

    As noted above, the proposed Trade-Through Disclosure Rule and the 
proposed amendments to the Quote Rule are intended to bolster investor 
confidence in the options markets by better informing customers about 
the quality of their executions and the implications of their broker-
dealers' execution decisions. The proposed Trade-Through Disclosure 
Rule likely would help minimize the number of customer orders that do 
not receive an execution at the best available published quote. 
Further, the proposed Trade-Through Disclosure Rule would assist 
broker-dealers in evaluating and complying with their best execution 
obligations. Finally, it would provide an incentive for options markets 
to develop effective means to access quotes on other markets to avoid 
trade-throughs.
    The proposed amendments to the Quote Rule would also bolster 
investor confidence in the options markets by ensuring that quotes made 
by market participants are available for a specified number of options 
contracts, thus providing greater certainty for investors. The proposed 
amendments to the Quote Rule also would assist broker-dealers in making 
their best execution determinations. Further, it would provide 
information to the market as a whole as to the various factors 
affecting the market, including the current levels of buying and 
selling interest.
    The Commission is proposing the Trade-Through Disclosure Rule and 
the amendments to the Quote Rule under the authority set forth in 
Exchange Act Sections 3(b), 5, 6, 15, 11A, 17(a) and (b), 19, and 
23(a).

C. Small Entities Subject to the Rules

    Commission rules generally define a broker-dealer as a small entity 
for purposes of the Exchange Act and the Regulatory Flexibility Act if 
the broker-dealer had a total capital (net worth plus subordinated 
liabilities) of less than $500,000 on the date in the prior fiscal year 
as of which its audited financial statements were prepared, and it is 
not affiliated with any person (other than a natural person) that is 
not a small

[[Page 47934]]

entity.\116\ The Commission estimates that as of December 31, 1999, 
approximately 41 Commission-registered broker-dealers were small 
entities that would be subject to the proposed Trade-Through Disclosure 
Rule.\117\ However, the Commission estimates that none of the 41 
registered broker-dealers that would be considered small entities for 
purposes of the statute regularly represent options orders on behalf of 
their customers. In addition, the Commission notes that only those 
broker-dealers that are also options specialists or market markers 
would be required to comply with the proposed amendments to the Quote 
Rule. As of December 31, 1999, our data indicates that only one broker-
dealer that was a small entity was an options specialist or market 
maker.
---------------------------------------------------------------------------

    \116\ 17 CFR 240.0-10(c).
    \117\ The Commission's estimate of 41 small entities includes 
all of the registered broker-dealers that do not have relationships 
with clearing firms.
---------------------------------------------------------------------------

    The proposed amendments to the Quote Rule also would directly 
affect the national securities exchanges that trade listed options, 
none of which is a small entity as defined by Commission rules. 
Paragraph (e) of Exchange Act Rule 0-10 \118\ states that the term 
``small business,'' when referring to an exchange, means any exchange 
that has been exempted from the reporting requirements of Exchange Act 
Rule 11Aa3-1. The proposed amendments to the Quote Rule also would 
directly affect national securities associations. There is one national 
securities association, which is not a small entity as defined by 13 
CFR 121.201.
---------------------------------------------------------------------------

    \118\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

D. Reporting, Recordkeeping, and other Compliance Requirements

    The proposed Trade-Through Disclosure Rule would require a broker-
dealer to disclose to its customer (on the confirmation statement) in 
the event that an options trade executed for the customer was made at a 
price inferior to a price published by another exchange. The broker-
dealer would not be required to provide such disclosure to its customer 
if the options trade was executed on an exchange that participates in 
an approved linkage plan that has rules reasonably designed to limit 
customers' orders from being executed at prices that are inferior to a 
published price, even if that better published price is on a market 
that is not part of the linkage plan.
    The proposed amendments to the Quote Rule would require a broker-
dealer that is either a specialist or market maker to honor its quote 
for a size determined and disseminated by the options market where the 
specialist or market maker is quoting. The proposal also would require 
national securities exchanges and national securities associations to 
collect quote information from their members and disseminate that 
information to quotation venders.

E. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission believes there are no rules that duplicate, overlap, 
or conflict with the proposed rules.

F. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entity 
issuers. In connection with the proposed rules, the Commission 
considered the following alternatives: (a) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources available to small entities; (b) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities; (c) the use 
of performance rather than design standards; and (d) an exemption from 
coverage of the rules, or any part thereof, for small entities.
    The Commission believes that different compliance or reporting 
requirements or timetables for small entities would interfere with 
achieving the primary goals of bolstering investor confidence, 
assisting broker-dealers in best execution determinations, and 
providing information as to the various factors affecting the market, 
including the current levels of buying and selling interest. For 
example, if all broker-dealers quoting prices in options are not 
required to comply with the proposed amendments to the Quote Rule, 
investors and market participants would be unable to determine true 
buying and selling interest, undermining investor confidence and the 
ability of a broker-dealer to make best execution decisions. Further, 
broker-dealers would not be certain that a quote was firm without 
knowing whether the broker-dealer making the quote is a small broker-
dealer. In addition, if all broker-dealers were not obligated to comply 
with the proposed Trade-Through Disclosure Rule, all investors (those 
that are customers of small broker-dealers) would not benefit fully 
from the rule, potentially reducing the benefits of the rule.
    For the same reasons, the Commission believes that exempting small 
entities from the proposed rules, in whole or in part, is not 
appropriate. In addition, the Commission has concluded preliminarily 
that it is not feasible to further clarify, consolidate, or simplify 
the proposed rules for small entities. The Commission has used 
performance elements in the proposed rules. The rules do not require a 
broker-dealer to satisfy its obligations in accordance with any 
specific design, but rather provide each broker-dealer, including small 
entities, with the flexibility to select the method of compliance that 
is most efficient and appropriate for its business operations. The 
Commission does not believe different performance standards for small 
entities would be consistent with the purpose of the proposed rules.
    Further, the Commission believes that none of the above 
alternatives is applicable to the proposed amendment with regard to 
national securities exchanges or national securities associations. The 
markets are directly subject to the requirements of the rules and are 
not ``small entities'' because they are all national securities 
exchanges or national securities associations that do not meet the 
definition of small entity. Therefore, the Commission does not believe 
the alternatives to the proposed rules are applicable to the markets.

G. Solicitation of Comments

    The Commission encourages the submission of comments with respect 
to any aspect of this IRFA. In particular, the Commission requests 
comments regarding: (1) The number of small entities that may be 
affected by the proposed rules; (2) the existence or nature of the 
potential impact of the proposed rules on small entities discussed in 
the analysis; and (3) how to quantify the impact of the proposed rules. 
Commenters are asked to describe the nature of any impact and provide 
empirical data supporting the extent of the impact. Such comments will 
be considered in the preparation of the Final Regulatory Flexibility 
Analysis, if the proposed rules are adopted, and will be placed in the 
same public file as comments on the proposed Regulation and Rules 
themselves.

IX. Statutory Authority

    We are proposing the rules pursuant to our authority under Exchange 
Act Sections 3(b), 5, 6, 15, 11A, 17(a) and (b), 19, and 23(a).

[[Page 47935]]

List of Subjects in 17 CFR Part 240

    Brokers-dealers, Fraud, Issuers, Reporting and recordkeeping 
requirements, Securities.

Text of the Proposed Rules

    For the reasons set out in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

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

    1. The authority citation for Part 240 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 
80b-11, unless otherwise noted.
* * * * *
    2. Section 240.11Ac1-1 is amended by revising paragraphs (a)(5), 
(a)(20); in the second sentence of paragraph (b)(3)(i) by revising the 
phrase ``under paragraph (c)(2)'' to read ``under paragraphs (c)(2) and 
(d)(3)'', and (d) and adding paragraphs (a)(26), (a)(27), (a)(28), and 
(e) to read as follows:


Sec. 240.11Ac1-1  Dissemination of quotations.

    (a) Definitions. * * *
    (5) The term consolidated system shall mean the consolidated 
transaction reporting system, including a transaction reporting system 
operating pursuant to an effective national market system plan.
* * * * *
    (20) The term reported security shall mean any security or class of 
securities for which transaction reports are collected, processed and 
made available pursuant to an effective transaction reporting plan or 
an effective national market system plan for reporting transactions in 
listed options.
* * * * *
    (26) The term customer shall mean any person that is not a 
registered broker-dealer.
    (27) The term listed option shall have the meaning provided in 
Sec. 240.15c3-1(c)(2)(x)(B)(1).
    (28) The term options series means the contracts in an options 
class that have the same unit of trade, expiration date, and exercise 
price, and other terms or conditions.
* * * * *

[Alternative A for paragraph (d)]

    (d) Transactions in listed options.
    (1) An exchange or association that establishes by rule and 
periodically publishes the size associated with its best bid or offer 
in each options series that is a subject security listed on such 
exchange or association shall not be required, under paragraph (b) of 
this section, to collect and make available to quotation vendors the 
quotation size and aggregate quotation sizes from responsible brokers 
or dealers who are members of such exchange or association.
    (2) With respect to listed options, if, pursuant to paragraph 
(d)(1) of this section, the rules of an exchange or association do not 
require its members to communicate to it their quotation sizes, a 
responsible broker or dealer that is a member of such exchange or 
association shall:
    (i) Be relieved of its obligations under paragraph (c)(1) of this 
section to communicate to such exchange or association its quotation 
sizes for any listed option that is a subject security; and
    (ii) Comply with its obligations under paragraph (c)(2) of this 
section by executing any order to buy or sell a listed option that is a 
subject security, in an amount up to the size associated with its bid 
or offer as established by such exchange's or association's rules under 
paragraph (d)(1) of this section.
    (3) Thirty second response.
    (i) Each responsible broker or dealer, within thirty seconds of 
receiving an order to buy or sell a listed option must:
    (A) Execute the entire order; or
    (B)(1) Execute that portion of the order equal to at least:
    (i) The minimum firm quote size established by an exchange's or 
association's rules pursuant to paragraph (d)(1) of this section, if 
such exchange or association does not collect and make available to 
quotation vendors quotation size and aggregate quotation size under 
paragraph (b) of this section; or
    (ii) The size of the exchange's or association's quotation made 
available to quotation vendors by such exchange or association under 
paragraph (b) of this section; and
    (2) Revise its bid or offer.
    (ii) Notwithstanding paragraph (d)(3)(i) of this section, no 
responsible broker or dealer shall be obligated to execute a 
transaction for any subject security if:
    (A) Any of the circumstances in paragraphs (c)(3) of this section 
exist; or
    (B) The order for the purchase or sale of a listed option is 
presented during a trading rotation in that listed option.

[Alternative B for paragraph (d)]

    (d) Transactions in listed options.
    (1)(i) An exchange or association that establishes by rule and 
periodically publishes the size associated with its best bid or offer 
in each options series that is a subject security listed on such 
exchange or association:
    (A) Shall not be required, under paragraph (b) of this section, to 
collect and make available to quotation vendors the quotation size and 
aggregate quotation sizes from responsible brokers or dealers who are 
members of such exchange or association; and
    (B) May allow, pursuant to such exchange rules, responsible brokers 
or dealers obligated under paragraph (c)(2) of this section to execute 
an order to buy or sell a listed option that is a subject security for 
the account of a broker or dealer that is different from the quotation 
size for which it is obligated to execute such an order for the account 
of a customer.
    (ii) An exchange or association that establishes and maintains 
procedures and mechanisms for collecting bids, offers, quotation sizes 
and aggregate quotation sizes from responsible brokers and dealers for 
listed options that are subject securities listed on such exchange or 
association may allow, pursuant to exchange rules, responsible brokers 
or dealers to publish a quotation size for which it will be obligated 
under paragraph (c)(2) of this section to execute an order to buy or 
sell a listed option that is a subject security for the account of a 
broker or dealer that is different from its published quotation size 
for which it is obligated to execute such an order for the account of a 
customer.
    (2) With respect to listed options, if, pursuant to paragraph 
(d)(1) of this section, the rules of an exchange or association do not 
require its members to communicate to it their quotation sizes, a 
responsible broker or dealer that is a member of such exchange or 
association shall:
    (i) Be relieved of its obligations under paragraph (c)(1) of this 
section to communicate to such exchange or association its quotation 
sizes for any listed option that is a subject security; and
    (ii) Comply with its obligations under paragraph (c)(2) of this 
section by executing any order to buy or sell a listed option that is a 
subject security, in an amount up to the size associated with its bid 
or offer as established by such exchange's or association's rules under 
paragraph (d)(1) of this section.
    (3) Thirty second response.
    (i) Each responsible broker or dealer, within thirty seconds of 
receiving an order to buy or sell a listed option must:
    (A) Execute the entire order; or
    (B)(1) Execute that portion of the order equal to at least:

[[Page 47936]]

    (i) The minimum firm quote size established by an exchange's or 
association's rules pursuant to paragraph (d)(1) of this section, if 
such exchange or association does not collect and make available to 
quotation vendors quotation size and aggregate quotation size under 
paragraph (b) of this section; or
    (ii) The size of the exchange's or association's quotation made 
available to quotation vendors by such exchange or association under 
paragraph (b) of this section; and
    (2) Revise its bid or offer.
    (ii) Notwithstanding paragraph (d)(3)(i) of this section, no 
responsible broker or dealer shall be obligated to execute a 
transaction for any subject security if:
    (A) Any of the circumstances in paragraphs (c)(3) of this section 
exist; or
    (B) The order for the purchase or sale of a listed option is 
presented during a trading rotation in that listed option.
    (e) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any responsible broker or dealer, electronic communications 
network, exchange, or association if the Commission determines that 
such exemption is consistent with the public interest, the protection 
of investors and the removal of impediments to and perfection of the 
mechanism of a national market system.
    3. Section 11Ac1-7 is added to read as follows:


Sec. 240.11Ac1-7.  Trade-through disclosure rule.

    (a) Definitions. For purposes of this section:
    (1) The term complex trade means a transaction in an options series 
that is executed in conjunction with a related transaction occurring at 
or near the same time for the purpose of executing a particular 
investment strategy.
    (2) The term customer means any person that is not a registered 
broker-dealer.
    (3) The term effective national market system plan shall have the 
meaning provided in Sec. 240.11Aa3-2 (Rule 11Aa3-2 under the Act).
    (4) The term listed option shall have the meaning provided in 
Sec. 240.15c3-1(c)(2)(x)(B)(1).
    (5) The term options class means all of the put option or call 
option series overlying a security, as defined in Section 3(a)(10) of 
the Act.
    (6) The term options series means the contracts in an options class 
that have the same unit of trade, expiration date, and exercise price, 
and other terms or conditions.
    (7) The term receipt means, with respect to an order sent to an 
away market displaying a superior price, the time at which the order is 
either represented in the trading crowd or received by the specialist.
    (8) The term trading rotation means, with respect to a specified 
options class at a given exchange, the time period during which opening 
transactions in individual options series are being completed and 
continuous trading has not yet commenced in such options class.
    (b) Broker-dealer disclosure requirements. (1) Any broker or dealer 
that effects a transaction in a listed option for the account of its 
customer must disclose to such customer, in conformance with the 
procedures set forth in Sec. 240.10b-10:
    (i) When such transaction is effected at a price that trades 
through a better price published at the time of execution; and
    (ii) That better published price at the time of execution;
    (2) A broker-dealer shall not be required to provide the disclosure 
set forth in paragraph (b)(1) of this section if it effects such 
transaction on a market that is a participant in an effective national 
market system options linkage plan that includes provisions reasonably 
designed to limit the incidence of customer orders being executed at 
prices that trade through a better published price, including prices 
published other than by a linkage plan participant.
    (3) A customer order is executed at a price that trades through a 
better published price if:
    (i) The price at which an order to purchase a listed option is 
executed is higher than the lowest offer at the time the order was 
executed published pursuant to a national market system plan for 
reporting quotations in listed options; or
    (ii) The price at which an order to sell a listed option is 
executed is lower than the highest bid at the time the order was 
executed published pursuant to a national market system plan for 
reporting quotations in listed options.
    (4) Notwithstanding paragraph (b)(2) of this section, a customer 
order is not considered to be executed at a price that trades through a 
better published price if:
    (i) Such better published price cannot be accessed due to a 
failure, material delay, or malfunction of the systems of the market 
publishing the better price;
    (ii) The quotation price reporting system provided for by the 
national market system plan for reporting quotations indicates that it 
is experiencing queuing;
    (iii) Such better published price was published by an exchange 
whose members are relieved of their obligations under paragraph (c)(2) 
of Sec. 240.11Ac1-1 because, pursuant to paragraph (b)(3) of 
Sec. 240.11Ac1-1, such exchange is not required to meet its obligations 
under paragraph (b)(1) of Sec. 240.11Ac1-1;
    (iv) The market publishing such better price is in a trading 
rotation for that option class;
    (v) The customer order is executed during a trading rotation in 
that options class;
    (vi) The customer order is executed as part of a complex trade; or
    (vii) The customer order is executed only after the market 
publishing the better price fails to respond to an order routed to it 
within 30 seconds of the order's receipt by that market.

    Dated: July 28, 2000.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-19728 Filed 8-3-00; 8:45 am]
BILLING CODE 8010-01-P