[Federal Register Volume 65, Number 153 (Tuesday, August 8, 2000)]
[Proposed Rules]
[Pages 48406-48434]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-19729]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-43084; File No. S7-16-00]
RIN 3235-AH95


Disclosure of Order Routing and Execution Practices

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rules.

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SUMMARY: The Securities and Exchange Commission is proposing two rules 
to improve public disclosure of order routing and execution practices. 
Under proposed Rule 11Ac1-5, market centers that trade national market 
system securities would be required to make available to the public 
monthly electronic reports that include uniform statistical measures of 
execution quality on a security-by-security basis. Under proposed Rule 
11Ac1-6, broker-dealers that route orders in equity and option 
securities on behalf of customers would be required to make publicly 
available quarterly reports that describe their order routing practices 
and disclose the venues to which customer orders are routed for 
execution. In addition, broker-dealers would be required to disclose to 
customers, on request, where their individual orders were routed for 
execution. By enhancing disclosure of order routing and execution 
practices, the proposed rules are intended to promote fair and vigorous 
competition among broker-dealers and among market centers. Finally, 
this release discusses a number of measures that the Commission 
currently is considering to strengthen quote and price competition in 
the securities markets.

DATES: Comments are due on or before September 22, 2000.

ADDRESSES: Interested persons should submit three copies of their 
written data, views, and opinions to Jonathan G. Katz, Secretary, 
Securities and Exchange 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. S7-16-00. Comments submitted by E-mail should 
include this file number in the subject line. Comment letters received 
will be available for public inspection and copying in the Commission's 
Public Reference Room, 450 Fifth Street, NW., Washington DC 20549. 
Electronically submitted comment letters will be posted on the 
Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Susie Cho, Attorney, at (202) 942-
0748, Division of Market Regulation, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:   

Table of Contents

I. Introduction
II. Summary of Fragmentation Release and Public Comments
III. Disclosure of Order Routing and Execution Practices
    A. Need for Improved Disclosure
    B. Proposed Rule 11Ac1-5--Disclosure of Order Execution 
Information
    1. Scope of Rule
    a. Market Center
    b. Covered Order
    c. National Market System Security
    2. Required Information
    a. Information Required for All Types of Orders
    b. Information Required for Market and Marketable Limit Orders
    3. Procedures for Making Reports Available to the Public
    C. Proposed Rule 11Ac1-6--Disclosure of Order Routing 
Information
    1. Scope of Rule
    2. Quarterly Reports
    3. Customer Requests for Information
IV. Further Action to Strengthen Competition in the Markets
    A. Strengthening Price Competition in the Quote
    1. Limit Orders
    2. ECN Quotes
    B. Strengthening Price Priority
    C. Conclusion
V. General Request for Comment
VI. Paperwork Reduction Act
    A. Summary of Collections of Information
    B. Need for and Proposed Use of Information
    C. Respondents
    D. Total Annual Reporting and Recordkeeping Burdens
    E. General Information about the Collections of Information
    F. Request for Comment
VII. Cost-Benefit Analysis
    A. Costs and Benefits of Proposed Rule 11Ac1-5
    1. Benefits
    2. Costs
    B. Costs and Benefits of Proposed Rule 11Ac1-6
    1. Benefits
    2. Costs
VIII. Consideration of Burden on Competition and Promotion of 
Efficiency, Competition, and Capital Formation

[[Page 48407]]

IX. Initial Regulatory Flexibility Analysis
    A. Reasons for the Proposed Action
    B. Objectives and Legal Basis
    C. Small Entities Subject to the Rule
    1. Small Entities Affected by Proposed Rule 11Ac1-5
    2. Small Entities Affected by Proposed Rule 11Ac1-6
    D. Reporting, Recordkeeping and other Compliance Requirements
    1. Reporting Requirements under Proposed Rule 11Ac1-5
    2. Reporting Requirements under Proposed Rule 11Ac1-6
    E. Duplicative, Overlapping or Conflicting Federal Rules
    F. Significant Alternatives
    1. Alternatives to Proposed Rule 11Ac1-5
    2. Alternatives to Proposed Rule 11Ac1-6
    G. Solicitation of Comments
X. Statutory Authority
Text of Proposed Rules

I. Introduction

    On February 23, 2000, the Securities and Exchange Commission 
(``Commission'') issued a release (``Fragmentation Release'') 
requesting the public's views on a broad range of issues relating to 
market fragmentation--the trading of orders in multiple locations 
without interaction among those orders.\1\ The Fragmentation Release 
was published along with the proposed rule change by the New York Stock 
Exchange, Inc. (``NYSE'') to rescind Rule 390, its off-board trading 
rule. Because the elimination of off-board trading restrictions raised 
the potential for increased fragmentation of trading interest in 
exchange-listed equities, the rescission of Rule 390 presented an 
opportune time to consider the effects of fragmentation on the 
securities markets.\2\
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    \1\ Securities Exchange Act Release No. 42450 (February 23, 
2000), 65 FR 10577 (``Fragmentation Release'').
    \2\ Since publication of the Fragmentation Release, the 
Commission has approved the rescission of the off-board trading 
restrictions for the NYSE, American Stock Exchange LLC, Boston Stock 
Exchange, Incorporated, Chicago Stock Exchange, Incorporated, 
Pacific Exchange, Inc., and Philadelphia Stock Exchange, Inc. 
Securities Exchange Act Release No. 42758 (May 5, 2000), 65 FR 30175 
(NYSE) (``NYSE Rescission Order''); Securities Exchange Act Release 
No. 42888 (June 1, 2000), 65 FR 36855 (Amex); Securities Exchange 
Act Release No. 42887 (June 1, 2000), 65 FR 36856 (BSE); Securities 
Exchange Act Release No. 42886 (June 1, 2000), 65 FR 36859 (CHX); 
Securities Exchange Act Release No. 42890 (June 1, 2000), 65 FR 
36877 (PCX); Securities Exchange Act Release No. 42889 (June 1, 
2000), 65 FR 36878 (Phlx).
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    In undertaking its review of fragmentation issues, the Commission 
sought to assure that this country's national market system for 
equities will continue to meet the needs of investors by: (1) 
Maintaining the benefits of vigorous quote competition and innovative 
competition among market centers; (2) promoting the price discovery 
process by encouraging market participants (including investors and 
dealers) to display trading interest in the public quotes; (3) assuring 
the practicability of best execution of all investor orders, including 
limit orders, no matter where they originate in the national market 
system; and (4) providing the deepest, most liquid markets possible 
that facilitate fair and orderly trading and minimize short-term price 
volatility.
    The Fragmentation Release requested the public's views on whether 
fragmentation is now, or may become in the future, a problem that 
significantly detracts from the fairness and efficiency of the U.S. 
equities markets. To assist commenters in formulating their views, the 
Commission briefly described six potential options to address 
fragmentation, ranging from increased disclosure of order routing and 
execution practices to the establishment of a national market linkage 
system that mandated price/time priority for all displayed trading 
interest. The Commission also noted that decimal pricing of securities 
would be introduced in the coming months and that a reduced quoting 
increment could significantly change current market dynamics. It 
requested commenters to consider the extent to which their views would 
be affected by the initiation of decimal pricing.
    The comments submitted in response to the Fragmentation Release 
reflected a wide range of views on these issues. Many commenters, 
especially institutional investors, expressed serious concern about 
market fragmentation in general and internalization and payment for 
order flow practices in particular. Most of these commenters supported 
a nationwide system of price/time priority. Many other commenters, 
however, believed that such a system would have an overall negative 
impact because it would impair the ability of market centers to 
compete.
    The Commission recognizes the potentially deleterious effects of 
mandating price/time priority across competing markets. Commenters 
presented compelling arguments that the operational and technological 
problems in imposing such a system under current conditions could be 
severe. In addition, the Commission recognizes that impending changes 
in the markets, particularly the move to decimal trading, could have a 
significant, and not wholly predictable, impact on market structure. It 
also recognizes that new technologies continually are being introduced 
to the markets that could change the current patterns of order 
interaction in fundamental ways. For these reasons, the Commission is 
not taking action at this time on the price/time priority alternatives 
described in the Fragmentation Release, but is moving forward with the 
option to improve disclosure of order routing and execution practices.
    Nonetheless, the Commission remains deeply concerned, particularly 
in light of the unanimous views expressed by investors responding to 
the Fragmentation Release, about the potential for internalization and 
payment for order flow arrangements to interfere with order interaction 
and discourage the display of aggressively-priced quotations. To more 
fully evaluate these concerns, the Commission's Office of Economic 
Analysis currently is conducting an in-depth study of trading in 
equities qualified for inclusion in The Nasdaq Stock Market, Inc. 
(``Nasdaq'') and equities listed on the NYSE. The study is based on 
trading in a broad-based, random sample of 200 Nasdaq issues and a 
matched sample of 200 NYSE issues. Most importantly, the study is 
utilizing information on orders and order executions for Nasdaq trading 
that has not previously been available. Comparisons of order execution 
quality now can be made both for individual market centers trading the 
same Nasdaq or NYSE security and for trading in general in Nasdaq and 
NYSE securities. The Commission intends to use the results of this 
study, as well as its experience with changing market conditions, to 
determine whether further steps are needed to address internalization 
and payment for order flow. In addition, the Commission will continue 
in the coming months to monitor closely how the rescission of off-board 
trading restrictions affects order-routing practices in exchange-listed 
equities. As data become available and analyses are completed, the 
Commission intends to make them publicly available to enhance the 
opportunity for public debate of these vital issues concerning the 
structure of the national market system. Finally, in light of many 
comments on the Fragmentation Release, the Commission is considering 
further ways to strengthen price competition and price priority within 
the existing market structures. These options are discussed in section 
IV below.

II. Summary of Fragmentation Release and Public Comments

    The Fragmentation Release presented an overview of the current 
structure of the national market system. Section 11A

[[Page 48408]]

of the Exchange Act creates a framework for fostering transparency and 
competition in the securities markets and sets forth findings and 
objectives that are to guide the Commission in its oversight of the 
national market system. As developed under this framework, our equity 
markets are characterized by competition between market centers, price 
transparency, intermarket linkages, and broker best execution 
obligations.
    Competition between market centers. One of the principal objectives 
of the national market system is assuring fair competition among market 
centers.\3\ The Commission has sought to establish a market structure 
that gives the forces of competition room to flourish and develop 
according to the needs of market participants. Market centers, 
including exchange markets, over-the-counter (``OTC'') market makers, 
and alternative trading systems, compete to provide a forum for the 
execution of securities transactions, particularly by attracting order 
flow from brokers seeking execution of their customer's orders. As a 
result, market centers have an incentive to offer improvements in 
execution quality and to reduce trading costs in order to attract order 
flow away from other market centers. This competition also encourages 
ongoing innovation and the use of new technology, all to the benefit of 
investors.
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    \3\ Section 11A(a)(1)(C)(ii) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C)(ii).
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    Price transparency. Price transparency is a minimum essential 
component of a unified national market system. All significant market 
centers are required to make available to the public their best prices 
and the size associated with the prices.\4\ This information not only 
includes the best quotations of market makers, but also the price and 
size of customer limit orders that improve a market center's quotation. 
Central processors collect quote and trade information from individual 
market centers, consolidate the information of individual market 
centers, determine the national best bid and best offer for each 
security, and disseminate the information to broker-dealers and 
information vendors. Thus, the best displayed prices for a particular 
security are made available to the public, thereby helping to assure 
that investors are aware of such prices no matter where they arise in 
the national market system.
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    \4\ See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1; Exchange 
Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4.
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    Intermarket linkages. Congress has found that the ``linking of all 
markets for qualified securities through communication and data 
processing facilities'' will further the objectives of a national 
market system.\5\ Linkages among competing market centers help ensure 
that brokers can access the best quotes available in the market for 
their customers. The market centers that trade exchange-listed equities 
currently are linked through the Intermarket Trading System (``ITS''), 
which is linked to the National Association of Securities Dealer's 
(``NASD's'') Computer Assisted Execution System (``CAES''). The market 
centers that trade Nasdaq equities are linked by the Nasdaq SelectNet 
System, by telephone, and through private links.
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    \5\ Exchange Act Section 11A(a)(1)(D).
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    Broker's duty of best execution. In accepting orders and routing 
them to a market center for execution, brokers act as agents for their 
customers and owe them a duty of best execution.
    The duty is derived from common law agency principles and fiduciary 
obligations. It is incorporated both in self-regulatory organization 
(``SRO'') rules and, through judicial and Commission decisions, in the 
antifraud provisions of the federal securities laws. The duty requires 
a broker to seek the most favorable terms reasonably available under 
the circumstances for a customer's transaction.
    Although each of the foregoing elements contribute to the fairness 
and efficiency of the national market system, the Fragmentation Release 
expressed concern about the possibly harmful effects of market 
fragmentation, particularly internalization and payment for order flow. 
The Commission noted that fragmented markets may isolate customer limit 
orders and dealer quotes from full interaction with other buying and 
selling interest in today's markets. For example, a customer may enter 
a limit order to buy at a price higher than the current quote, thus 
setting a new best price in the market. Even though the customer offers 
to pay more than any other market participant, market centers holding 
sell orders have no obligation to route a sell order to fill the price-
setting buy order. To the extent that the customer's limit order 
remains unexecuted and subsequent buying interest is filled at the 
limit order price, the customer's order has been disadvantaged, and the 
incentive to improve prices potentially compromised.
    Internalization and payment for order flow practices also have 
contributed to an environment in which vigorous quote competition is 
not always rewarded. Under such practices, orders are routed to a 
particular market maker or specialist that can execute the orders as 
principal without facing significant competition from investors or 
other dealers to interact with the directed order flow. Even where 
linkages between market centers exist, there is no requirement that 
orders be routed to the market center that is displaying the best 
prices, even if that price represents a customer limit order. One of 
the initial findings of the ongoing analysis by the Commission's Office 
of Economic Analysis indicates that approximately 85% of the executed 
market orders in Nasdaq securities are routed to market centers when 
they are not quoting at the best price.\6\ Market makers typically 
provide a private guarantee to their customers and routing brokers, 
subject to various conditions, that market orders will be executed at 
prices that match the best prices displayed elsewhere. These passive, 
``price-matching'' business strategies employed by dealers may weaken 
the incentive to display competitive quotes and blunt the forces that 
otherwise could lead to less fragmented markets.\7\ The Commission is 
concerned that such practices may ultimately harm the process of public 
price discovery, increase price volatility, and detract from the depth 
and liquidity of the markets.
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    \6\ This analysis is based on data from the NASD's Order Audit 
Trail System for a broad-based, random sample of 200 Nasdaq stocks 
during June 6-9, 2000. It excludes orders routed outside of the 
continuous trading period and orders with special handling 
conditions. The 85% figure in the text only includes executed market 
orders. Consequently, if an order was initially routed to a market 
center that was not quoting the best price and subsequently routed 
to a market center that was quoting the best price (for example, via 
SOES or SelectNet), the order is counted only once at the executing 
market center. The 85% figure is unchanged when the analysis is 
limited to only 100-499 share market orders.
    \7\ As Chairman Greenspan noted in his congressional testimony 
on market structure issues, ``[i]n the long run, unfettered 
competitive pressures will foster consolidation as liquidity tends 
to centralize in the system providing the narrowest bid-offer spread 
at volume. Two or more venues trading the same security or commodity 
will naturally converge toward a single market. * * * Of course, 
this process may not be fully realized if there are impediments to 
competition or if markets are able to establish and secure niches by 
competing on factors other than price.'' Statement of Allen 
Greenspan, Chairman, Board of Governors of the Federal Reserve 
System, before the Committee on Banking, Housing, and Urban Affairs, 
United States Senate (April 13, 2000), at 2-3.
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    In response to the Fragmentation Release, the Commission received 
87 comment letters.\8\ Of those letters, 72

[[Page 48409]]

comment letters specifically addressed market fragmentation issues, 
while most of the others limited their comments to the rescission of 
NYSE Rule 390. The comments received by the Commission reflected a wide 
range of views, as commenters did not reach a consensus on most issues. 
In particular, the commenters debated whether fragmentation posed a 
threat to the interests of investors and diminished the opportunity for 
investor order interaction.
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    \8\ The comment letters and a comprehensive summary of comments 
have been placed in Public File SR-NYSE 99-48, which is available 
for inspection in the Commission's Public Reference Room.
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    Comments submitted by institutional investors and associations 
representing such investors consistently said that fragmentation 
results in a lack of transparency and creates an inefficient and unfair 
trading environment. They stated that fragmentation hampers the ability 
of large institutional investors to execute large trades at a favorable 
price. Comments by and on behalf of investors also frequently asserted 
that competitive practices associated with increased market 
fragmentation, such as internalization and payment for order flow, 
impede price discovery, hinder the best execution of limit orders, and 
increase stock price volatility. The Consumer Federation of America, 
for example, noted that ``market centers naturally compete for brokers' 
low on terms other than just price. While some of these forms of 
competition may benefit investors, others are less benign. Two 
practices that have become common--internalization and payment for 
order flow--clearly contribute to market fragmentation.'' It 
recommended that improved linkages between market centers ``should be 
accompanied by new rules to limit practices, such as internalization 
and payment for order flow, that inappropriately isolate order flow.'' 
\9\
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    \9\ Letter from Barbara L. N. Roper, Director of Investor 
Protection, Consumer Federation of America, to Jonathan G. Katz, 
Secretary, Commission, dated June 5, 2000, at 2, 5.
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    In contrast, many broker-dealers and regional exchanges generally 
questioned whether fragmentation was a detriment to the markets. They 
asserted that the increased number of venues available for executing 
transactions has invigorated competition to the benefit of public 
investors and fostered greater innovation, resulting in narrower 
spreads and lower transaction costs.
    Commenters likewise differed considerably on the alternative 
approaches to address fragmentation that were described in the 
Fragmentation Release. Commenters were particularly divided over the 
prospect of a national market linkage system with price/time priority 
for all displayed trading interest. The commenters who supported the 
establishment of intermarket price/time priority, including most 
institutional investors, believed that it would enhance price 
competition and increase transparency. Numerous commenters, however, 
believed that intermarket price/time priority would be anti-
competitive, hinder innovation, and increase market volatility. These 
commenters further noted that a single system linking the markets would 
create a single point of failure.
    Several commenters, moreover, urged the Commission not to implement 
any market structure changes until decimal trading has been instituted. 
Commenters noted that the impact of decimalization has yet to be 
determined. It may lead to greater quote competition, or it may reduce 
the display of limit orders, and the utility of the best published 
quote. Commenters suggested that market structures dependent on 
sizeable quotation increments might be counterproductive in a decimal 
trading environment.
    Although commenters did not agree on most of the alternative 
approaches described in the Fragmentation Release, many voiced their 
support for greater disclosure to investors of order routing and 
execution practices. Of the 44 commenters who discussed this option, 32 
commenters supported some form of disclosure by market centers and 
broker-dealers of factors concerning their trade executions and 
arrangements for handling orders. Commenters supporting increased 
disclosure believed that it would allow investors to make informed 
judgments about where to route their orders, as well as enable brokers 
to evaluate the quality of executions among market centers and fulfill 
their duty of best execution. Most of those opposing the disclosure 
option did so because they did not believe it would effectively address 
fragmentation concerns.
    Some of the broker-dealer and SRO commenters further suggested that 
the current ITS linkage be reformed. Several commenters recommended 
abolishing the requirement that ITS participants achieve unanimity to 
enact any proposed change. Others suggested that the time frames for 
processing ITS commitments be significantly reduced. A few commenters, 
however, urged the Commission to dismantle ITS entirely. The NYSE 
argued that ``ITS was designed to address market structure issues'' of 
floor-based auction markets and that a ``different approach to deal 
with today's environment is appropriate.'' \10\ Other commenters 
advocated that the Commission oversee the development of new 
intermarket linkages. They believed that a new linkage would increase 
transparency and enhance competition among individual market centers. 
They suggested that a new linkage should employ state of the art 
technology, provide automatic execution capability, allow 
representation in the governance of the linkage by all qualified market 
centers, and provide access to all qualified market centers.\11\
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    \10\ Letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Jonathan G. Katz, Secretary, Commission, dated 
May 31, 2000 (``NYSE Letter''), at 22-23.
    \11\ In section IV below, the Commission discusses and requests 
comment on improving linkages between markets.
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    Finally, several commenters recommended that a price priority rule 
be instituted with a new intermarket linkage. For example, the Market 
Structure Committee of the Securities Industry Association (``SIA'') 
strongly endorsed adoption of a Commission rule under which a market 
center receiving an order would be required either to route the order 
to a market center displaying the best price or to match the best 
price.\12\ Island ECN Inc. (``Island''), however, disagreed, believing 
that such a trade-through rule would restrict new automated markets 
from competing with slower market centers. Island also asserted that a 
trade-through rule is inconsistent with a customer's freedom of choice 
as well as a fiduciary's duty of best execution, because such a rule 
requires an order to be sent to a market solely on the basis of 
price.\13\
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    \12\ Letter from Mark B. Sutton, Chairman, SIA Market Structure 
Committee, to Jonathan G. Katz, Secretary, Commission, dated May 5, 
2000 (``SIA-Market Structure Letter''), at 2, 12.
    \13\ Letter from Cameron Smith, General Counsel, Island ECN, to 
Jonathan Katz, Secretary, Commission, dated May 16, 2000 (''Island 
Letter''), at 5. In section IV below, the Commission discusses and 
requests comment on an alternative regulatory approach to promote 
price priority. Trade-throughs would not be prohibited, but would 
have to be disclosed to the customer, thereby creating an incentive 
for market participants to develop methods of access to avoid trade-
throughs that are not in an investor's best interest. Fiduciaries, 
however, would continue to have the flexibility to consider factors 
other than price in meeting their best execution responsibilities. 
Moreover, the proposed public disclosure of measures of order 
execution quality may allow market forces to better align the 
interests of brokers and their customers in light of conflict-of-
interest concerns raised by internalization and payment for order 
flow practices.
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III. Disclosure of Order Routing and Execution Practices

    As noted above, a significant majority of the commenters that 
addressed the Fragmentation Release's alternative of increased 
disclosure of order routing

[[Page 48410]]

and execution practices expressed support for the option. The 
Commission agrees that there is a need for improved disclosure in this 
area. Particularly for a significantly fragmented market structure with 
many different market centers trading the same security, the decision 
of where to route orders to obtain best execution for investors is 
critically important. There must be a full and fair opportunity for 
market centers to compete for order flow based on price, as well as on 
other factors. Currently, brokerage customers, particularly retail 
investors, typically submit orders to their brokers and receive 
confirmations of their transactions, but have little ability to monitor 
what happens to their order between the time of submission and 
execution. They also currently possess few tools to evaluate the 
quality of order executions that might have been provided by other 
brokers and market centers. Given this lack of information, customers 
may conclude that the most rational strategy is simply to opt for a 
broker that offers the lowest commission and a fast execution. As a 
result, there currently may be limited opportunities for fair 
competition among brokers and market centers based on the quality of 
their order routing and execution services.
    Section 11A(c)(1) of the Exchange Act grants the Commission 
authority to promulgate rules necessary or appropriate to assure, among 
other things, the fairness and usefulness of information on securities 
transactions (subparagraph B) and that broker-dealers transmit orders 
for securities in a manner consistent with the establishment and 
operation of a national market system (subparagraph E). \14\ The 
Commission believes that improved disclosure of order routing and 
execution practices will further important national market system 
objectives and therefore has decided to propose two new Exchange Act 
rules--one for ``market centers'' (generally, exchange specialists, OTC 
market makers, and alternative trading systems (``ATSs'') that hold 
themselves out as willing to receive and execute orders) and another 
for broker-dealers that route orders as agent on behalf of their 
customers.
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    \14\ In addition, Section 17(a) of the Exchange Act, 15 U.S.C. 
78q(a), provides that SROs and broker-dealers shall make and 
disseminate such reports as the Commission, by rule, prescribes as 
necessary or appropriate in the public interest, for the protection 
of investors, or otherwise in furtherance of the purposes of the 
Exchange Act.
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A. Need for Improved Disclosure

    The heart of the U.S. national market system is the consolidated 
stream of transaction reports and quotations that is made available to 
the public on a real-time basis. The best displayed quotations of each 
significant exchange, OTC market maker, and ATS that executes orders in 
listed equities and Nasdaq equities are collected by a single 
processor, which then calculates a consolidated best bid and offer 
(``consolidated BBO'') and disseminates the information to the public. 
This centralized source of information, however, may convey an 
inaccurate impression of the extent to which the quality of order 
executions can vary among different market centers trading the same 
security.
    For example, the execution of investor market orders can vary 
widely in relation to the consolidated BBO at the time of order receipt 
and the price at which the order is executed. The consolidated BBO does 
not necessarily represent the best price at which a security can be 
bought or sold. Many market centers offer significant opportunities for 
execution of orders at prices better than the consolidated BBO. These 
price improvement opportunities are attributable to undisplayed trading 
interest that may take many forms. Large investors, for example, often 
are not willing to display their full trading interest to the general 
market and therefore seek other ways to interact with other trading 
interest. The floors of the primary exchanges provide a vehicle for 
this type of undisclosed trading interest to be represented. In 
addition, some OTC market makers have adopted algorithms under which 
price improvement is offered to selected types of orders.
    Conversely, some market orders are executed at prices less 
favorable than the consolidated BBO at the time of order receipt.
    One of the initial findings of the research being conducted by the 
Commission's Office of Economic Analysis indicates, for example, that 
approximately 5.3% of small Nasdaq market orders (100-499 shares) are 
executed at prices outside the quotes at the time of order receipt. 
Similarly, an analysis performed by the NYSE staff indicated that 
approximately 7.5% of small NYSE market orders (100-499 shares) are 
executed outside the quotes at the time of order receipt.\15\ This type 
of price disimprovement can occur for several reasons. First, there may 
be ``quote exhaustion''--multiple orders hit a quote at the same time 
with cumulative volume greater than the quoted size. Price 
disimprovement also can occur when order size exceeds the size at which 
a specialist or market maker is willing to guarantee executions at 
prices that match the consolidated BBO. Finally, some market orders are 
executed at prices less favorable than the consolidated BBO at the time 
the order was executed. This type of price disimprovement--or trade-
throughs of the best quote--can occur simply because of mistakes, poor 
executions, or lack of easy access to the better quoted price. 
Currently, there is no requirement that price disimprovement for 
individual transactions be disclosed to customers or that the overall 
price disimprovement rate for a market center's trading be disclosed to 
the public.
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    \15\ The Nasdaq estimate is based on OATS data for a broad-
based, random sample of 200 Nasdaq stocks for the week of June 5-9, 
2000. It excludes orders routed outside of the continuous trading 
period and orders with special handling conditions. The NYSE 
estimate is based on system orders and is taken from data in Jeffrey 
Bacidore, Katharine Ross & George Sofianos, Quantifying Best 
Execution at the New York Stock Exchange: Market Orders, NYSE 
Working Paper No. 99-05, Tables 7 & 14 (Dec. 1999) (available at 
http://www.nyse.com). Approximate price improvement rates for these 
samples of market orders are 8.7% for Nasdaq market orders and 37.3% 
for NYSE market orders.
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    With both price improvement and price disimprovement, the amounts 
per share may seem small and therefore can be difficult for investors 
to detect, particularly when the consolidated BBO is changing rapidly. 
Nevertheless, they may result in appreciable benefits or costs for 
investors. A difference in execution price of \1/16\th for a 1000 share 
order equals $62.50, dwarfing the differences between e-brokers' 
commissions. As commission rates for retail investors have dropped in 
recent years, the relative significance of order execution costs has 
correspondingly increased and heightened the need for improved 
disclosure of execution quality.
    From the standpoint of the many investors who use non-marketable 
limit orders to implement their investment decisions, assessing 
execution quality among different market centers is, if anything, more 
difficult. With non-marketable limit orders, the most significant risk 
is that they will not be executed and will miss the market. 
Consequently, an important order-routing consideration is the 
likelihood of execution at a particular market center, which can vary 
depending on how well the order is handled (for example, speed of 
public display),\16\ the

[[Page 48411]]

extent of trading interest at the same price that has priority, and the 
flow of incoming market orders on the other side of the market. The 
likelihood of execution also can vary depending on the extent to which 
``local'' traders (such as specialists, floor traders, and OTC market 
makers) are able to step in front of displayed limit orders by 
improving on the limit price as market orders arrive on the other side 
of the market.\17\ This can lead to another type of trading cost for 
limit orders that is commonly referred to as ``adverse selection''--the 
greater likelihood that limit orders will be executed when the market 
is moving significantly against them. The frequency and skill with 
which local traders step in front of limit orders can heighten the cost 
of adverse selection for limit order investors.
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    \16\ The Commission's Office of Compliance, Inspections, and 
Examinations and Office of Economic Analysis recently issued a 
report concerning the display of customer limit orders. Report 
Concerning Display of Customer Limit Orders (May 4, 2000). The 
report cited significant weaknesses in market centers' display of 
limit orders. It concluded that many exchange specialists and OTC 
market makers should take steps to improve their systems for limit 
order display and that many SROs can take steps to ensure better 
compliance with display requirements. Id. at 2-4.
    \17\ As discussed in section IV.A.1 below, the opportunity for 
local traders to step ahead of displayed limit orders may increase 
substantially in a market with penny trading increments. The 
Commission notes that it intends to consider whether market makers 
and similarly-situated market participants should be able to step 
ahead of limit orders by as little as a penny without previously 
quoting at that price.
---------------------------------------------------------------------------

    Thus, the routing decision for both market and limit orders can be 
complex. For each individual security, there are a variety of market 
centers to which orders can be routed. With listed equities, for 
example, orders can be routed to the primary exchange markets, which 
employ a single specialist per stock and historically have handled from 
70-80% of the volume. Orders in listed equities also are routed to 
regional exchanges, often pursuant to ``preferencing'' programs under 
which orders are routed to particular dealers for execution, and to OTC 
market makers in the ``third market.'' Finally, orders in listed 
equities can be routed to ATSs, which offer agency limit order books 
that provide a high degree of internal interaction among investor 
orders. Indeed, one of the primary reasons the Commission approved the 
rescission of off-board trading restrictions was to assure an 
opportunity for fair competition by ECNs in the market for listed 
equities.\18\
---------------------------------------------------------------------------

    \18\ See Rule 390 Rescission Order, note 2 above, text 
accompanying nn. 23-27.
---------------------------------------------------------------------------

    With Nasdaq equities, orders have been routed to an even greater 
number of distinct market centers. In May 2000, for example, there were 
an average of 53.5 market makers in the top 1% of Nasdaq issues by 
daily trading volume, 26.3 market makers in the next 9% of issues, and 
an overall average of 12.3 market makers per issue.\19\ In addition, 
orders in Nasdaq equities can be routed to an ATS. Finally, several of 
the regional exchanges trade, or are planning to trade, Nasdaq 
equities.
---------------------------------------------------------------------------

    \19\ NASD Economic Research, http://www.marketdata.nasdaq.com 
(visited July 8, 2000).
---------------------------------------------------------------------------

    Although each exchange specialist, OTC market maker, and ATS 
represents a distinct trading venue and order executions can vary 
widely among them, there currently is little publicly available 
information that allows broker-dealers, much less investors, to compare 
and evaluate execution quality among different venues. Some market 
centers make order execution information privately available to 
independent companies, which then prepare reports on execution quality 
that are sold to broker-dealers. Other market centers provide reports 
of execution quality directly to broker-dealers or to their members. 
The information in these reports generally has not been publicly 
disseminated. Moreover, some broker-dealers have reported difficulty in 
obtaining useful information on execution quality from market centers. 
For example, participants in a Commission roundtable on the on-line 
brokerage industry indicated that not all market centers were willing 
to make order execution information available and, even when such 
information was made available, not all of it was useful or in a form 
that allowed for cross-market comparisons.\20\
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    \20\ See Report by Commissioner Laura S. Unger, On-Line 
Brokerage: Keeping Apace of Cyberspace 40-41 (Nov. 1999) (available 
at http://www.sec.gov). One of the recommendations in Commissioner 
Unger's Report was that the Commission should consider requiring 
market centers to make publicly available certain uniform 
information on execution quality and requiring broker-dealers to 
provide their customers with plain English information about the 
execution quality available at different market centers, order 
handling practices, and the broker-dealer's receipt of inducements 
for order flow. Id. at 45. In addition, one of the largest broker-
dealers noted in its comment letter on the Fragmentation Release 
that even it had been frustrated in its own attempts to obtain 
useful order execution data from certain markets. Letter from Lon 
Gorman, Vice Chairman and President, Capital Markets & Trading 
Group, Charles Schwab & Co., Inc., to Jonathan G. Katz, Secretary, 
Commission, dated July 5, 2000, at 7.
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    In contrast, the NYSE on occasion has made available to academics 
sample databases that contain sufficient order and trade information to 
provide the basis for a useful evaluation of execution quality for 
orders that are routed to the NYSE.\21\ In addition, the NYSE staff 
itself has published analyses of order executions on the NYSE.\22\
---------------------------------------------------------------------------

    \21\ See, e.g., Lawrence Harris and Joel Hasbrouck, Market v. 
Limit Orders: The SuperDot Evidence on Order Submission Strategy, 31 
J. Financial and Quantitative Analysis 213 (June 1996).
    \22\ See, e.g., Quantifying Best Execution at the New York Stock 
Exchange: Market Orders, note 15 above.
---------------------------------------------------------------------------

    Although many other analyses of U.S. equity trading have been 
prepared and published, they are necessarily of somewhat limited 
utility for evaluating order executions because of the limited nature 
of their data sources. These sources typically include the trades and 
quotes in a security, but do not include information on the customer 
orders that resulted in trades. Using this limited data to assess order 
execution quality is quite difficult given the absence of even the most 
basic information on the nature of the orders themselves (e.g., buy/
sell, market/limit) or the time that orders were received for execution 
by a market center.\23\
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    \23\ The study of trading in Nasdaq and NYSE securities 
currently being conducted by the Commission's Office of Economic 
Analysis incorporates the newly available, comprehensive order 
information collected through the NASD's Order Audit Trail System. 
This data source provides the basis for much more informative 
analysis of Nasdaq trading than has been possible in the past.
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    Moreover, even if individual market centers were to make more 
information on order executions publicly available, the ability to 
compare execution quality across markets requires uniformity in the 
underlying data and statistical measures. To enable a true ``apples-to-
apples'' comparison of execution quality, the order execution 
statistics made available by different market centers must reflect 
uniform procedures, data formats, and calculations. Otherwise, the 
already complex issues inherent in evaluating order execution quality 
can become hopelessly confused.\24\
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    \24\ One of the alternatives to requiring market centers 
themselves to prepare statistical measures of execution quality is 
to require them simply to make available raw data on an order-by-
order basis. Comment is requested on this alternative in section 
III.B below. If this type of information were made available to the 
public, much of the need for required uniform statistics would be 
eliminated because everyone would have access to the data necessary 
to calculate whatever statistics they believed most appropriate, as 
well as evaluate the data supporting statistics generated by others. 
When the only information available is statistics prepared by market 
centers, however, the uniformity of such statistics is critically 
important.
---------------------------------------------------------------------------

    Finally, improved information concerning the quality of order 
executions available at different market centers will provide little 
benefit to investors if they do not know where their orders are routed 
for execution. Currently, there is no market-wide requirement that 
brokers disclose where they route orders on behalf of

[[Page 48412]]

customers. Although NYSE Rule 409(f) requires NYSE members, when 
confirming transactions, to disclose ``the name of the securities 
market on which the transaction was made,'' transactions executed at 
venues other than exchanges typically are classified as ``OTC.'' Thus, 
the identity of the particular OTC market maker or ATS that executed an 
order is not required to be disclosed. Moreover, the NYSE's rule does 
not cover non-members or securities that are not listed on the NYSE.
    Consequently, the Commission believes that market-wide rules 
setting forth uniform measures of execution quality and requiring 
disclosure of broker-dealer order routing practices will help further 
many of the vital national market system objectives set forth in 
Section 11A(a)(1)(C) of the Exchange Act.\25\ In particular, greater 
information about execution quality should assist brokers and investors 
in finding the best market for orders to be executed, help promote 
competition among markets and brokers on the basis of execution 
quality, and ultimately thereby lead to more efficient securities 
transactions.
---------------------------------------------------------------------------

    \25\ These include (1) the availability to broker-dealers and 
investors of information with respect to transactions in securities, 
(2) the practicability of brokers executing investors' orders in the 
best market, (3) fair competition among broker-dealers, exchange 
markets, and markets other than exchange markets, and (4) the 
economically efficient execution of securities transactions.
---------------------------------------------------------------------------

    In recent years, the interest of individual investors in receiving 
market-related information has expanded exponentially as advancing 
technology has allowed such information to be provided efficiently and 
at reasonable cost. This trend particularly has been reflected in the 
demand by individual investors for real-time quotes and last sale 
information.\26\ Against this backdrop of expanding market 
transparency, the scarcity of useful public information on the quality 
of order executions is striking.\27\ As discussed further below, 
improved technology for processing and disseminating information now 
offers new alternatives for making available to the public valuable 
information on order routing and execution practices. By putting this 
information in the hands of investors and others, the rules proposed 
today are intended to energize competitive forces that will produce a 
fairer and more efficient national market system.
---------------------------------------------------------------------------

    \26\ See Securities Exchange Act Release No. 42208 (Dec. 9, 
1999), 64 FR 70613 (``Market Information Concept Release''), text 
accompanying n. 3 (demand by retail investors for real-time market 
information expanded by more than 1000% between 1994 and 1998).
    \27\ Independent third parties currently prepare evaluations of 
the trade execution services offered by brokers, but must make do 
with limited sources of information. One such evaluation, for 
example, rated the order execution services of brokers based on a 
single market order and a single limit order. The Commission is 
particularly interested in receiving comment on the proposed rules 
from independent analysts of order routing and execution practices.
---------------------------------------------------------------------------

B. Proposed Rule 11Ac1-5--Disclosure of Order Execution Information

    Proposed Rule 11Ac1-5 would require market centers to prepare and 
make available to the public monthly reports in electronic form that 
categorize their order executions and set forth uniform statistical 
measures of execution quality. The rule as proposed is designed to 
avoid two serious pitfalls that can arise with such measures of 
execution quality. First, as noted above, varying and inconsistently 
calculated measures of execution quality can confuse the already 
complex task of comparing execution quality across different market 
centers. To address this problem, the proposed rule adopts certain 
basic measures of execution quality (such as effective spread, rate of 
price improvement and disimprovement, fill rates, and speed of 
execution) and sets forth specific instructions on how the measures are 
to be calculated.
    Second, even uniform statistical measures can be unhelpful or even 
misleading if they are applied across a wide range of stocks, order 
types, and order sizes. Overly general statistics can be particularly 
problematic if a market center is sent many orders that are, for any 
number of reasons, difficult to fill. There may be a wide disparity in 
the average effective spreads for the execution of market orders by 
different market centers if calculated for all stocks and all sizes of 
orders. This disparity, however, may convey a misleading impression of 
the execution quality provided by the market centers. For example, if 
the orders executed by one market center primarily consisted of small 
orders in the most actively traded stocks, its average effective spread 
across all orders likely would be relatively small. Conversely, if the 
orders executed by a second market center primarily consisted of larger 
orders in less actively traded stocks, its average effective spread 
across all orders likely would be substantially higher than the first 
market center. Although the second market center may have offered 
higher quality executions than the first market center for both small 
orders in actively traded stocks and medium sized orders in less 
actively traded stocks, this fact would not be evident if the two 
classes of orders were not analyzed separately. In sum, overly general 
statistics for even a high-quality market center can appear less 
favorable than those of other market centers, not because of poor 
executions, but because of good execution of tough orders.
    Clearly, a mandatory disclosure requirement must not create a 
disincentive for market centers to accept and execute orders that are 
difficult to fill. In the past, the only possible solution to this 
intractable problem would have been for the Commission to attempt, as 
best it could, to mandate statistics that encompassed a broad range of 
securities and orders without being overly general. Today, however, 
advancing technology offers another alternative that would allow 
competitive forces, rather than regulatory mandate, to determine the 
most appropriate classes of stocks and orders to provide a basis for 
cross-market comparisons of execution quality. In particular, improved 
technologies for processing and disseminating information make it 
feasible to require disclosures in electronic form that are divided 
into fairly discrete categories. Under the proposed rule, statistical 
information would be categorized by individual security, by five types 
of order (e.g., market and inside-the-quote limit), and four order 
sizes (e.g., 100-499 shares and 500-1999 shares). As a result, users of 
the market center reports will have great flexibility in determining 
how to summarize and analyze statistical information. Order executions 
could be analyzed for a particular security or for any particular group 
of securities, as well as for any size or type of orders across those 
groups of securities.
    Primarily because information will be categorized on a stock-by-
stock basis, the market center reports generally will contain too much 
data to be handled in written form. Each market center will be required 
to generate 20 rows of information for each security that it trades. 
For example, the report of an OTC market maker that trades 500 
securities would include 10,000 rows of information. Clearly, if 
reports of this size could only be prepared by hand and disseminated in 
written form, they would be impossibly burdensome to generate. With 
current data processing capacities, however, the task is vastly 
simplified. Once systems have been programmed to perform a task once, 
there is little additional cost or burden associated with performing 
substantially the same task over and over. In addition, the Internet 
and private communications networks allow large amounts of data to be 
transmitted to

[[Page 48413]]

widely dispersed users with little cost or difficulty. Indeed, SROs, 
broker-dealers, and independent companies currently maintain and 
process a very large volume of order-by-order raw data to generate 
their own statistical measures of execution quality.\28\ Consequently, 
the Commission preliminarily believes that requiring market centers to 
prepare disclosures on a stock-by-stock basis would not be 
significantly more burdensome than requiring shorter reports with 
disclosures that were summarized across many stocks. Comment is 
requested on this issue.
---------------------------------------------------------------------------

    \28\ For example, all market centers trading Nasdaq securities 
are required to submit electronic data on individual order 
executions to the NASD pursuant to its Order Audit Trail System 
requirements. NASD Rules 6950-6957. This data includes the basic 
order information (such as the type and size of an order, and the 
time of order receipt, cancellation, and execution) that would be 
necessary to calculate the statistical measures of execution quality 
required by the proposed rule.
---------------------------------------------------------------------------

    Given the volume of data to be included in the electronic reports 
by market centers, most individual investors likely would not be 
interested in receiving and digesting the reports themselves. Rather, 
the information will need to be summarized and analyzed before it is 
helpful to investors in general. The Commission anticipates that 
independent analysts, consultants, broker-dealers, the financial press, 
and other market centers will analyze this information and produce 
summaries that respond to the needs of investors. Once basic, uniform 
information regarding order execution quality is available, the 
Commission believes that market forces will produce analyses of order 
execution quality adapted for different types of investors.
    Comment is requested on the approach of adopting uniform 
statistical measures of execution quality, divided into discrete 
subcategories of security/order type/order size. Is the approach 
feasible and implementable without undue burden on market centers? Will 
there be sufficient interest by third parties in collecting and 
summarizing the electronic reports so that the public and investors in 
general will have reasonable access to useful information on execution 
quality?
    A potential alternative to the approach reflected in the proposed 
rule is simply to require all market centers to make available 
electronic files with raw data on an order-by-order basis. For each 
order, market centers would provide the necessary fields of information 
(e.g., time (to the second) of order receipt, type of order, limit 
price, size of order, time of order execution, price of execution, 
cancellation, whether the order was routed to another venue and the 
identity of that venue) for analysts to calculate the statistical 
measures of execution quality that they consider appropriate. This 
approach may offer the advantage of avoiding the need to reassess the 
viability and usefulness of specific statistical measures and to update 
them periodically. Comment is requested on this alternative. Would it 
be feasible in light of the large volume of data that would be 
disclosed? In addition, comment is requested on whether the raw data 
alternative should be available only to small market centers that 
execute relatively few transactions in national market system 
securities. In particular, would small market centers find it easier 
and less burdensome to provide raw data rather than the statistical 
measures required by the proposed rule?
1. Scope of Rule
    Paragraph (b)(1) of proposed Rule 11Ac1-5 provides that every 
market center shall make available for each calendar month a report on 
covered orders in national market system securities that it received 
for execution from any person. Thus, the rule is limited in scope to 
market centers, covered orders, and national market system securities.
    a. Market Center. Paragraph (a)(14) of the proposed rule defines 
the term ``market center'' as any exchange market maker, OTC market 
maker,\29\ alternative trading system, national securities 
exchange,\30\ and national securities association. This definition is 
intended to cover entities that hold themselves out as willing to 
accept and execute orders in national market system securities. In 
addition, the language in paragraph (b)(1) that a market center must 
report on orders that it ``received for execution from any person'' is 
intended to assign the disclosure obligation to the entity that is 
expected to control whether and when an order will be executed.\31\
---------------------------------------------------------------------------

    \29\ The term ``exchange market maker'' is defined in paragraph 
(a)(9) of the proposed rule in substantially the same language as it 
is defined in Exchange Act Rule 11Ac1-1, the Commission's quote 
dissemination rule. The definition of ``OTC market maker'' in 
paragraph (a)(18) has been modified, however, to clarify that 
proposed Rule 11Ac1-5 would apply to any dealer that holds itself 
out as willing to buy from and sell to customers or others in the 
United States, regardless of whether the dealer is located outside 
the United States or trades on a foreign exchange.
    \30\ A national securities exchange is an exchange registered 
under Section 6 of the Exchange Act. An exchange exempted from 
registration pursuant to Section 5 of the Exchange Act therefore 
would not be included within the proposed rule's definition of 
market center. Comment is requested on the appropriateness of this 
exclusion.
    \31\ Under the rule as proposed, when a market center receives 
an order for execution, the order must be included in its 
statistical disclosures of execution quality even if the order is 
routed to another venue for execution. See note 35 below and 
accompanying text.
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    The Commission anticipates that the reporting entity for the vast 
majority of orders will be an exchange specialist, OTC market maker, or 
ATS. Although specialists and market makers frequently operate under 
the auspices of an SRO (and such an SRO likely would assist its members 
in meeting the disclosure requirements of the proposed rule), the 
responsibility for executing orders generally is handled by individual 
members. In some cases, however, orders may be executed through a 
facility operated by an SRO without a member significantly controlling 
the order executions. Examples may include the Small Order Execution 
System (``SOES'') operated by Nasdaq, the OptiMark systems operated by 
Nasdaq and the PCX, and floor brokers who receive orders on the floor 
of an exchange and obtain an execution of the orders with little 
participation by a specialist. The definition of market center includes 
exchanges and associations to cover these situations. Comment, however, 
is requested on the manner in which such order executions should be 
disclosed by the SRO, as well as the feasibility and cost of such 
generating such disclosures. In addition, comment is requested in 
general on the definition of market center and on the language of 
paragraph (b)(1) that imposes the disclosure requirement on market 
centers that receive an order for execution. In particular, are these 
workable concepts that will clearly assign the responsibility to 
disclose order executions?
    Interpretative questions would arise when a broker-dealer receives 
an order from a customer in a security for which the broker-dealer also 
is an OTC market maker or an exchange specialist. The Commission 
preliminarily believes that such a market center should be considered 
as having received an order for execution only when the order is 
transmitted to the department of the firm responsible for making a 
market in the security. Comment is requested on whether this is a fair 
and appropriate application of the disclosure requirement.
    Finally, comment is requested on whether the rule should exclude 
market centers that execute relatively few orders in national market 
system securities in total, or eliminate the disclosure requirement for 
individual

[[Page 48414]]

securities in which a market center executed relatively few orders. In 
particular, would the benefits of disclosure in these situations 
justify the costs of compliance?
    b. Covered Order. The definition of ``covered order'' in paragraph 
(a)(8) of the proposed rule contains several conditions or exclusions 
that are intended to limit the scope of the rule to those orders that 
provide a basis for meaningful and comparable statistical measures of 
execution quality. First, the rule applies only to market orders or 
limit orders that are received by a market center during the time that 
a consolidated BBO is being disseminated. This restriction is necessary 
because nearly all of the statistical measures included in the proposed 
rule depend on there being available a consolidated BBO at the time of 
order receipt. The term ``consolidated best bid and offer'' is defined 
in paragraph (a)(7) as the highest firm bid and the lowest firm offer 
for a security that is calculated and disseminated on a current and 
continuous basis pursuant to a national market system plan. The two 
plans that currently provide for the calculation and dissemination of a 
consolidated best bid and offer are the Consolidated Quotation Plan for 
listed equities, and the Nasdaq/National Market System Plan for Nasdaq 
equities.\32\ Comment is requested on the advisability and practicality 
of this condition. In addition, comment is requested on how the rule 
should apply to orders that are received when the consolidated BBO is 
locked or crossed.
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    \32\ Joint Self-Regulatory Plan Governing the Collection, 
Consolidation, and Dissemination of Quotation and Transaction 
Information for Exchange-Listed Nasdaq/National Market System 
Securities and for Nasdaq/National Market System Securities Traded 
on an Unlisted Trading Privilege Basis.
---------------------------------------------------------------------------

    The definition of covered order excludes any orders for which the 
customer requested special handling for execution and that, if not 
excluded, would skew general statistical measures of execution quality. 
These include, but are not limited to, orders to be executed at a 
market opening or closing price, stop orders, orders such as short 
sales that must be executed on a particular tick or bid, orders that 
are submitted on a ``not held'' basis, orders for other than regular 
settlement, and orders that are to be executed at prices unrelated to 
the market price at the time of execution. Comment is requested on the 
appropriateness of excluding these orders, particularly on the 
exclusion of market opening orders. The Commission recognizes, for 
example, that the quality of execution of market opening orders in the 
Nasdaq market has been an issue of significant concern. Nearly all of 
the statistical measures in the proposed rule, however, require the use 
of a consolidated BBO at the time of order receipt, which would not be 
available for orders that are to be executed at the market opening. The 
Commission requests comment on whether statistics should be included in 
the rule to measure the quality of execution of market opening orders 
and whether such statistics could be generated without undue burden or 
cost for market centers. In addition, comment is requested on whether 
there are additional types of orders that should be excluded from the 
scope of the proposed rule.
    c. National Market System Security. As proposed, Rule 11Ac1-5 would 
apply only to securities that are designated as a national market 
system security under Exchange Act Rule 11Aa2-1. Currently, this 
designation applies to exchange-listed equities and equities included 
in the National Market tier of Nasdaq.\33\ It does not apply to Nasdaq 
SmallCap securities and exchange-listed options. SmallCap stocks tend 
to be inactively traded and, as a group, generate less than 5% of the 
dollar volume on Nasdaq while making up nearly 25% of Nasdaq 
companies.\34\ Given the relatively light trading in these securities, 
the Commission preliminarily believes that the value of statistical 
measures of trading may not justify the costs to produce the 
information. Comment is requested on this issue.
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    \33\ Rule 11Aa2-1 incorporates the definition of ``reported 
security'' that is used in Exchange Act Rule 11Aa3-1--any security 
for which transaction reports are made available pursuant to a 
reporting plan approved under Rule 11Aa3-1. Only exchange-listed 
equities and Nasdaq National Market equities fall within this 
definition.
    \34\ See NASD Economic Research, http://www.marketdata.nasdaq.com (visited June 27, 2000).
---------------------------------------------------------------------------

    With respect to listed options, the Commission is concerned about 
the need for improved disclosure of execution quality in the options 
markets, particularly now that there is widespread trading of options 
on multiple exchanges and expanding payment for options order flow. 
Nevertheless, listed options are not included within the proposed rule 
principally because a consolidated BBO is not, at this time, calculated 
and disseminated for options trading. A consolidated BBO is an 
essential element for nearly every statistical measure in the proposed 
rule, such as calculating price improvement and classifying types of 
limit orders (e.g., inside-the-quote and at-the-quote limit orders). 
Comment is requested on the exclusion of listed options from the scope 
of the proposed rule and on whether there are other means to improve 
disclosure of execution quality by the national securities exchanges 
that trade listed options. In addition, comment is requested on whether 
the Commission should require that a consolidated BBO be calculated and 
disseminated for the options markets, thereby facilitating the 
disclosure of order execution practices.
2. Required Information
    Paragraph (b)(1) of the proposed rule requires that reports be 
categorized by order type, order size, and security. Each of these 
three categories is defined in paragraphs (a)(4)-(6) of the proposed 
rule. With this degree of categorization, a market center would, for 
example, produce statistical information for the subcategory of (1) 
market orders (2) of 100-499 shares (3) in an individual stock. Comment 
is requested on the appropriateness of these categories and whether 
they will generate useful information. Comment specifically is 
requested on the elimination from the rule's statistics of limit orders 
with limit prices that are more than $0.10 outside the consolidated BBO 
at the time of order receipt. The Commission preliminarily believes 
that the rule's statistical measures (e.g., fill rates and speed of 
execution) for this type of order may be less meaningful because they 
would be more dependent on the extent to which the orders' limit prices 
were outside the consolidated BBO (and movements in market prices) than 
on their handling by a market center.
     a. Information Required for All Types of Orders. For each 
subcategory of security/order type/order size, paragraph (b)(1)(i) of 
the proposed rule specifies eleven columns of information that must be 
provided. In addition, paragraph (b)(1)(ii) specifies nine additional 
columns of information for subcategories that include market orders and 
marketable limit orders. As a result, each market center's report would 
include 20 subcategories for each security, and up to 20 columns of 
information for a subcategory.
    The first five columns of information specified in paragraph 
(b)(1)(i) provide general information on the orders received by a 
market center in a subcategory and the disposition of those orders. The 
first column is ``the number of covered orders.'' The second, however, 
is ``the cumulative number of shares of covered orders''; and 
thereafter all statistics required by the rule are expressed either in 
number of shares or

[[Page 48415]]

in share-weighted amounts. The rule uses share-based statistics 
primarily to deal appropriately with those situations in which a single 
order receives less than a full execution or more than one partial 
execution.
    The rule as proposed requests the number of shares executed at both 
the receiving market center and at any other venue (after being routed 
elsewhere by the receiving market center). Thereafter, all statistical 
measures of order execution for a market center will encompass both 
orders that were executed at the receiving market center and orders 
that were executed elsewhere. In calculating its statistics, a market 
center will use the time it received the order and the consolidated BBO 
at the time it received the order,\35\ not the time and consolidated 
BBO when the venue to which an order was forwarded received the order. 
The Commission preliminarily believes that a market center should be 
held responsible for all orders that it receives and should not be 
given an opportunity to exclude difficult orders from its statistical 
measures of execution quality by routing them to other venues. In 
addition, from the perspective of the customer who submitted the order, 
the fact that a market center chooses to route the order elsewhere does 
not reduce the customer's interest in a fast execution that reflects 
the consolidated BBO as close to the time of order submission as 
possible. Consequently, in evaluating the quality of order routing and 
execution services, it is important for customers to know how a market 
center handles all orders that it receives and not just those it 
chooses to execute. Comment is requested on this issue. Would, for 
example, it be more appropriate to require market centers to provide 
separate statistics for orders that they executed and orders that were 
executed elsewhere, or would such a requirement unduly increase the 
volume of data required by the rule (presumably doubling the number of 
subcategories for each security)?
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    \35\ The term ``time of order receipt'' is defined in paragraph 
(a)(20) of the proposed rule as the time (to the second) that an 
order was received by a market center for execution. The definition 
is intended to identify the time that an order reaches the control 
of the market center that is expected, at least initially, to 
execute the order. Comment is requested on whether this definition 
is both workable and sufficiently clear to facilitate cross-market 
comparisons of execution speed and quality.
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    The next five columns of information required by the proposed rule 
ask for the percentage of shares that were executed within specified 
periods of time after order receipt (such as ``from 0 to 9 seconds'' 
and ``from 10 to 29 seconds''). Although required for all types of 
orders, the Commission anticipates that this information will be most 
useful for evaluating the execution of non-marketable limit orders. 
These statistics are intended to provide useful comparisons to the 
overall fill rates for non-marketable limit orders.\36\ Particularly 
for inside-the-quote and at-the-quote limit orders, the submitter of 
the order reasonably may expect that the order should be executed 
relatively quickly, and information on the likelihood that such an 
order will be executed with 10 seconds, 30 seconds, and so on, at 
different market centers may be helpful in guiding the order routing 
decision. Comment is requested on the usefulness of these measures of 
execution quality for non-marketable limit orders, as well as any other 
measures that commenters believe the Commission should consider. For 
example, one conceivable alternative would be the length of time that 
an order remained on a market center's order book while the limit price 
was at the consolidated BBO or better. Another alternative would be the 
number of trades or share volume printed on the consolidated tape at 
prices that are equal to or worse than the limit order price. Comment 
is requested on whether these alternative statistical measures would 
provide useful information, as well as on the difficulty and cost for 
market centers to generate the information.
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    \36\ The overall fill rates for such orders can be calculated by 
comparing the number of shares executed with the total number of 
shares received. Such overall fill rates for non-marketable limit 
orders can be difficult to interpret because of the problem of 
cancelled orders. An aggressive user of non-marketable limit orders 
frequently will submit orders with limit prices at or inside the 
current consolidated BBO. If market prices move away from the order, 
the order submitter may cancel and resubmit the order at a new limit 
price that reflects the changing consolidated BBO. Consequently, the 
same person potentially may cancel and resubmit an order several 
times to maintain the aggressiveness of the limit price. These 
cancellations can make it difficult to evaluate overall fill rates 
and cancellation rates.
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    The final column of information required by the proposed rule for 
all types of orders is the average realized spread. The term ``average 
realized spread'' is defined in paragraph (a)(3) of the proposed rule 
and is calculated by comparing the execution price of an order with the 
midpoint of the consolidated BBO as it stands 30 minutes after the time 
of order execution.\37\ By comparing execution prices with the post-
trade values, the average realized spread provides an important measure 
of execution quality that can be interpreted differently for non-
marketable limit orders and for market orders. For non-marketable limit 
orders, the average realized spread is a measure of adverse selection 
costs--the extent to which limit orders on average tend to be executed 
when the market is moving significantly against them. As noted 
above,\38\ this tendency can be exacerbated by the frequency and skill 
with which the local trading interest at a market center (whether those 
on the trading floor of an exchange or an OTC market maker) step in 
front of displayed limit orders by offering a better price as orders 
arrive for execution at the market center. This ``last mover'' 
advantage for local trading interest could be substantial, and the 
average realized spread can measure the extent to which it affects the 
execution costs of limit orders.
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    \37\ The proposed rule uses the midpoint of the consolidated BBO 
30 minutes after the time of execution as a proxy for the post-trade 
value of the security. This time period also has been used in 
analyses of execution quality. See, e.g., Hendrik Bessembinder, 
Trade Execution Costs on NASDAQ and the NYSE: A Post-Reform 
Comparison, 34 J. Financial & Quantitative Analysis 387, 395 (1999). 
Comment is requested on whether 30 minutes is an appropriate period 
of time to measure the post-trade value of a security, or whether it 
should be shorter or longer.
    \38\ See note 17 above and accompanying text.
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    For market orders (as well as marketable limit orders), the average 
realized spread can measure the extent to which ``informed'' and 
``uninformed'' orders are routed to different market centers. Informed 
orders are those submitted by persons with better information than is 
generally available in the market. They therefore represent a 
substantial risk to liquidity providers that take the other side of 
these informed trades. In contrast, orders submitted by those without 
an information advantage (often small orders) present less risk to 
liquidity providers and in theory should receive the most favorable 
prices available in the market. With a practice sometimes referred to 
as ``cream-skimming,'' market centers can attempt to identify and 
secure a substantial flow of uninformed orders. If these uninformed 
orders are executed at prices established by markets with a substantial 
volume of informed order flow, they may generate increased trading 
profits for liquidity providers. The average realized spread for market 
and marketable limit orders can highlight the extent to which market 
centers receive uninformed orders (as indicated by higher realized 
spreads than other market centers), thereby potentially helping to spur 
more vigorous competition to provide the best prices to these orders to 
the benefit of many retail investors.
    Comment is requested on the usefulness of the average realized

[[Page 48416]]

spread as a measure of execution quality for both non-marketable limit 
orders, and market and marketable limit orders. Comment also is 
requested on the difficulty and cost for market centers in generating 
statistics based on the consolidated BBO 30 minutes after the time of 
execution. As discussed below, the other measures of execution quality 
included in the proposed rule require comparisons with the consolidated 
BBO at the time of order receipt.
    b. Information Required for Market and Marketable Limit Orders. 
Subparagraph (ii) of paragraph (b)(1) of the proposed rule specifies an 
additional nine columns of information for subcategories of market 
orders and marketable limit orders.
    These columns are intended to help evaluate how well these orders 
are executed by comparing their execution prices with the consolidated 
BBO at the time of order receipt. The time of order receipt is used 
rather than the time of order execution primarily based on an 
understanding that customers, at least for purposes of evaluating 
execution quality, generally expect orders to be executed at prices 
that reflect, as closely as possible, the displayed quotes at the time 
they submit their orders. The earliest time at which a market center 
can be held responsible for executing an order is the time of receipt. 
The Commission also recognizes, however, that executions at prices 
outside the consolidated BBO at the time of order execution are 
troubling, both from the standpoint of the customer who received an 
inferior price and the displayed quote establishing the consolidated 
BBO that is passed over. Nevertheless, rather than require statistics 
for both the time of order receipt and order execution (and thereby 
increase the volume of data required by the rule), the rule as proposed 
adopts the time of order receipt for evaluating effective spreads, 
price improvement, and price disimprovement. Comment is requested on 
whether any statistics based on time of order execution also should be 
required.
    The first of these columns is the average ``effective'' spread (in 
contrast to the average ``realized'' spread that was discussed above). 
Average effective spread is defined in paragraph (a)(2) of the proposed 
rule and is calculated by comparing the execution price of an order 
with the midpoint of the consolidated BBO at the time of order receipt. 
The average effective spread is a comprehensive statistic that 
summarizes the extent to which market and marketable limit orders are 
given price improvement, executed at the quotes, and executed outside 
the quotes. As such, it is a useful single measure of the overall 
liquidity premium paid by those submitting market and marketable limit 
orders to a market center.
    The final eight columns of information required for market and 
marketable limit orders essentially break out the major determinants of 
execution quality that are summarized in the average effective spread. 
They also are intended to provide a substantial basis to weigh any 
potential trade-offs between execution speed and execution price. 
Orders would be classified based on whether they were ``executed with 
price improvement,'' ``executed at the quote,'' or ``executed outside 
the quote,'' as defined in paragraphs (a)(10)-12. For shares executed 
with price improvement and shares executed outside the quote, market 
centers would disclose the number of shares, the average amount per 
share of price improvement or price disimprovement, and the average 
speed of execution. For shares executed at the quote, market centers 
would disclose the number of shares and the average speed of execution. 
Not only will these statistics help broker-dealers and investors 
evaluate where to find the fastest executions at the best prices, they 
also will indicate the extent to which market centers are able to 
execute larger orders at prices equal to or better than the quotes and 
thereby provide an indication of the liquidity enhancement available at 
different market centers.
    Comment is requested on each of the statistical measures included 
in the rule as proposed, particularly as to their usefulness, 
practicality, and cost. Commenters also are requested to suggest any 
additional measures that they believe the Commission should consider.
3. Procedures for Making Reports Available to the Public
    In light of the large volume of data they necessarily will include, 
the monthly order execution reports must be made available by market 
centers in electronic form rather than in writing. Consequently, 
paragraph (b)(2) of the proposed rule directs the SROs to act jointly 
in establishing procedures for market centers to follow in making their 
monthly reports available to the public in a readily accessible, 
uniform, and usable electronic format.\39\ In addition, paragraph 
(b)(3) requires market centers to make their reports available within 
one month after the end of the month addressed in the report.
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    \39\ Section 11A(a)(3)(B) of the Exchange Act authorizes the 
Commission, by rule or order, to require SROs to act jointly with 
respect to matters as to which they share authority in planning, 
developing, operating, or regulating the national market system.
---------------------------------------------------------------------------

    To comply with the proposed rule, the Commission anticipates that 
the SROs would prepare and submit a joint plan to the Commission for 
approval under Exchange Act Rule 11Aa3-2. At that point, public comment 
would be invited on the proposed plan prior to Commission approval. 
Many of the more detailed issues relating both to the format of the 
reports and to the means of access to the reports can perhaps more 
appropriately be addressed in the context of approval of a joint plan. 
As a preliminary matter, however, the Commission anticipates that, 
although the volume of data in each report would be large if evaluated 
in written form, the volume of data would not be large when compared 
with many electronic databases currently available to the public. 
Accordingly, the Commission preliminarily believes that the public 
should have access to the reports in electronic form at very little 
cost.
    Comment is requested on the cost and logistics of making the 
monthly reports on order execution practices available in an electronic 
format. In particular, does it seem likely, as the Commission now 
believes, that the reports can be made available to the public in a 
reasonably efficient manner at low cost?

C. Proposed Rule 11Ac1-6--Disclosure of Order Routing Information

    Proposed Rule 11Ac1-6 would require disclosure of the order routing 
practices of broker-dealers that route orders as agent on behalf of 
their customers. Broker-dealers owe a duty of best execution to their 
customers in this context and must review their order routing practices 
periodically to assure they are meeting this responsibility. A primary 
purpose of proposed Rule 11Ac1-6 would be to bring this review process 
out into the open and afford customers a greater opportunity to monitor 
their broker-dealer's order routing decisions. The proposed rule would 
require broker-dealers to disclose, among other things, the venues to 
which they routed customer orders, the significant objectives that the 
broker-dealer considered in determining where to route orders, and the 
results actually achieved compared with the result available at other 
venues. On customer request, broker-dealers also would be required to 
disclose where an individual customer's orders were routed.
1. Scope of Rule
    The scope of proposed Rule 11Ac1-6 is not the same as the scope of 
proposed

[[Page 48417]]

Rule 11Ac1-5. First, proposed Rule 11Ac1-6 covers a wider range of 
securities. The definition of ``covered security'' in paragraph (a)(1) 
includes not only reported securities (i.e., exchange-listed equities 
and Nasdaq National Market equities), but also Nasdaq SmallCap equities 
and listed options.\40\ Second, the rule as proposed applies to all 
broker-dealers that route orders on behalf of their customers. The term 
``customer order'' is defined as any order to buy or sell a covered 
security that is not for the account of a broker-dealer, but excludes 
any order for a quantity of a security having a market value of at 
least $50,000 for a covered security that is an option contract and a 
market value of at least $200,000 for any other covered security.\41\ 
Large orders are excluded in recognition of the fact that statistics 
for where orders are routed and general descriptions of order routing 
practices are more useful for smaller orders that tend to be 
homogenous.
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    \40\ To include Nasdaq SmallCap equities, paragraph (a)(1)(i) of 
proposed Rule 11Ac1-6 incorporates the language of current Rule 
11Ac1-1(a)(1)--``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 Act.'' This language covers SmallCap equities, but excludes 
equities quoted on the OTC Bulletin Board operated by the NASD. To 
include option securities, paragraph (a)(1)(ii) of the proposed rule 
includes ``any option contract traded on a national securities 
exchange for which last sale reports and quotation information are 
made available pursuant to a national market system plan.'' This 
language includes any option securities for which market information 
is disseminated on a real-time basis pursuant to the national market 
system plan administered by the Options Price Reporting Authority 
(``OPRA'').
    \41\ Comment is requested on whether the amounts of $50,000 for 
option contracts and $200,000 for other securities are appropriate 
to exclude large orders for which general statistics are less 
useful.
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    Finally, the proposed rule applies to all types of orders (e.g., 
pre-opening orders and short sale orders), but broker-dealers must 
discuss and analyze their routing practices only for ``non-directed 
orders.'' Paragraph (a)(5) defines a non-directed order as any customer 
order other than a directed order. Paragraph (a)(3) defines a directed 
order as a customer order that the customer specifically instructs the 
broker-dealer to route to a particular venue for execution. 
Consequently, all customer orders are non-directed orders in the 
absence of specific customer instructions on where they are to be 
routed.
    The Commission preliminarily believes that a broad scope is 
appropriate for disclosure of order routing practices in light of the 
fact that broker-dealers currently have an obligation to obtain best 
execution of all orders represented on behalf of a customer, and this 
obligation entails a periodic review of the quality of markets. The 
proposed rule primarily requires a quantitative disclosure of where 
orders are routed and an explanation by the broker of the steps it took 
to obtain best execution of customer orders. The Commission requests 
comment in general on the scope of proposed Rule 11Ac1-6. Is it 
appropriate to include Nasdaq SmallCap equities and listed options? 
Should the rule also encompass orders for other types of securities, 
such as those quoted on the OTC Bulletin Board or otherwise in the 
over-the-counter market? Should the rule exclude broker-dealers that 
route a relatively small number of orders on behalf of customers? Are 
there any types of non-directed orders that should be excluded from the 
rule, or should any types of directed orders be included within the 
rule?
2. Quarterly Reports
    Paragraph (b)(1) of the proposed rule requires broker-dealers to 
make publicly available a report for each calendar quarter that 
discusses and analyzes its routing of non-directed orders in covered 
securities. The term ``make publicly available'' is defined in 
paragraph (a)(3) as posting on a free Internet web site, furnishing a 
written copy on request, and notifying customers at least annually that 
a written copy will be furnished on request. Unlike the monthly 
electronic reports on order execution practices required by proposed 
Rule 11Ac1-5, the quarterly reports on order routing practices are 
intended to be disseminated directly to investors. The purpose of using 
a primarily Internet method of dissemination is to assure ready access 
to the reports by interested parties, but also to ease the burden of 
compliance on broker-dealers by reducing paperwork and costs. Paragraph 
(b)(2) requires that a quarterly report be made publicly available 
within two months after the end of the quarter addressed in the report. 
This somewhat lengthy time lag is intended to allow broker-dealers an 
opportunity to evaluate the monthly electronic reports by market 
centers under Rule 11Ac1-5 prior to preparing their order routing 
disclosures. Comment is requested on the method and timing of 
dissemination of the quarterly reports.
    Paragraphs (b)(1) (i) and (ii) of proposed Rule 11Ac1-6 would 
require broker-dealers to disclose a quantitative analysis of the 
nature of their order flow. This would include the percentage of total 
customer orders that were non-directed orders, and the percentages of 
non-directed orders that were market orders, limit orders, and other 
orders. The quantitative analysis also would include the identity of 
each venue to which non-directed orders were routed for execution, the 
percentage of non-directed orders routed to the venue, and the 
percentages of non-directed market orders, non-directed limit orders, 
and non-directed other orders that were routed to the venue.\42\ The 
percentages, rather than numbers, of orders are used to facilitate 
customer understanding of the probability that particular types of 
orders will be routed to different venues without the need for 
calculations, as well as to protect potentially sensitive order flow 
information. Comment is requested on the quantitative analysis of where 
orders are routed in terms of percentages.
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    \42\ The term ``venue'' is intended to be interpreted broadly to 
cover market centers within the meaning of proposed Rule 11Ac1-
5(a)(14), as well as any other person or entity to which a broker 
routes non-directed orders for execution. As with market centers, 
interpretative questions may arise in identifying the appropriate 
venue when a person or entity trades under the auspices of an 
exchange or association. If, however, a particular market maker or 
dealer receives orders pursuant to any arrangement that gives it a 
preference to trade with the order as principal, that market maker 
or dealer, rather than the exchange, would appropriately be 
identified as the venue to which the order was routed.
---------------------------------------------------------------------------

    Under paragraph (b)(1)(iii), a broker-dealer also would be required 
to discuss the material aspects of its relationship with each venue to 
which non-directed orders were routed, including a description of any 
payment for order flow arrangement or profit-sharing relationship. The 
term ``payment for order flow'' is defined broadly in Exchange Act Rule 
10b-10(d)(9) to include any payment or benefit that results in 
compensation to the broker-dealer for routing orders to a particular 
venue. The term ``profit-sharing relationship'' is defined in paragraph 
(a)(7) of the proposed rule to mean any ownership or other type of 
affiliation under which the broker-dealer, directly or indirectly, 
shares in any profits that may be derived from the execution of non-
directed orders. It therefore specifically covers internalization of 
customer orders by a broker-dealer that executes customer orders as 
principal.
    The purpose of requiring disclosure of any relationships between a 
broker-dealer and the venues to which it routes orders is to alert 
customers to potential conflicts of interest that may influence the 
broker-dealer's order-routing practices. Currently, Rule 10b-
10(a)(2)(i)(C) requires a broker-dealer, when acting as agent for the 
customer, to disclose on the confirmation of a

[[Page 48418]]

transaction whether payment for order flow was received and that the 
source and nature of the compensation for the transaction will be 
furnished on written request. In addition, Exchange Act Rule 11Ac1-3(a) 
requires broker-dealers to disclose in new and annual account 
statements its policies on the receipt of payment for order flow and 
its policies for routing orders that are subject to payment for order 
flow. The Commission preliminarily believes that disclosure of 
potential conflicts of interest in conjunction with a quantitative 
analysis of where all non-directed orders are routed may provide 
customers with a clearer understanding of a broker-dealer's order 
routing practices than is provided under current rules. Comment is 
requested on whether, if proposed Rule 11Ac1-6 were to be adopted, the 
disclosure requirements currently in effect should be modified to 
reflect the new disclosure requirements.
    The Commission considered including in the proposed rule a 
requirement that broker-dealers provide a quantitative estimate of the 
aggregate dollar amount of payment for order flow received during a 
quarter from each order execution venue. It has not proposed such a 
requirement for two principal reasons.\43 \ First, there potentially 
are a multitude of varying arrangements for payment for order flow; 
estimating the amounts produced by such arrangements could be 
difficult, subjective, and costly. Second, the Commission is concerned 
that disclosure of the aggregate dollar amounts of payment for order 
flow, without requiring comparable disclosure of the dollar amount of 
trading profits that redound to the benefit of broker-dealers pursuant 
to profit-sharing relationships, potentially could paint an inaccurate 
picture of the relative financial incentives generated by the two types 
of relationships. Comment is requested on whether any disclosure of the 
aggregate amount of payment for order flow and shared trading profits 
should be required.
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    \43\ Although the proposed rule would not require an estimate of 
the aggregate dollar amount of payment for order flow, a broker's 
description of a payment for order flow arrangement must include 
disclosure of the material aspects of the arrangement. These would 
include a description of the terms of the arrangement, such as any 
amounts per share or per order that the broker receives. Similarly, 
in describing a profit-sharing relationship, a broker would be 
expected to disclose the extent to which it could share in profits 
derived from the execution of non-directed orders. An example would 
be the extent of the ownership relation between the broker and 
execution venue.
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    Finally, paragraph (b)(1)(iv) of the proposed rule requires broker-
dealers to discuss and analyze their order routing practices, including 
the significant objectives that affected order routing decisions, the 
results obtained for customers, a comparison of such results with the 
quality of order executions available at other venues, and whether the 
broker-dealer has made or intends to make any material changes in its 
order routing practices. This part of the report would essentially 
require a description of the basis of the broker-dealer's order routing 
decisions. The Commission repeatedly has stressed the importance of 
considering opportunities for price improvement to a broker's best 
execution analysis.\44\ At a minimum, the information required by 
paragraph (b)(1)(iv) of the proposed rule would include a description 
of the basis of any decision to forgo price improvement opportunities 
available at other venues. The Commission believes that responsible 
broker-dealers generally consider these issues as a matter of good 
business practice. It preliminarily believes that requiring public 
disclosure will be helpful to customers and others in evaluating the 
quality of a broker-dealer's order routing practices and promoting fair 
competition among broker-dealers. Comment is requested on the 
usefulness and cost of preparing the quarterly report on order routing 
practices.
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    \44\ See, e.g., Securities Exchange Act Release No. 37619A 
(Sept. 6, 1996), 61 FR 48290 (``Order Handling Rules Release''), 
text accompanying nn. 356-357.
---------------------------------------------------------------------------

3. Customer Requests for Information
    A broker-dealer's quarterly reports should provide a useful picture 
of its order routing practices as a whole, but will not inform 
individual customers where their own orders were routed. As noted 
above,\45\ broker-dealers currently are not required to disclose where 
orders are routed for execution, with the limited exception of NYSE 
Rule 409(f). To assure that customers have ready access to this 
information, paragraph (c) of the proposed rule would require broker-
dealers, on request of a customer, to disclose to the customer the 
identity of the venue to which the customer's orders were routed for 
execution in the six months prior to the request, whether the orders 
were directed orders or non-directed orders, and the time of the 
transactions, if any, that resulted from such orders.\46\ To alert 
customers to the availability of individual order routing information, 
paragraph (c)(2) of the proposed rule would require broker-dealers to 
notify their customers at least annually of their option to request 
such information.
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    \45\ See text following note 24 above.
    \46\ Currently, Rule 10b-10(a)(1) requires a broker-dealer to 
include the time of transaction on the confirmation of a transaction 
or a statement that the time of transaction will be furnished on 
written request. Paragraph (a)(9) of the proposed rule adopts the 
definition of the term ``time of the transaction'' set forth in Rule 
10b-10(d)(3)--``the time of execution, to the extent feasible, of 
the customer's order.''
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    Under the rule as proposed, those customers interested in 
monitoring the quality of their order executions would be entitled to 
learn important information about how their orders were handled. When 
combined with information that such customers may already maintain, 
such as the time they submitted an order to their broker-dealer, the 
consolidated BBO at the time they submitted the order, and the price at 
which an order was executed, the information to be provided on request 
potentially could give customers a substantial ability to monitor and 
evaluate their broker-dealer's order routing decisions and the quality 
of executions obtained at different venues. Broker-dealers would not, 
however, be required to bear the expense of providing individualized 
order routing information to those who had not asked to receive it. 
Comment is requested on the usefulness of this information and the 
costs to broker-dealers of responding to requests. In particular, do 
broker-dealers currently maintain information sufficient to respond to 
customer requests without undue additional burden or cost?

IV. Further Action To Strengthen Competition in the Markets

    The Commission is committed to maintaining vigorous competition 
between individual market centers. As the Commission discussed in the 
Fragmentation Release, competition in the securities markets can take 
two forms: competition among market centers, and competition among 
quotes and orders within and across market centers. Competition among 
market centers, in which each market center strives to attract order 
flow from intermediaries based on the overall quality of its market, 
has proven to be a primary force in improving the operation of the 
markets. It has encouraged innovation in trading systems, fostering the 
use of new technology and creative trading rules to offer an array of 
execution choices. Vigorous market center competition has driven 
markets to offer faster executions, charge lower fees, and provide 
greater liquidity at the best quoted price. These competition-driven 
market improvements have produced

[[Page 48419]]

enormous enhancements in service for both retail and institutional 
customers.
    The key service provided by a market center, however, is its 
quality of trade executions. First and foremost, customers seek to 
obtain from market centers the best possible execution price for their 
orders, and they may view the market's speed, depth, and cost-
efficiency as contributory factors to this key goal. For there to be 
meaningful competition between market centers, market participants need 
the ability to easily compare market centers on the basis of execution 
quality in addition to the other service factors that contribute to 
market quality. The execution quality disclosure rules proposed today 
are intended to empower market participants to evaluate, and hold 
accountable, market centers for the quality of execution they provide. 
These rules should encourage competition between market centers on the 
full range of factors important to customers.
    Consistent with encouraging competition among market centers on 
execution quality, the Commission believes that it is important to 
encourage the second form of competition--competition among orders on 
the basis of price. This competition is central to the operation of the 
equities markets. Price competition among orders is the primary price 
discovery vehicle in the markets. The best bid and ask quotes set the 
prices for most smaller trades, and these quotes (validated by trade 
reports) are the main reference point for larger institutional trades. 
The best bid and ask are the measure of market quality used to evaluate 
trades by all market participants. The spread between the best bid and 
ask is set by disclosed, priced orders competing to be the best price. 
If this competition wanes, the quote spread may widen, raising 
transaction costs for most or all investors. In addition, the depth of 
displayed trading interest may be reduced, leading to increased price 
volatility.
    Therefore, maintaining strong competition among published quotes is 
of fundamental importance to the price setting mechanism of the U.S. 
equity markets. Competition based on published quotes depends on the 
published quote's ability to interact with a flow of orders: better 
prices will not be quoted unless quoting is likely to produce an 
execution at the quote, and this likelihood depends on the availability 
of orders with which to trade.
    For this reason, the Commission remains concerned about the 
potential for fragmentation, and in particular widespread 
internalization of customer orders, to discourage quote competition in 
the markets. Without an incentive for competitive quotes, the best bid 
and offer may widen, resulting in worse prices for many investors. This 
issue was the core inquiry of the Fragmentation Release.
    In light of the comments of investors on the impact of 
internalization, the Commission remains deeply concerned about the 
potential for internalization to interfere with order interaction and 
discourage the display of aggressively-priced quotations. Nonetheless, 
as discussed previously, many comments criticized the price/time 
alternatives of the Fragmentation Release as premature in light of 
changing market structures, and potentially preventing vigorous 
competition among market centers. For these reasons, the Commission is 
taking action at this time only on the execution quality disclosure 
approach discussed in the Fragmentation Release, while deferring action 
on the Release's price/time priority alternatives. As described 
previously, the Commission is studying the market impact of 
fragmentation and internalization. The Commission intends to use the 
results of this analysis, and its experience with changing conditions 
in the market, to determine whether further steps are needed to 
increase competition among quoted prices.
    In addition to discussing proposals intended to address 
fragmentation issues directly, such as the proposed execution quality 
disclosures, a number of commenters on the Fragmentation Release argued 
that the Commission should do more to strengthen price competition and 
price priority within the existing market structure. The Commission 
believes that it is important now to consider further ways to improve 
the existing national market systems to better achieve these 
objectives.

A. Strengthening Price Competition in the Quote

    Many commenters on the Fragmentation Release argued that, in place 
of broader fragmentation measures, the Commission should strengthen the 
existing national market system structures that tie together the 
competing markets. One important means of strengthening these 
structures is to encourage sources of price competition within the 
consolidated quote.
    Today, the public consolidated quote plays a critical role in 
combating the fragmentation of isolated market centers by bringing 
together and making widely available the quotes of the market centers 
trading the same security. The consolidated quote provides 
intermediaries with a reliable indicator of the best prices of the 
various market centers, which they depend on in routing and executing 
orders. Investors also rely on the consolidated quote in placing their 
orders and monitoring the quality of their executions.
    Recently, questions have been raised about the fees charged for 
market information and the current methods of consolidating quotes from 
different markets.\47\ The Commission agrees that these issues warrant 
further consideration. On December 9, 1999, the Commission published a 
concept release on the topic of market data fees, to discuss various 
approaches to the review of fees for market information and the 
oversight of the consolidated information systems.\48\ Virtually all 
the commenters on the release agreed on the importance of consolidated 
information in the equities markets. They differed on many other issues 
in the release, including the proper approach to evaluating market data 
fees and the means of consolidating market data across markets. To 
further consider these issues, the Commission is establishing a formal 
advisory committee on market information to provide advice on the 
issues related to consolidated data in the equities and options 
markets, including alternative models for disseminating and 
consolidating information from multiple markets, and appropriate 
governance structures for joint market information plans.
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    \47\ See, e.g., Letter from James E. Buck, Senior Vice President 
and Secretary, New York Stock Exchange, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated April 10, 2000 (File No. S7-28-99); 
Letter from Marc E. Lackritz, President, SIA, to Jonathan G. Katz, 
Secretary, Commission, dated April 11, 2000 (File No. S7-28-99); 
Letter from David S. Pottruck, President & Co-Chief Executive 
Officer, The Charles Schwab Corporation, to Jonathan G. Katz, 
Secretary, Commission, dated March 14, 2000 (File No. S7-28-99) 
(``Schwab Market Data Letter'').
    \48\ Market Information Concept Release, note 26 above.
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    The Commission and most observers view a consolidated quote as an 
essential element of a national market system composed of competing 
markets.\49\ Strengthening price competition within the consolidated 
quote could improve prices for all participants in the competing 
markets. In recent years, two sources of prices have been critical in 
improving the consolidated quote: limit orders

[[Page 48420]]

displayed by specialists and market makers, and ECN quotes.
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    \49\ See, e.g., Letter from Craig S. Tyle, General Counsel, 
Investment Company Institute, to Jonathan G. Katz, Secretary, 
Commission, dated March 24, 2000 (File No. S7-28-99); Schwab Market 
Data Letter, note 47 above.
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1. Limit Orders
    The Commission believes that, in order to maintain vigorous price 
competition in quotes, it is important to maintain incentives for the 
display of limit orders. The Commission's Order Handling Rules for 
equities required the display of limit orders in the quote, unless the 
investor chose not to display the limit order.\50\ The display of limit 
orders in the quote is a dynamic stimulant of price competition in both 
listed and Nasdaq securities. For example, limit order display 
contributed to the substantial narrowing of Nasdaq spreads after the 
Order Handling Rules.\51\ Thus, it is imperative that the competitive 
force of limit orders be protected as markets evolve.
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    \50\ See Order Handling Rules Release, note 44 above.
    \51\ The narrowing of spreads after implementation of the Order 
Handling Rules is discussed in section IV.B of the Fragmentation 
Release, note 1 above.
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    The advent of decimal trading portends substantial benefits from 
narrower spreads in actively traded securities, resulting in lower 
trading costs for retail investors. Observers have raised concerns, 
however, that in a penny trading environment, displayed limit orders 
may be disadvantaged.\52 \Currently, in order for specialists and other 
exchange participants to trade ahead of a limit order with priority, 
they must trade at a \1/16\th better price (or 6.25 cents), because 
they can only trade in \1/16\th increments. Under NASD rules, to step 
ahead of a customer limit order, OTC market makers must trade at a \1/
16\th better price, or half the spread if the spread is a \1/16\th or 
less.\53\ If in a penny trading environment market makers, and other 
market participants, can trade with market orders for only a penny 
better than displayed limit orders, these market participants will 
likely step ahead of limit orders much more frequently. Market makers 
holding customer limit orders will be able to use their knowledge of 
market conditions to trade with incoming market orders at a penny 
better price, with the option of liquidating their position against 
customer limit orders at an insignificant loss.
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    \52\ See Letter from Daniel J. Schaub, Senior Vice President and 
Director of Nasdaq/OTC Trading, A.G. Edwards & Sons, Inc., to 
Jonathan G. Katz, Secretary, Commission, dated May 26, 2000; Letter 
from Henry H. Hopkins, Managing Director and Chief Legal Counsel, 
and Andrew M. Brooks, Vice President and Head of Equity Trading, T. 
Rowe Price Associates, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated June 19, 2000, at 3.
    \53\ NASD, Notice to Members No. 97-57, Question 7.
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    If these trading patterns develop, limit orders will be filled less 
frequently and under more disadvantageous conditions. Fewer limit 
orders may be entered, reducing the benefits of limit orders for price 
competition. For these reasons, the Commission intends to carefully 
consider, and discuss with the SROs, whether market makers and 
similarly-situated market participants should be able to step ahead of 
limit orders by as little as a penny without previously quoting at that 
price.
2. ECN Quotes
    Several commenters on the Fragmentation Release argued that the 
Commission should strengthen the consolidated quote in listed 
securities by including the quotes of ECNs, believing that these quotes 
could add a new source of aggressive price competition in the listed 
markets.\54\ Since the implementation of the Order Handling Rules in 
1997, ECN quotes have been displayed in the Nasdaq quotation montage, 
and they have been a major source of price discovery in the Nasdaq 
market. The inside quote for many Nasdaq securities, particularly 
actively-traded issues, includes an ECN a substantial majority of the 
time.\55\ ECNs currently account for approximately 30% of the trading 
volume in Nasdaq securities.\56\
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    \54\ See, e.g., Letter from Harold S. Bradley, et al., American 
Century Investments, dated May 21, 2000 (``American Century 
Letter''), at 6; Letter from Jonathan G. Breckenridge, Vice 
President, General Counsel, MarketXT, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated April 25, 2000, at 2; Island Letter, 
note 13 above, at 7. ECNs are electronic agency markets representing 
the limit orders of their customers, sometimes including market 
makers.
    \55\ See, e.g., Michael J. Barclay, et al., Effects of Market 
Reform on the Trading Costs and Depths of Nasdaq Stocks, 54 J. 
Finance 1, 29-30 (Feb. 1999) (following implementation of Order 
Handling Rules in 1997, the quotes of Instinet, an ECN, were on at 
least one side of the inside market 77% of the time, and the quotes 
of other ECNs were on a least one side of the inside market 70% of 
the time); American Century Letter, note 54 above, at 7-8.
    \56\ NASD Economic Research, http://www.marketdata.nasdaq.com 
(visited July 17, 2000) (in May 2000, ECNs accounted for 31.0% of 
Nasdaq dollar volume, 24.7% of share volume, and 30.9% of trades).
---------------------------------------------------------------------------

    Although the Order Handling Rules and Regulation ATS \57\ apply 
equally to ECNs trading both listed and Nasdaq securities, to date the 
ECNs have not accounted for a substantial volume of trading in listed 
securities. Moreover, the quotes of ECNs have not yet been included in 
the consolidated quote system for listed securities, largely because of 
significant issues regarding the terms and means of access to these 
quotes.\58\ The Commission believes that including ECN prices in the 
listed quote has the potential to increase quote competition in the 
listed markets. Consequently, the Commission is committed to resolving, 
with the ECNs, and the SROs that operate the consolidated quotation 
system for listed securities,\59\ the remaining issues hindering 
inclusion of all ECN prices in the public quote for listed equities.
---------------------------------------------------------------------------

    \57\ 17 CFR. 242.301.
    \58\ Nasdaq recently announced that it would include three ECNs 
in the consolidated quote through participation in its system 
linking Nasdaq market makers to the consolidated quote and ITS. See 
``Nasdaq InterMarket Forges Links with Major ECNs,'' Nasdaq Press 
Release, June 13, 2000 (available at http://www.nasdaqnews.com/news/pr2000) (visited July 13, 2000). Other major ECNs have refrained 
from participating in Nasdaq's system for listed securities because 
of differences over fees, and the ITS trade-through rule.
    \59\ In adopting Regulation ATS under the Exchange Act in 1998, 
the Commission comprehensively reconsidered the regulatory treatment 
of alternative trading systems such as ECNs. Securities Exchange Act 
Release No. 40760 (December 8, 1998), 63 FR 70844 (``ATS Release''). 
Reg ATS allowed alternative trading systems to choose whether to 
register as national securities exchanges, and thus take on the 
responsibilities of self-regulatory organizations, or to register as 
broker-dealers and be a member of a self-regulatory organization. 
(Since then, the International Securities Exchange has registered as 
an all-electronic securities exchange, two ECNs have applied for 
registration as exchanges, and another ECN has announced its 
intention to combine with an existing securities exchange.) ATSs 
that become exchanges are expected to participate directly in the 
national market systems; ATSs that remain broker-dealers would 
participate in these systems through an SRO. See ATS Release at text 
accompanying n. 396 & text following n. 596.
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    One of the most important issues to be resolved is the treatment of 
access fees charged by ECNs to their non-subscribers.\60\ For Nasdaq 
securities, ECNs that display customer order prices currently charge 
non-subscribers separate fees of between $.0025 and $.015 per share to 
trade with those customer orders. To comply with the equivalent access 
requirements of the Order Handling Rules, these fees cannot exceed the 
fees charged internally to a substantial proportion of the ECN's active 
broker-dealer subscribers.\61\

[[Page 48421]]

Access fees are consistent with the purely agency business model of 
ECNs. They charge a separate commission to one or both sides of a trade 
within their system, but do not trade as principal with customer order 
flow and therefore do not profit from the spread between the bid and 
offer, or from position trading. In contrast to ECNs, OTC market makers 
do not charge fees to other broker-dealers in addition to their quoted 
prices, in either the Nasdaq or listed markets.\62\ They primarily 
derive their profits from principal trading. Finally, most exchanges 
charge their members a transaction fee or communication fee to trade on 
their market. These fees generally have been de minimus in size.\63\ 
Under the ITS Plan, however, participant markets are allowed to access 
each others' quotes for free through the ITS linkage, subject to 
various terms and conditions.
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    \60\ An ECN subscriber is a person that has contracted for 
direct access to the ECN. Non-subscribers must obtain access to an 
ECN indirectly through a linkage, such as Nasdaq's SelectNet System.
    \61\ This policy has been communicated to the ECNs through no-
action letters issued by the Commission's Division of Market 
Regulation (``Division''). See, e.g., Letter from Richard R. 
Lindsey, Director, Division, Commission, to Charles R. Hood, Senior 
Vice President and General Counsel, Instinet Corp., dated January 
17, 1997 (Instinet Real-Time Trading Service); Letter from Richard 
R. Lindsey, Director, Division, Commission, to Joshua Levine and 
Jeffrey Citron, Smith Wall Associates, and Michael McCarthy, Datek 
Inc., dated January 17, 1997 (Island System). Charging a non-
subscriber a larger fee than subscribers pay creates a 
discriminatory barrier to access.
    \62\ For this reason, the manner that ECNs currently charge fees 
in the Nasdaq market has been controversial with market makers. Some 
market makers have not paid the fees billed by particular ECNs, and 
the ECNs have denied these market makers further access to the ECN's 
quotes. The Securities Traders Association has petitioned the 
Commission to prohibit ECNs from charging a fee for executing an 
order through an ECN when the ECN is alone at the inside quotation. 
Letters from Andrew N. Grass, Jr., Vice President, General Counsel, 
Securities Traders Association (``STA''), to Jonathan G. Katz, 
Secretary, Commission, dated August 28, 1998 and April 8, 1999. The 
Commission believes that this release responds to the STA's 
petition. In connection with its proposal to allow market makers to 
separately publish agency quotes, see Securities Exchange Act 
Release No. 41128 (March 2, 1999), 64 FR 12198, the NASD proposed to 
allow market makers to charge fees to access these quotes, but would 
have required market makers or ECNs charging a fee exceeding $.005 a 
share to include that fee in the quote. The Commission sought 
comment on ECN fee issues in the release publishing the latter 
proposal. See Securities Exchange Act Release No. 41343 (April 28, 
1999), 64 FR 24430. No action has been taken on the NASD's 
proposals.
    \63\ Exchanges also charge their members fees that are less 
transaction-specific, such as facilities or equipment fees and 
membership fees. Finally, the exchanges derive a significant portion 
of their total revenues from market data fees. See Market 
Information Concept Release, note 26 above, Appendix Tables 9-17.
---------------------------------------------------------------------------

    In today's Nasdaq market, ECN fees are small in relation to the 
existing quotation increment of \1/16\th. As a result, an ECN quote 
displayed at \1/16\th better than the next best quote ordinarily still 
offers a substantially better price than the next best quote, even with 
a separate fee charged. With the coming of trading in penny increments, 
however, the significance of ECN fees in comparison to the minimum 
quotation increment will become much greater, for both the Nasdaq and 
listed markets.
    The Commission believes that it is essential to preserve the 
integrity of the consolidated quote as a standard for execution quality 
among competing market centers. To meet this objective, each market's 
quotes must be substantially comparable to the quotes of other market 
centers. In particular, they should reflect in as comparable manner as 
possible the net price at which transactions can be effected on a 
market. If a market charges fees to intermediaries for access to its 
quote that are substantially higher than the cost of access to the 
quotes of other markets, the usefulness of the public quote as a guide 
to attainable prices could be impaired.
    The advent of decimal pricing offers one potential means to address 
the problem of disparate access fees--significant fees could be 
included in a market's public quote.\64\ Including the access fee in 
the quote would reflect the economic fact that the net price available 
is not in fact the quoted price alone, but also includes a fee. This 
approach would improve the comparability of ECN quotes without 
preventing ECNs from continuing to charge fees to access their markets.
---------------------------------------------------------------------------

    \64\ The Commission sought comment on the issue of ECN fees in 
the Reg ATS release, and specifically focused on whether the fees 
should be included in the quote after moving to decimal quotation 
increments. See Reg ATS Release, note 59 above, text accompanying n. 
236. In response to the comments, the Commission said that it would 
reconsider whether fees should be included in the ECNs' quotes when 
quotes are represented in decimals.
---------------------------------------------------------------------------

    The Commission recognizes, however, that ECN quotes frequently 
reflect the best displayed prices, particularly in the Nasdaq market, 
and that including fees in ECN quotes would potentially widen spreads. 
These concerns would be ameliorated somewhat, however, in a penny 
quoting environment. Including access fees in the public quote 
generally would widen the spread between bid and offer by only a penny 
or two, rather than a full \1/16\th or \1/8\th as would result under 
current quoting increments. Thus, the impact on both quoted spreads and 
the willingness of others to access ECN quotes would be reduced.\65\
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    \65\ In addition, this impact on spreads would be reduced by 
taking into account better prices at a smaller increment available 
within the ECN. Currently, ECN public quotes are rounded away to the 
next \1/16\th price when the ECN's best internal price is at a 
smaller fraction than \1/16\th (the current quote increment). Even 
if fees were included in the quote, if the ECN's better internal 
price, combined with its fee, were still better than the next public 
quotation increment, the ECN quote would not need to be rounded 
further because of the fee. For example, if an ECN had an internal 
buy order at $.2075, which would be rounded down to $.20 for public 
display, and the ECN charged a non-subscriber fee of $.005, the 
order would still be displayed at $.20 despite the fee. ECN access 
fees that were de minimus in size would not raise significant 
comparability issues.
---------------------------------------------------------------------------

    Another approach to improve the accuracy of quotes would be to 
include in the quote those access fees that are large relative to the 
quoting increment, but to allow access fees that are small in relation 
to the quoting increment to continue to be charged separately, instead 
of being reflected in the quote. For example, access fees of over half 
the quoting increment--\1/2\ cent--could be included in the quote, with 
the quote rounded to the next penny increment, while access fees of \1/
2\ cent or less could be charged separately in addition to the quote. 
This approach would avoid reducing the displayed quote a full cent due 
to a relatively small access fee. At the same time, it would reflect in 
the displayed quote larger access fees, which otherwise would make the 
net price only marginally better, or even worse, than the next best 
displayed price.
    If access fees are not included in the displayed quote, competitive 
forces may reduce, but not eliminate, the comparability problems that 
could arise from access fees. First, such fees are of practical 
importance primarily when markets with significant fees are alone at 
the best price. If a quote without a fee is at the same price as a 
quote with a fee, the fee-less quote typically would be the most 
attractive to brokers seeking the best execution of customer orders. In 
addition, if more than one market with a fee were quoting at the best 
price, the quote with the lowest fee attached normally would be the 
most attractive. These factors could create some competitive pressure 
for lower fees. If these fees are publicized, customers or brokers who 
routed limit orders for display on markets with the highest fees would 
know that the quotes displaying their orders would be the least 
attractive at the price. In practice, however, these factors have not 
reduced the ECN charges to non-subscribers on Nasdaq to insignificant 
levels.
    The Commission regards achieving comparability of ECN quotes with 
the quotes of other markets as an important pre-condition to including 
ECN quotes in the consolidated public quote for listed stocks. In the 
coming months, the Commission intends to work with the ECNs and 
interested SROs to find, prior to the full-scale implementation of 
decimal trading, the fairest and most efficient approach to achieve 
this goal. In addition to the comparability of quotes, the display of 
ECN quotes in listed stocks raises issues concerning the methods of 
access by other market

[[Page 48422]]

centers to displayed ECN quotes. These issues are discussed further 
below in the context of intermarket linkages to strengthen price 
priority.

B. Strengthening Price Priority

    The Fragmentation Release's alternatives involving price/time 
priority requirements across markets were intended to address 
fragmentation concerns by encouraging order interaction and price 
competition across markets. Many of the investor comments advocated 
price/time priority as the best means of encouraging price competition. 
Further, even many of the dealers who opposed price/time priority as 
interfering with existing markets advocated further action to ensure 
price priority across the markets. For example, the comment letter 
submitted by the SIA Market Structure Committee asserted that ``in 
order to promote quote competition, the Committee believes the 
Commission also must mandate price priority across market centers.\66\
---------------------------------------------------------------------------

    \66\ SIA Market Structure Letter, note 12 above, at 12.
---------------------------------------------------------------------------

    Price priority provides assurance that other markets will not trade 
at inferior prices before a better-priced quote is satisfied, which is 
important to investor confidence. When most individual investors enter 
a market order, they expect to receive at a minimum the best quoted 
price available when the order is executed. When the markets trade at 
prices inferior to the best quotes published by other markets, 
investors may lose confidence that orders are treated fairly across 
markets and that they can be assured of obtaining the best possible 
prices for their orders. Therefore, the Commission believes that it is 
important to encourage price priority across markets, particularly as 
new sources of quotes emerge and order routing technology improves.
    In response to the Fragmentation Release, a number of commenters 
advocated that the Commission should strengthen price priority by 
ensuring the development of improved electronic linkages between market 
centers, and mandating that market centers either match the best quoted 
price or route orders they receive to that better price.\67\ These 
commenters believed that these actions to strengthen price priority 
within the existing market structure would improve the price discovery 
process and combat the adverse affects of fragmentation.
---------------------------------------------------------------------------

    \67\ See Letter from Dongwook Park and John Braniff, Executive 
Vice Presidents, Global Equity Division, PaineWebber Inc., to 
Jonathan G. Katz, Secretary, Commission, dated May 22, 2000, at 1; 
Letter from Thomas M. Joyce, Managing Director, Head of Equity 
Market Structures, Merrill Lynch, Pierce, Fenner & Smith Inc., to 
Jonathan G. Katz, Secretary, Commission, dated May 19, 2000, at 2; 
Letter from Joseph T. McLaughlin, Executive Vice President, Legal 
and Regulatory Affairs, Credit Suisse First Boston Corp., to 
Jonathan G. Katz, Secretary, Commission, dated May 12, 2000, at 2-3; 
SIA Market Structure Letter, note 12 above, at 10-12.
---------------------------------------------------------------------------

    The Commission agrees that fair and effective access to market 
centers displaying the best quote is essential. This access enables 
orders to be routed from other markets to a better quote, rewarding the 
quote for displaying the best price, and allowing orders in other 
market centers to interact with that price. This access also ensures 
that other market centers can trade with the quote if they view that 
quoted price as inconsistent with the true market price in the 
security.
    Currently, access to quotes in the OTC equities markets is provided 
through Nasdaq's SelectNet system, which allows order routing between 
Nasdaq market makers, ECNs, and order entry firms, and Nasdaq's SOES 
system, which allows the automatic execution of small agency orders 
against market maker quotes.\68\ Market makers and ECNs also can be 
accessed by telephone and through private connections. Market makers 
are required to be firm for their quote for all broker-dealers; \69\ 
major ECNs are required to provide fair access to subscribers to their 
systems.\70\ In the listed equities markets, exchanges are required to 
provide broker-dealers fair access to membership (subject to the number 
of seats available),\71\ and the exchanges compete to provide members 
with efficient access to their markets. In addition, the ITS system 
allows orders to be routed among participating markets to access a 
better quote available on another participant market for listed 
equities. The recipient market is required to execute the ITS order 
within a minute if its better quote is still available when the order 
is received from another market. As discussed previously, the NASD has 
announced that it will link several participating ECNs with ITS as part 
of including the ECNs' quotes in the consolidated system, so that other 
ITS participants can access these ECNs' quotes through ITS.
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    \68\ The NASD has proposed to establish the Nasdaq Order Display 
Facility and the Order Collector Facility, collectively referred to 
as the SuperMontage. See Securities Exchange Act Release No. 42574 
(March 23, 2000), 65 FR 16981 (Amendment No. 4 to the SuperMontage 
proposal); and Securities Exchange Act Release No. 42166 (Nov. 22, 
1999), 64 FR 69125 (original SuperMontage proposal). The NASD has 
also proposed an order delivery and execution system, known as the 
Nasdaq National Market Execution System. See Securities Exchange Act 
Release No. 42344 (Jan. 18, 2000), 65 FR 3987.
    \69\ Exchange Act Rule 11Ac1-1(c)(2).
    \70\ 17 CFR 242.301(b)(5).
    \71\ 15 U.S.C. 78f(b)(2).
---------------------------------------------------------------------------

    The Commission recognizes that fair and efficient linkages to 
market centers publishing quotes are important to encourage price 
competition and strengthening price priority. For example, fair access 
to ECN prices published in the consolidated quote is necessary to allow 
orders to interact with these prices, and to enable other market 
centers to access these prices to achieve price equilibrium across 
markets.\72\ Because of the importance of interconnectivity, many 
markets are striving to build faster and more efficient links 
internally within their own market.\73\ At the same time, the 
Commission believes that wherever possible, market-based incentives, 
not government imposed systems, should determine the connections 
between markets. Mandating a specific form of linkage across markets 
could interfere with the ability of independent market centers to 
compete by structuring their own manner of trading. For instance, while 
automatic execution of small orders is widely sought by order entry 
firms and is used internally within many markets, mandating automatic 
execution of orders through a linkage could be incompatible with the 
business model of other market centers that rely on manual interaction 
of orders with interest represented on their floors.
---------------------------------------------------------------------------

    \72\ Under Reg ATS, ATSs that display quotes through an SRO must 
provide broker-dealers with access to their quotes that is 
equivalent to those broker-dealers' access to other quotes displayed 
by the SRO. 17 CFR 242.301(b)(3)(iii). At a minimum, this requires 
ATSs to accept orders from order routing systems operated by the SRO 
for its members. The Order Handling Rules have a similar requirement 
for ECNs. Exchange Act Rule 11Ac1-1(c)(5).
    \73\ See, e.g., Securities Exchange Act Release No. 42913 (June 
8, 2000), 65 FR 37587 (NYSE proposal for NYSe Direct+, a new NYSE 
facility to provide automatic execution of limit orders of a 
specified size); Securities Exchange Act Release No. 42574 (March 
23, 2000), 65 FR 16981 (Amendment No. 4 to proposal to establish the 
Nasdaq Order Display Facility and the Order Collector Facility, 
collectively referred to as the SuperMontage); Securities Exchange 
Act Release No. 42166 (Nov. 22, 1999), 64 FR 69125 (original 
proposal to establish the SuperMontage).
---------------------------------------------------------------------------

    There may of course be situations where market centers create 
contractual or operational barriers to access from other market 
centers, or where internal resistance to access prevents markets from 
agreeing on mutually beneficial methods to provide effective access 
among themselves. Clearly, market centers should not be allowed to 
frustrate the ability of other markets to reach their quotes through 
unfair limitations on access,\74\ and efficient

[[Page 48423]]

vehicles to reach these quotes are necessary. Regulatory action may be 
necessary to remove barriers to access. Given fair access, however, the 
Commission questions whether mandating a particular form of automated 
electronic linkage across markets is the best means of ensuring access. 
Rather, the Commission is considering whether market participants 
should now be expected to develop their own efficient linkages to other 
market centers sufficient to protect price priority for displayed 
quotes.
---------------------------------------------------------------------------

    \74\ Subject to certain exceptions, Exchange Act Rule 11Ac1-
1(c)(2) provides that a broker-dealer is obligated to execute orders 
in listed and Nasdaq equities at a price at least as favorable as 
the broker-dealer's published quotations in any amount up to its 
published quotation size.
---------------------------------------------------------------------------

    Multilateral linkage agreements among markets, such as the ITS 
Plan,\75\ are one possible method. Bilateral linkages between specific 
market centers are another. Another method is for a market to open its 
internal linkage systems to other markets, such as Nasdaq's SelectNet 
link to the Chicago Stock Exchange, and the linkage between Nasdaq's 
CAES and ITS. Moreover, markets increasingly may be able to access each 
other through electronic linkages provided by broker-dealers. The NYSE 
has stated that it could provide electronic access to its floor to 
other market centers through arrangements with broker-dealers that 
participate in those other market centers.\76\
---------------------------------------------------------------------------

    \75\ In addition to establishing and governing a specific 
technical linkage between participating markets, the ITS Plan 
includes standards for interaction among the participating markets. 
These include trade-through satisfaction processes, autoquote 
restrictions, procedures for cross-market openings, and restrictions 
on quotations that lock or cross the quotation of another market. If 
the quoting markets in listed securities do not all participate in 
the ITS plan, these significant cross-market issues must be 
addressed in another fashion.
    \76\ NYSE Letter, note 10 above, at 24-25.
---------------------------------------------------------------------------

    The Commission recognizes that developing individual or 
multilateral linkages to all the markets participating in the 
consolidated quote is no small task. In light of the effort necessary 
to establish this access, broker-dealers and market centers may in some 
cases fail to develop means to reach better quotes in other markets, 
instead choosing to simply ignore a better price displayed in an 
inconvenient market. The consequences of not developing efficient 
access could be a failure to honor the better quotes of other market 
centers, and worse executions for customer orders. To strengthen price 
priority across markets and protect customer orders, the Commission is 
considering whether to provide further incentives to broker-dealers and 
market centers to honor better quotes through a customer disclosure 
approach.
    For a similar purpose, the Commission today proposed a rule for the 
options markets designed to encourage price priority, and to protect 
customer orders, without mandating a specific linkage.\77\ This rule 
would require broker-dealers effecting transactions in listed options 
to disclose to their customer when the customer's order traded at a 
worse price than the best quote published in the options quote 
reporting system. In light of the limited number of exchanges trading 
listed options and the linkage plans that they have negotiated, 
pursuant to Commission order,\78\ the rule would provide an exception 
for orders routed to an options market that participated in a linkage 
plan that has provisions reasonably designed to limit trading through 
the quotes of another market center, including market centers not 
participating in the plan.
---------------------------------------------------------------------------

    \77\ Securities Exchange Act Release No. 43085 (July 28, 2000).
    \78\ See Securities Exchange Act Release No. 42029 (Oct. 19, 
1999), 64 FR 57674 (order directing the options exchanges to create 
an intermarket options linkage plan); Securities Exchange Act 
Release No. 42456 (Feb. 24, 2000), 65 FR 11402 (notice of options 
linkage plans submitted by the exchanges).
---------------------------------------------------------------------------

    The options trade-through disclosure rule is intended to encourage 
broker-dealers, and indirectly options market centers, to provide their 
customers with access to an execution at the best quote available. It 
does not prohibit trading through the superior quote, in recognition 
that there may be times when trading at an inferior price is in the 
customer's interest. In this case, however, it would require that 
customers be informed when their order traded at an inferior price. The 
rule would not require a linkage to other markets; rather, by requiring 
disclosure to customers, the rule would create an incentive for market 
participants to develop methods of access to avoid trade-throughs. The 
rule also would encourage participation in a linkage plan.
    The Commission is considering whether a similar trade-through 
disclosure approach is workable in the equities markets, to strengthen 
the price priority provided to the best published quotes. A trade-
through disclosure requirement in the equity markets could give a 
strong incentive to market centers to develop effective access to all 
market centers participating in the quote, without the Commission 
mandating a particular form of linkage. It could help ensure that the 
best quote interacts with orders across the markets by discouraging 
broker-dealers from routinely executing customer orders at inferior 
price levels. It also could help protect customer orders from 
unintended executions at inferior prices.
    Currently, trade-throughs of a superior quote on another equities 
market are discouraged by a combination of linkages between market 
centers, which facilitate access to the better price, and the broker-
dealer duty of best execution. Broker-dealers routing small customer 
orders generally seek to ensure they are executed at prices no worse 
than the best consolidated quote at the time the order is executed,\79\ 
reducing the incidence of trade-throughs. In addition, in the listed 
market, trade-throughs are discouraged by the ITS trade-through rule. 
The ITS trade-through rule, adopted by each ITS participant market, 
requires members of those markets to avoid trading-through superior 
quotes on another participant, and establishes procedures for obtaining 
redress from another market that trades through a superior quote. 
However, these provisions only cover participants in the ITS Plan. And 
their effectiveness in preventing trade-throughs depends in large part 
on market participants taking steps to seek redress for trade-throughs 
from another market, which does not always occur. For various reasons, 
executions of small customer orders at prices inferior to the best 
quote still appear to occur to a limited extent today.
---------------------------------------------------------------------------

    \79\ Broker-dealers also seek to ensure that small customer 
orders are executed at better than the best quote at the time the 
order is received.
---------------------------------------------------------------------------

    The incidence of trades at a worse price than the best displayed 
quote may increase if ECN quotes are included in the consolidated quote 
for listed markets. If an ECN is not part of ITS, as discussed above, 
the ITS trade-through rule would not apply to its quotes. Even when ECN 
quotes improve the consolidated quote for listed equities (as they have 
in the Nasdaq market), there may be a risk that other market centers 
will ignore these quotes at times on the grounds that the quotes are 
not easily accessible through ITS. Some ECNs, however, have argued 
against being subject to the ITS trade-through rule, on the grounds 
that their customers would prefer an immediate execution at an inferior 
price to another market's quote rather than a delay while seeking to 
reach that better price through ITS.\80\
---------------------------------------------------------------------------

    \80\ See Island Letter, note 13 above, at 5.
---------------------------------------------------------------------------

    The response to these issues by a number of commenters on the 
Fragmentation Release was to advocate that the Commission promote quote 
competition by requiring each market center executing an order to 
either match the better price quoted by another

[[Page 48424]]

market center, or route the order to that better quote.\81\ The 
Commission is concerned, however, 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 Commission is also concerned that it could be unfair to 
investors to require a fast, electronic market to route an order to a 
traditional exchange with a trading floor and wait up to a minute for 
the exchange to respond.
---------------------------------------------------------------------------

    \81\ See note 67 above.
---------------------------------------------------------------------------

    These concerns are not raised, however, by a trade-through 
disclosure requirement like that proposed for the options markets. This 
requirement would link execution quality more closely to the choices of 
the customer. It would not impede customers that are willing to trade 
at inferior prices in return for faster or more certain executions; 
these customers would presumably be unconcerned by disclosure that they 
traded at a worse price than the quote. Nor would it apply to broker-
dealers trading as principal. Yet this requirement could promote price 
priority by encouraging broker-dealers and market centers to match or 
route to a better quote in executing the orders of most customers, for 
whom obtaining the best quoted price is important.
    This requirement would supplement, but not replace, the broker-
dealer's duty to obtain best execution for its customer orders. Under 
this duty, the broker-dealer is required to seek to obtain best 
execution for its orders by, at a minimum, regularly reviewing the 
quality of executions provided by its choice of markets, including the 
possibility of price improvement for its orders over the best quoted 
price.\82\ By providing customer disclosure after the trade of the 
instances when a better quote was available at the time the trade 
occurred, a trade-through disclosure requirement would provide a better 
means for the investor to monitor whether its order received an 
inferior execution. In some cases, the investor may be satisfied with 
that execution. In situations where the customer would not be 
satisfied, the broker-dealer has an incentive to route the order to the 
best quote, or ensure that the market center that receives the order 
prevents trade-throughs through a linkage or other means.
---------------------------------------------------------------------------

    \82\ See Order Handling Rules Release, note 44 above, section 
III.C.2.
---------------------------------------------------------------------------

    A trade-through disclosure requirement also could complement 
proposed rules on disclosure of order routing and execution practices. 
These rules would allow market observers to analyze market center 
execution quality on a collective basis, and to assess the quality of 
order routing decisions made by the order routing broker-dealers. 
Moreover, by requesting information about where their orders were 
routed, customers could analyze the execution quality of their 
destination market centers for their types of orders. A trade-through 
disclosure requirement would further inform customers if their 
particular orders received an inferior execution, allowing them to 
assess execution quality on both a collective and an individual basis.
    The Commission recognizes that, in considering a trade-through 
disclosure requirement for the equities markets, a number of questions 
must be addressed. The first is whether a trade-through disclosure 
requirement is a cost-effective way to encourage price priority in the 
equities markets while avoiding prohibitions on trading strategies or 
mandatory linkages. This question may depend in part on the specific 
disclosure requirements for broker-dealers. For instance, a broker-
dealer may need to rely on notification from the market centers 
receiving its orders of when a trade-through occurred, and at what 
price, in order for the broker-dealer to determine whether disclosure 
to its customer is required. In addition, the proposed options trade-
through disclosure rule would except orders routed to markets 
participating in a joint industry linkage plan that contains provisions 
reasonably designed to limit trade-throughs of other markets' quotes. 
If a similar exception were to be given in the equities markets, the 
ITS Plan may need to be strengthened, or new joint industry plans may 
need to be developed, to take advantage of that exception.
    Second, the trade-through requirement depends in part on the 
comparability of quotes that are used for determining trade-throughs. 
If significant fees are charged in addition to the displayed quote, a 
trade-through of this quote may in fact not be as significant as it 
appears.
    In a decimal trading environment, where quotes may be for smaller 
size, and trade-throughs for smaller amounts, the Commission also must 
consider 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 acute 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 order. Another response would be to exempt large 
block orders from the disclosure requirement because of their size in 
relation to the quote, special handling, and general customer awareness 
of the quality of executions received.
    For smaller customer orders, trade-through disclosure may be more 
useful if it includes more than just disclosure of the better quote at 
the time of execution. For instance, many order entry firms monitor 
whether orders receive at least as good a price as the best quote as of 
the time the market center received the order, in addition to the quote 
at the time the order was executed. Disclosure of the quote at the time 
of receipt would help customers monitor whether they received a worse 
price because the execution was delayed. To address this issue, a 
trade-through disclosure requirement could require disclosure if the 
trade received a worse price than the best quote either at time of 
receipt or execution.
    The Commission also believes strongly that the preservation of 
investor confidence in the prices produced by our markets depends on a 
continuing commitment to the principle of price priority by both market 
centers and brokers routing customer orders. In some respects, current 
execution and order routing practices reflect a recognition of the 
basic expectation of the investing public that they will not trade at a 
price inferior to the quote. Specifically, a significant portion of the 
over-the-counter order flow in today's market is executed pursuant to 
arrangements where the market center undertakes to execute orders at 
the consolidated BBO at the time the order is received.
    In the case of an integrated firm handling orders placed with its 
retail network, the firm's commitment to match the consolidated BBO is 
obviously a critical component of the firm's best execution analysis 
with respect to internalized orders. Where order routing firms send 
orders to market centers with which they are not affiliated, the 
routing firm typically receives representations from the market center 
about execution quality, statements on which they rely in fulfilling 
their best execution obligations. In either event, the Commission 
believes that firms responsible for the handling of customer orders, at 
a minimum, must assess the ability of a market center to perform upon a 
commitment to execute or

[[Page 48425]]

otherwise handle orders in a particular manner at the time an initial 
routing decision is made. In addition, as part of their regular and 
rigorous review, brokers must assess the actual performance of the 
market in light of those commitments.
    The Commission wishes to stress the importance of the accuracy and 
completeness of representations made by market centers to order routing 
firms regarding execution quality, including, for example, promises to 
match the consolidated BBO, liquidity guarantees, opening guarantees, 
and assurance regarding the handling and display of customer limit 
orders. False or misleading statements made by market centers to 
routing firms regarding execution quality, if material and made with 
the requisite state of mind, may be actionable under antifraud 
provisions.\83\ Given the significance of such commitments to 
fulfillment of best execution obligations, the Commission intends to 
carefully monitor them, and, where appropriate, take action if they 
were found to be false or misleading.
---------------------------------------------------------------------------

    \83\ For example, Rule 15c1-2(b), 17 CFR 240.15c1-2(b), defines 
the manipulative, deceptive, or other fraudulent devices or 
contrivances proscribed in Section 15(c)(1) of the Exchange Act, 15 
U.S.C. 78o(c)(1), ``to include any untrue statement of a material 
fact and any omission to state a material fact necessary in order to 
make the statements made, in the light of the circumstances under 
which they are made, not misleading, which statement or omission is 
made with knowledge or reasonable grounds to believe that it is 
untrue or misleading.'' See also Rule 10b-5(b), 17 CFR 240.10b-5(b). 
The obligation to refrain from such statements or omissions does not 
depend on the existence of any fiduciary or similar duty, since even 
absent such a duty there is an ``ever-present duty not to mislead'' 
persons who trade in securities. Basic Inc. v. Levinson, 485 U.S. 
224, 240 n.18 (1988). See, e.g., Kline v. Western Government 
Securities, Inc., 24 F.3d 480, 491 (3d Cir.), cert. denied, 513 U.S. 
1032 (1994); Ackerman v. Schwartz, 947 F.2d 841, 847 (7th Cir. 
1991).
---------------------------------------------------------------------------

    The Commission welcomes the views of market participants on whether 
a trade-through disclosure requirement, similar to that proposed for 
the options markets, would strengthen price priority in the equities 
markets. The Commission also invites comment on whether a trade-through 
disclosure requirement would give market centers sufficient incentives 
to develop access arrangements to other equity markets, including ECNs, 
whose quotes are displayed in the best consolidated quote; or whether 
there are impediments to access that should be addressed directly 
rather than by relying on market-based incentives.

C. Conclusion

    The market structure dialogue resulting from the Commission's 
Fragmentation Release reflected a deep concern among many about the 
impact of fragmentation and internalization on the U.S. equities 
markets. At the same time, many others expressed a faith in competing 
markets' ability to use technology to create innovative solutions not 
yet envisioned. The dialogue also revealed a strong consensus in favor 
of greater standardized disclosure of the quality of executions 
provided by competing market centers, and disclosure of the order 
routing choices of broker-dealers handling customer orders. These rules 
could help brokers assess execution quality across markets. They could 
provide data to evaluate the order routing decisions of brokers. Once 
publicly known, this information could discipline markets and brokers 
that provided less than the best service for their customers. Building 
on this consensus, the Commission is proposing rules requiring market 
centers and broker-dealers to disclose publicly their order execution 
and order routing practices, so that customers, other market 
participants, analysts, and academics can evaluate their performance in 
this critical, but previously opaque, area of customer service. The 
Commission is continuing to consider the need for further market 
measures in response to fragmentation and internalization and is 
conducting an economic study of the impact of these forces on market 
quality.
    In a world of competing market centers, quote competition and price 
priority are critical to maintaining the display of the best possible 
market prices. The Commission is committed to encouraging quote 
competition and protecting price priority within the existing market 
structure. The Commission is considering ways to preserve the 
incentives to publish limit orders, which contribute so significantly 
to the price setting process. The Commission also is committed to 
resolving the issues impeding including ECN prices in the consolidated 
quote for listed securities. The Commission is considering new 
approaches to encourage linkage and protection of these quotes across 
market centers without directly mandating the form of a linkage. In 
particular, the Commission is considering a disclosure rule, as that 
proposed for the options markets, requiring broker-dealers to inform 
their customers on their confirmations of the price of the best quote 
and their trade price when the customer did not receive the best quoted 
price in their trade.

V. General Request for Comment

    The Commission seeks comment on the proposals described in this 
release and also on its discussion of further action to strengthen 
competition in the markets in section IV above. In addition to the 
specific requests for comment included throughout the release, the 
Commission asks commenters to address whether the proposed rules would 
further the national market system goals set out in Section 11A of the 
Exchange Act. The Commission also invites commenters to provide views 
and data as to the costs and benefits associated with the proposed 
rules. For purposes of the Small Business Regulatory Enforcement 
Fairness Act of 1996,\84\ the Commission also is requesting information 
regarding the potential impact of the proposed rules on the economy on 
an annual basis. If possible, commenters should provide empirical data 
to support their views. Comments should be submitted on or before 
September 22, 2000.
---------------------------------------------------------------------------

    \84\ Pub. L. No. 104-121, 110 Stat. 857.
---------------------------------------------------------------------------

VI. Paperwork Reduction Act

    Certain provisions of the proposed rules contain ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995,\85\ and the Commission has submitted them to the 
Office of Management and Budget for review in accordance with 44 U.S.C. 
3507(d) and 5 CFR 1320.11. The titles for the collection of information 
are: ``Rule 11Ac1-5'' and ``Rule 11Ac1-6.'' 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.
---------------------------------------------------------------------------

    \85\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collections of Information

    Proposed Rule 11Ac1-5 would require a market center that trades 
national market system securities to prepare and make available to the 
public monthly electronic reports that include uniform statistical 
measures of order execution quality. For each national market system 
security traded by the market center, the report would include 20 
subcategories (based on order type and size), and each subcategory 
could include up to 20 columns of statistical information.
    Proposed Rule 11Ac1-6 would require broker-dealers that route 
customer orders in equity and options securities to prepare and make 
available to the public quarterly reports that describe and analyze 
their order routing practices. In the reports, broker-dealers would be 
required to quantify the nature of their order flow, identify each 
venue

[[Page 48426]]

to which they directed orders, state the percentage of orders sent to 
that venue, discuss the material aspects of their relationship with 
each venue, and discuss significant factors that affected their order 
routing decisions. In addition, proposed Rule 11Ac1-6 would require 
broker-dealers to disclose, upon the request of a customer, the venues 
to which that customer's orders were routed for execution in the six 
months prior to the request, whether the orders were directed or non-
directed orders, and the time of the transactions, if any, that 
resulted from such orders.

B. Need for and Proposed Use of Information

    The Commission believes that the order execution information 
required by proposed Rule 11Ac1-5 is needed to further the national 
market system objectives set forth in Exchange Act Section 
11A(a)(1)(C). These objectives include the economically efficient 
execution of orders, fair competition among broker-dealers and among 
markets, the availability to broker-dealers and investors of 
information with respect to transactions in securities, and the 
practicability of brokers executing investors' orders in the best 
market. While the currently available consolidated quote provides some 
information on the prices available from market centers, this 
information may not accurately reflect the quality of order executions 
that may be obtained from individual market centers. Many market 
centers execute orders at prices better than, and in some cases 
inferior to, the consolidated quote at the time of order receipt. 
Although some market centers currently disseminate information on 
execution quality, that information generally is not made available to 
the public and may not permit comparative analysis across markets.
    The information disclosed by market centers pursuant to proposed 
Rule 11Ac1-5 would be made available to the public, and the Commission 
expects that this information would be used by broker-dealers, 
investors, and market centers. The Commission believes that broker-
dealers would use the information to make more informed choices in 
deciding where to route orders for execution. The Commission also 
expects that broker-dealers would use the information in connection 
with their regular evaluations of internal order handling practices, as 
required by the duty of best execution. Investors may use the 
information to evaluate the order handling practices of their brokers. 
They also may use the information to instruct their broker-dealers to 
route orders to market centers that offer superior executions for their 
types of orders. Market centers may use the information to compete on 
the basis of execution quality.
    Like the information required by proposed Rule 11Ac1-5, the 
Commission believes that the order routing information required by 
proposed Rule 11Ac1-6 is needed to further the national market system 
objectives set forth in Exchange Act Section 11A(a)(C). Improved order 
execution information from the market centers will be of little benefit 
to investors if they cannot determine where their orders are routed. In 
addition, order routing information will allow customers to monitor 
their broker-dealer's order routing decisions.
    The Commission believes that investors may use the information 
submitted pursuant to proposed Rule 11Ac1-6 in selecting a broker-
dealer and in determining whether the broker-dealers they have chosen 
are making sound order-routing decisions. Broker-dealers may use the 
information to compete on the basis of order routing services.

C. Respondents

    The collection of information obligations of proposed Rule 11Ac1-5 
would apply to all market centers that receive covered orders in 
national market system securities. Market centers are defined as 
exchange market makers, OTC market makers, alternative trading systems, 
national securities exchanges, and national securities associations. 
The Commission estimates that approximately 140 exchange market makers, 
450 OTC market makers, 29 alternative trading systems, seven national 
securities exchanges, and one national securities association would be 
subject to the collection of information obligations of proposed Rule 
11Ac1-5. Each of these respondents would be required to respond to the 
collection of information on a monthly basis.
    The collection of information obligations of proposed Rule 11Ac1-6 
would apply to all broker-dealers that route non-directed customer 
orders in covered securities. The Commission estimates that there are 
currently approximately 3800 broker-dealers that would be subject to 
the collection of information obligations of proposed Rule 11Ac1-6.\86\ 
Each of these respondents would be required to respond to the 
collection of information on a quarterly basis with respect to the 
rule's reporting obligations, and on an ongoing basis with respect to 
the rule's requirement to respond to customer requests for order 
routing information.
---------------------------------------------------------------------------

    \86\ This estimate is based on FYE 1999 FOCUS Reports received 
by the Commission. While there are currently approximately 7500 
broker-dealers registered with the Commission, only approximately 
3800 broker-dealers potentially route non-directed orders in covered 
securities.
---------------------------------------------------------------------------

D. Total Annual Reporting and Recordkeeping Burdens

    Proposed Rule 11Ac1-5 would require market centers to make 
available to the public monthly order execution reports in electronic 
form. To prepare the reports, market centers first would need to 
collect basic data on orders and executions (e.g., type and size of 
order, time of order receipt and execution). Second, this data would 
need to be processed to calculate the statistics required by the 
proposed rule and present those statistics in an electronic report.
    The Commission believes that many market centers retain most, if 
not all, of the underlying raw data necessary to generate these reports 
in electronic format. Consequently, it does not appear that the 
proposed rule would require substantial additional data collection 
burdens. Based on this assumption, the Commission staff estimates that, 
on average, the proposed rule would cause respondents to spend 6 hours 
per month in additional time to collect the data necessary to generate 
the reports, or 72 hours per year.\87\ With an estimated 627 market 
centers subject to the proposed rule, the total data collection cost to 
comply with the monthly reporting requirement is estimated to be 45,144 
hours per year.
---------------------------------------------------------------------------

    \87\ This figure could vary substantially among market centers. 
In addition, some SROs may provide this data collection service for 
their members because such centralized data collection is more 
efficient than data collection by individual members.
---------------------------------------------------------------------------

    Once the necessary data is collected, market centers could either 
program their systems to generate the statistics and reports, or 
transfer the data to a service provider (such as an independent company 
in the business of preparing such reports or an SRO) that would 
generate the statistics and reports. Although the largest market 
centers and SROs may choose to generate the reports themselves, the 
Commission anticipates that the great majority of market centers will 
rely on service providers to prepare the reports for them. It is 
significantly more efficient to consolidate the processing and 
reporting function in a limited number of entities than for each market 
center to prepare its own reports. Once an entity has incurred the up-
front costs of programming its systems to process data and generate a 
report for a single

[[Page 48427]]

market center, there is very little additional cost to performing the 
same function for many additional market centers. Based on discussions 
with industry sources, the Commission staff estimates that an 
individual market center could retain a service provider to prepare a 
monthly report for approximately $2500 per month. This per-respondent 
estimate is based on the rate that a market center could expect to 
obtain if it negotiated on an individual basis. Based on discussions 
with industry sources, we believe it is likely that a group of market 
centers, particularly the smaller members of a particular SRO, could 
obtain a much lower per-respondent rate on a collective basis. Thus, 
particularly for the smaller members of an SRO, the monthly cost to 
retain a service provider could be substantially less than $2500. Based 
on the $2500 estimate, however, the monthly cost to the 627 market 
centers to retain service providers to prepare reports would be 
$1,567,500, or an annual cost of approximately $18.8 million.
    Proposed Rule 11Ac1-6 would require broker-dealers to prepare and 
disseminate quarterly order routing reports. Much of the information 
needed to generate these reports already should be collected by broker-
dealers in connection with their periodic evaluations of their order 
routing practices. To comply with the proposed rule, however, broker-
dealers would incur additional burdens in preparing the reports and 
disseminating them on a free Internet web site (and responding to 
requests for written copies of the reports).
    There are extreme differences in the nature of the securities 
business conducted by the approximately 3800 broker-dealers that would 
be subject to the proposed rule. They range from the very largest firms 
with nationwide operations, which are relatively few in number, to 
thousands of much smaller introducing firms. To handle their customer 
accounts, these small firms rely primarily on clearing brokers. There 
currently are approximately 330 clearing brokers. The Commission 
previously has noted that ``from a functional perspective, introducing 
and clearing brokers act as a unit in handling a customer's account. In 
most respects, introducing brokers are dependent on clearing firms to 
clear and to execute customer trades, to handle customer funds and 
securities, and to handle many back-office functions, including issuing 
confirmations of customer trades and customer account statements.'' 
\88\ The Commission anticipates that clearing brokers primarily will 
bear the burden of complying with the reporting and recordkeeping 
requirements of the proposed rule on behalf of very small introducing 
firms. In addition, however, there are approximately 610 introducing 
brokers that receive funds or securities from their customers.\89\ 
Because at least some of these firms also may have greater involvement 
in determining where customer orders are routed for execution, they 
have been included, along with clearing brokers, in estimating the 
total burden of the proposed rule.
---------------------------------------------------------------------------

    \88\ Securities Exchange Act Release No. 40122 (June 30, 1998), 
63 FR 35508, n. 65.
    \89\ This estimate is based on FYE 1999 FOCUS Reports received 
by the Commission.
---------------------------------------------------------------------------

    Based on discussions with industry sources, the Commission staff 
estimates that each firm significantly involved in order routing 
practices will incur an average burden of 40 hours to prepare and 
disseminate a quarterly report required by Rule 11Ac1-6, or a burden of 
160 hours per year. With an estimated 940 broker-dealers significantly 
involved in order routing practices, the total burden per year to 
comply with the quarterly reporting requirement in proposed Rule 11Ac1-
6 is estimated to be 150,400 hours.
    Proposed Rule 11Ac1-6 also would require broker-dealers to respond 
to individual customer requests for information on orders handled by 
the broker-dealer for that customer. Clearing brokers generally would 
bear the burden of responding to these requests. The Commission staff 
estimates that each clearing broker will incur an average burden of 0.2 
hours to prepare, deliver, and retain a response to a customer required 
by Rule 11Ac1-6. The annual burden could vary significantly among 
clearing brokers based on the number of customers and number of 
inquiries by each customer. The Commission staff estimates that an 
average clearing broker will incur an annual burden of 400 hours (2000 
responses  x  0.2 hours/response) to prepare, disseminate and retain 
responses to customers required by Rule 11Ac1-6. With an estimated 330 
clearing brokers subject to the proposed rule, the total burden per 
year to comply with the customer response requirement in proposed Rule 
11Ac1-6 is estimated to be 132,000 hours.

E. General Information About the Collections of Information

    Any collections of information pursuant to the proposed rules would 
be mandatory. The monthly order execution reports prepared and 
disseminated by market centers pursuant to proposed Rule 11Ac1-5 would 
be available to the public and would not be kept confidential. 
Likewise, the quarterly order routing reports prepared and disseminated 
by broker-dealers pursuant to Rule 11Ac1-6 would be available to the 
public and would not be kept confidential. The individual responses by 
broker-dealers to customer requests for order routing information 
required by Rule 11Ac1-6 would be made available the customer and not 
to the general public. The Commission, SROs, and other securities 
regulatory authorities would gain possession of the responses only upon 
request. Any responses received by the Commission, SROs, and other 
securities regulatory authorities would be kept confidential, subject 
to the provisions of the Freedom of Information Act, 5 U.S.C. 552.
    Market centers that are national securities exchanges or national 
securities associations would be required to retain the collections of 
information required under proposed Rule 11Ac1-5 for a period of not 
less than five years, the first two years in an easily accessible 
place. All other market centers would be required to retain the 
collections of information required under proposed Rule 11Ac1-5 for a 
period of not less than three years, the first two in an easily 
accessible place.
    Broker-dealers would be required to retain the collections of 
information required under proposed Rule 11Ac1-6 for a period of not 
less than three years, the first two in an easily accessible place.

F. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to: (1) Evaluate whether the proposed collections of 
information are 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 collections 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

[[Page 48428]]

Regulatory Affairs, Office of Management and Budget, Washington, DC 
20503; and (2) Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609, with 
reference to File No. S7-16-00. The Commission has submitted the 
proposed collections 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 
collections of information between 30 and 60 days after publication in 
the Federal Register. A comment to OMB is best assured of receiving 
full consideration if it is received by OMB within 30 days of 
publication of this release. Requests for the materials submitted to 
OMB by the Commission with regard to these collections of information 
should be in writing, refer to File No. S7-16-00, and be submitted to 
the Securities and Exchange Commission, Records Management, Office of 
Filings and Information Services at the address set forth above.

VII. Cost-Benefit Analysis

    The Commission is proposing two rules to improve public disclosure 
of broker-dealer and market center practices in the routing and 
execution of customer orders. The rules are intended to increase access 
to information about how investors' securities transactions are 
executed, thereby enhancing an investor's ability to make choices on 
the basis of execution criteria important to the particular investor. 
The required disclosures also should aid broker-dealers in satisfying 
their duty of best execution. The disclosures and enhanced investor 
knowledge should promote vigorous and beneficial competition among 
broker-dealers to seek out, and among market centers to provide, 
superior execution of customer orders.

A. Costs and Benefits of Proposed Rule 11Ac1-5

    Under proposed Rule 11Ac1-5, each market center (defined as any 
national securities exchange, national securities association, exchange 
market maker, OTC market maker, or alternative trading system) would be 
required to make monthly disclosure of certain statistical measures of 
execution quality on a security-by-security basis.\90\ The Commission 
anticipates that the proposed rule will generate the benefits and costs 
described below.
---------------------------------------------------------------------------

    \90\ As set out more specifically in section III.B.2 above, the 
required disclosures will reflect statistical measures of such 
things as number of orders, number of shares, number of cancelled 
orders, size of spreads, frequency and size of price improvement, 
frequency of executions at the quote, frequency of executions 
outside the quote, and speed of execution (both with and without 
price improvement).
---------------------------------------------------------------------------

1. Benefits
    The Commission anticipates that the proposed rule will help broker-
dealers fulfill their duty of best execution. That duty requires a 
broker-dealer to seek the most favorable terms reasonably available 
under the circumstances for a customer's order. Routing orders to a 
market center that merely guarantees an execution at the best published 
quote does not necessarily satisfy that duty. A broker-dealer must 
consider several other factors affecting the quality of execution, 
including, for example, the opportunity for price improvement, the 
likelihood of execution (which is particularly important for customer 
limit orders), the speed of execution, the trading characteristics of 
the security, and any guaranteed minimum size of execution. While 
broker-dealers currently may be able to obtain order execution 
information from some market centers, that information may be of 
limited use and may not allow broker-dealers to compare execution 
quality among the different market centers. The Commission expects that 
the monthly reporting of uniform statistical measures required by the 
rule will provide broker-dealers with a clearer sense of execution 
quality among market centers, and will facilitate a broker-dealer's 
ability to obtain best execution for its customers.
    The Commission also believes that the reporting required by the 
rule will facilitate investors' ability to evaluate the quality of 
order executions provided by different market centers and to have 
meaningful input into how their broker-dealer obtains execution of 
their orders. Currently, investors possess few tools to compare order 
executions on different markets, and they typically leave routing 
decisions to their broker-dealer. Different investors, however, may 
have different concerns and priorities related to execution of their 
orders, such as an opportunity for price improvement and the speed of 
execution. The proposed rule will require disclosure of information 
that will enhance investors' evaluation of these matters.
    The Commission believes that the proposed rule will have the 
additional benefit of stimulating competition between market centers to 
improve the quality of their executions. Market centers compete to 
attract order flow. An important way in which market centers seek to 
attract order flow is by providing--and developing a reputation for 
providing--superior executions. The proposed rule will give broker-
dealers and investors meaningful information, which they have not 
previously had, bearing on execution quality. Access to that 
information will allow broker-dealers and investors to direct orders to 
market centers on the basis of their order execution performance. The 
Commission anticipates that this will benefit investors by putting 
competitive pressure on market centers to reduce inefficiencies, to 
increase opportunities for price improvement, to decrease instances of 
price ``disimprovement,'' and to improve the quality of execution in 
all other respects. Ultimately, the Commission anticipates that these 
improvements in execution also will benefit investors by leading to 
reduced trading costs, increased trading quality, and possibly 
increased trading volume.
    For example, the competition that flows from the required 
disclosure will likely reduce differences in spreads between market 
centers. If this competition induces market centers whose effective 
spread is greater than the median effective spread to execute trades at 
the median effective spread, the rule could lead to substantial savings 
for investors. For example, the annual savings to investors who submit 
market orders in Nasdaq stocks under this assumption is estimated to be 
$160 million.\91\ Moreover, if all Nasdaq market centers executed 
trades at the lowest effective spread, the savings to investors would 
be even greater.\92\ There also could be a similar type of benefit for 
investors in the listed markets, although to a lesser extent given the 
smaller number of market centers.
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    \91\ These savings are based on a sample of Nasdaq securities 
from June 2000 and represent the benefits summed over all Nasdaq 
stocks for one year. The annual savings exclude changes in effective 
spread for marketable limit orders and for any trade greater than 
4999 shares. The sample also excludes trades on ECNs because ECNs 
generally do not accept market orders.
    \92\ Under this assumption, annual savings to Nasdaq investors 
would be approximately $385 million. These savings are calculated in 
the manner described in the preceding note.
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    The Commission requests comment on the benefits of the proposed 
rule. Will the proposed rule have the benefits that are described 
above? Are there benefits to the proposed rule other than those 
described here? Are there ways in which to quantify any of the benefits 
of the rule? We specifically request any supporting data and analyses 
quantifying the benefits.

[[Page 48429]]

2. Costs
    For purposes of the Paperwork Reduction Act, the Commission staff 
has estimated that the proposed rule could, on an annual basis, impose 
45,144 burden hours and $18.8 million in other costs on all market 
centers. The staff estimates that 100% of the burden hours could be 
expended by market centers' internal staff. Assuming internal staff 
costs of $53 per hour, a market center could expend a total of 
approximately $2.4 million. Consequently, the estimated aggregate 
annual cost for compliance with the proposed rule could be 
approximately $21.2 million ($18.8 million + $2.4 million). We request 
comment on the potential costs of the rule identified above. In 
addition, we request comment on whether the rule would impose any other 
costs not described here.

B. Costs and Benefits of Proposed Rule 11Ac1-6

    Under proposed Rule 11Ac1-6, broker-dealers that route orders in 
equity and options securities on behalf of customers would be required 
to prepare quarterly reports that describe their order routing 
practices. Proposed Rule 11Ac1-6 also would require broker-dealers to 
disclose to customers, on request, where that customer's individual 
orders were routed for execution.
1. Benefits
    The Commission anticipates that improved disclosure of order 
routing practices will result in better-informed investors, will 
provide broker-dealers with more incentives to obtain superior 
executions for their customer orders, and will thereby increase 
competition between market centers to provide superior executions. 
Currently, the decision about where to route a customer order is 
frequently made by the broker-dealer, and broker-dealers may make that 
decision, at least in part, on the basis of factors that are unknown to 
their customers. The rule's disclosure requirements will provide 
investors with a clearer picture of how their broker-dealers are 
meeting their best execution obligation. \93\ The Commission 
contemplates that this will result in greater investor involvement in 
order routing decisions and, ultimately, will result in improved 
execution practices. Because of the disclosure requirements, broker-
dealers may be more inclined (or investors may direct their broker-
dealers) to route orders to market centers providing superior 
execution. Broker-dealers who fail to do so may lose customers to other 
broker-dealers who will do so. This increased investor knowledge and 
involvement could ultimately have the effect of increasing competition 
between market centers to provide superior execution.
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    \93\ As described more fully in section III.C.2 above, the rule 
would require that broker-dealers provide quarterly reports 
describing its order routing objectives, the extent to which order 
executions achieved those objectives, a comparison of the quality of 
executions actually obtained with those produced by other venues, 
and material facts concerning the broker-dealer's relationship with 
market centers to which it routes orders.
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    We request comment on the benefits of the proposed rule. Will the 
proposed rule have the benefits that we have described? Are there ways 
in which to quantify any of those benefits? Are there benefits to the 
proposed rule other than those described here?
2. Costs
    For purposes of the Paperwork Reduction Act, the Commission staff 
has estimated that the proposed rule could, on an annual basis, impose 
150,400 burden hours on broker-dealers to comply with the quarterly 
reporting requirement of the proposed rule. The staff estimates that 
100% of those burden hours will be expended by broker-dealers' internal 
staff. Assuming internal staff costs that average $85 per hour,\94\ the 
aggregate annual cost of compliance with the quarterly reporting 
requirement could be approximately $12.8 million. In addition, 
compliance with the proposed rule will require staff time to respond to 
requests by customers for disclosure of the market centers to which 
their orders have been routed. For purposes of the Paperwork Reduction 
Act, the Commission staff has estimated that compliance with such 
requests could, on an annual basis, impose 132,000 burden hours. 
Assuming average internal staff costs of $53 per hour, the annual cost 
of compliance with the customer response requirement could be 
approximately $7 million.
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    \94\ A higher average rate of internal staff costs is used for 
the preparation of quarterly reports based on the assumption that 
they would be prepared, at least in part, by higher level staff than 
that involved with responding to customer requests.
---------------------------------------------------------------------------

    The Commission requests comment on the potential costs of the rule 
identified above. In particular, comment is invited on how best to 
estimate the number of customer requests that broker-dealers will 
receive pursuant to the rule, if adopted. The Commission also requests 
comment whether the rule would impose any other costs not described 
here.

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

    Section 23(a)(2) of the Exchange Act requires the Commission, when 
making rules under the Exchange Act, to consider the impact of such 
rules on competition.\95\ In addition, Section 3(f) of the Exchange Act 
requires the Commission, when engaging in rulemaking that requires it 
to consider or determine whether an action is necessary or appropriate 
in the public interest, to consider whether the action will promote 
efficiency, competition, and capital formation.\96\
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    \95\ 15 U.S.C. 78w(a).
    \96\ 15 U.S.C. 78c(f).
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    The Commission has considered the proposed rules in light of these 
standards and preliminarily believes that the proposed rules will not 
impose a burden on competition not necessary or appropriate in 
furtherance of the purposes of the Exchange Act. To the contrary, by 
enhancing the disclosure of order execution and order routing 
practices, the proposed rules may promote fair and vigorous 
competition. Investors currently have little information to evaluate 
the order routing practices of their broker-dealers. As a result, there 
currently may be limited opportunities for fair competition among 
broker-dealers based on the quality of their order routing services. By 
requiring broker-dealers to disclose information on their order routing 
practices, the proposed rules may stimulate competition among broker-
dealers based on the quality of their order routing services. 
Similarly, by requiring market centers to disclose order execution 
information in a manner that permits comparative analysis, the proposed 
rules may stimulate competition among market centers based on the 
quality of their order execution services. In addition, because the 
proposed rules would apply equally to market centers, with respect to 
order execution disclosure, and broker-dealers, with respect to order 
routing disclosure, the proposed rules would not result in disparate 
treatment of these entities that could hinder competition.
    The Commission also believes that the proposed rules would allow 
investors and broker-dealers to make better-informed choices in finding 
the best market for orders to be executed. Accordingly, the proposed 
rules may promote market efficiency. In addition, the availability of 
information on order execution and order routing quality may

[[Page 48430]]

bolster investor confidence, thereby promoting capital formation. The 
Commission requests comment on the effects of the proposed rules on 
competition, efficiency, and capital formation.

IX. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis (``IRFA'') has been 
prepared in accordance with the Regulatory Flexibility Act.\97\ It 
relates to proposed new Rules 11Ac1-5 and 11Ac1-6 under the Exchange 
Act. The proposed rules would require market centers to make 
disclosures of order execution information and broker-dealers to make 
disclosures of order routing information.
---------------------------------------------------------------------------

    \97\ 5 U.S.C. 601 et seq. 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.''
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A. Reasons for the Proposed Action

    The Commission believes that there is a need for improved 
disclosure of order execution information by market centers. Investors 
today can obtain consolidated quote information that represents the 
best bid and offer from among the different market centers. However, 
this information may not accurately reflect the quality of order 
executions that may be obtained from the different market centers. Many 
market centers offer significant opportunities for execution of orders 
at prices better that the consolidated quote. Conversely, some market 
centers execute orders at prices less favorable than the consolidated 
quote at the time of order receipt. The amount of price improvement or 
disimprovement may result in significant savings or costs to investors. 
Although some market centers make order execution information available 
to private companies or their members, this information generally has 
not been publicly disseminated. Moreover, the lack of uniformity in the 
way this information is prepared has made it difficult for users of the 
information to compare execution quality across market centers.
    The Commission also believes that there is a corresponding need for 
disclosure of order routing information by broker-dealers. If investors 
do not know where their broker-dealers route their orders for 
execution, then the order execution information provided by market 
centers will be of little benefit to investors. The unavailability of 
easily accessible order routing information also may make it difficult 
for investors to monitor their broker-dealer's order-routing decisions.

B. Objectives and Legal Basis

    Proposed Rule 11Ac1-5 is designed to address the need for improved 
disclosure of order execution information by market centers. In 
particular, the rule is intended to provide investors and broker-
dealers with uniform information on execution quality from the 
different market centers that can be used to compare execution quality 
across market centers. This information should assist investors and 
broker-dealers in finding the best market for orders to be executed, 
thereby promoting competition among market centers and broker-dealers 
on the basis execution quality and leading to more efficient 
transactions in securities.
    Proposed Rule 11Ac1-6 is designed to address the complementary need 
for broker-dealers to disclose to customers where their orders are 
routed for execution. The primary objective of the rule is to afford 
customers a greater opportunity to monitor their broker-dealer's order 
routing practices. Supplied with information on where their orders are 
routed, as well as information about the quality of execution from the 
market centers to which their orders are routed, investors will be able 
to make better informed decisions with respect to their orders. The 
information also may assist investors in selecting a broker-dealer.
    Rules 11Ac1-5 and 11Ac1-6 are proposed under the Commission's 
authority set forth in Sections 3(b), 5, 6, 11A, 15, 17, 19 and 23(a) 
of the Exchange Act.

C. Small Entities Subject to the Rules

    Both proposed Rule 11Ac1-5 and proposed Rule 11Ac1-6 would affect 
entities that are considered small entities for purposes of the 
Regulatory Flexibility Act.
1. Small Entities Affected by Proposed Rule 11Ac1-5
    Proposed Rule 11Ac1-5 would impose disclosure requirements on every 
market center that receives covered orders in national market system 
securities. Market centers are defined as exchange market makers, OTC 
market makers, alternative trading systems, national securities 
exchanges, and national securities associations.
    Exchange market makers, OTC market makers, and alternative trading 
systems that are not registered as exchanges are required to register 
as broker-dealers. Accordingly, these entities would be considered 
small entities if they fall within the standard for small entities that 
applies to broker-dealers. Under Exchange Act Rule 0-10(b), a broker-
dealer is considered a small entity for purposes of Regulatory 
Flexibility Act if (1) it had total capital of less than $500,000 on 
the date in the prior fiscal year as of which its audited financial 
statements were prepared, of, if not required to prepare such 
statements, it had total capital of less than $500,000 on the last 
business day of the preceding fiscal year, and (2) it is not affiliated 
with any person (other than a natural person) that is not a small 
entity.\98\ Based on this standard, the Commission estimates that two 
exchange market makers, one OTC market maker, and no alternative 
trading systems that would be subject to proposed Rule 11Ac1-5 are 
small entities.\99\
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    \98\ Exchange Act Rule 0-10(b), 17 CFR 240.0-10(c).
    \99\ These estimates are based on the FYE 1999 FOCUS Reports 
received by the Commission from exchange market makers, OTC market 
makers, and ATSs that would be subject to proposed Rule 11Ac1-5. 
[100]: 17 CFR 240.0-10(e).
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    None of the national securities exchanges or the national 
securities association subject to the proposed rule is a small entity. 
Paragraph (e) of the Exchange Act Rule 0-10 \100\ provides that the 
term ``small business,'' when referring to an exchange, means any 
exchange that has been exempted from the reporting requirements of 17 
CFR 240.11Aa3-1. Under this standard, none of the national securities 
exchanges affected by the proposed rule is a small entity. Similarly, 
the national securities association subject to the proposed rule is not 
a small entity as defined by 13 CFR 121.201.
---------------------------------------------------------------------------

    \100\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

2. Small Entities Affected by Proposed Rule 11Ac1-6
    Proposed Rule 11Ac1-6 would impose disclosure requirements on every 
broker-dealer that routes non-directed customer orders in covered 
securities. Under the standard for determining whether a broker-dealer 
is a small entity in Exchange Act Rule 0-10(b), the Commission 
estimates that approximately 41 broker-dealers subject to proposed Rule 
11Ac1-6 are small entities.\101\
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    \101\ This estimate is based on the FYE 1999 FOCUS Reports 
received by the Commission from broker-dealers subject to proposed 
Rule 11Ac1-6.
---------------------------------------------------------------------------

D. Reporting, Recordkeeping and Other Compliance Requirements

1. Reporting Requirements Under Proposed Rule 11Ac1-5
    Proposed Rule 11Ac1-5 would impose new reporting requirements on 
market centers, including those

[[Page 48431]]

considered small entities. Under the proposed rule, market centers 
would be required to prepare and make available to the public monthly 
reports that categorize and summarize their order executions. For 
purposes of the Paperwork Reduction Act, the Commission staff estimates 
that individual market centers would, on an annual basis, expend 72 
burden hours and incur $30,000 ($2500 per month) in monetary costs to 
comply with the monthly reporting requirement. Assuming internal 
compliance staff costs of $53 per hour, the total cost per small entity 
would be $3816. The Commission estimates the total cost per year 
required to prepare and disseminate the monthly reports by the 
estimated three small entities subject to the proposed rule would be 
$108,360 (3  x  ($30,000+$3816)). As discussed further above, small 
entities likely could obtain a much reduced rate through the auspices 
of an SRO or other organization.
2. Reporting Requirements Under Proposed Rule 11Ac1-6
    Proposed Rule 11Ac1-6 would impose new reporting requirements on 
broker-dealers, including those considered small entities. Under the 
proposed rule, broker-dealers would be required to prepare and make 
available to the public quarterly reports that discuss and analyze 
their routing of non-directed orders in covered securities. In 
addition, broker-dealers, on request of a customer, would be required 
to disclose the identity of the venues to which the customer's orders 
were routed in the six months prior to the request, whether the orders 
were directed or non-directed orders, and the time of the transactions 
resulting from such orders.
    As discussed in section VI.D above, it is unlikely that small 
entities in general will have significant involvement in order routing 
practices, primarily because they are affiliated with a clearing 
broker. With respect to the 41 small entities that are subject to the 
proposed rule and are not affiliated with a clearing broker, the 
Commission does not anticipate that they engage in significant order 
routing on behalf of customers. In section III.C.1 above, the 
Commission requested comment on whether the proposed rule should 
exclude broker-dealers that route a relatively small number of orders 
on behalf of customers. If any of the 41 small entities were required 
to comply with the proposed rule, the Commission staff estimates that 
they would expend, on average, 32 hours to prepare quarterly reports 
and 2 hours to respond to eight customer requests.\102\ Assuming 
internal compliance costs that average $85 per hour, the aggregate cost 
for each small entity to comply with the proposed rule is estimated to 
be $2890.
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    \102\ These estimates are smaller than those used generally to 
estimate the burden costs for purposes of the Paperwork Reduction 
Act. Assuming any of the 41 small entities actually route non-
directed orders on behalf of customers, it is likely that the number 
of orders would be very small. The burden of preparing quarterly 
reports and responding to customer requests would therefore be 
substantially less than the overall industry average.
---------------------------------------------------------------------------

E. Duplicative, Overlapping or Conflicting Federal Rules

    Proposed Rule 11Ac1-6 would require a broker-dealer to disclose the 
material aspects of its relationship with each venue to which it routes 
orders, including a description of any payment for order flow 
arrangements. Currently, Exchange Act Rule 10b-10(a)(2)(i)(C) requires 
a broker-dealer to disclose on each customer transaction confirmation 
(1) whether the broker-dealer received payment for order flow in 
connection with the transaction, and (2) that the broker-dealer will 
furnish to the customer the source and nature of the compensation upon 
written request. In addition, Exchange Act Rule 11Ac1-3(a) requires a 
broker-dealer to disclose in new and annual account statements its 
policies on the receipt of payment for order flow.
    The payment for order flow disclosure required under proposed Rule 
11Ac1-6 would complement the conflict of interest disclosures required 
in Rules 10b-10(a)(2)(i)(C) and 11Ac1-3. However, the Commission is 
requesting comment on whether the existing disclosure requirements 
should be modified to reflect the proposed new disclosure requirement.
    Proposed Rule 11Ac1-6 also would require broker-dealers, on request 
of a customer, to disclose (in addition to other information) the time 
of the transactions resulting from orders sent by the customer to the 
broker-dealer in the six months prior to the request. Currently, Rule 
10b-10(a)(1) requires a broker-dealer to include on a transaction 
confirmation either the time of the transaction or a statement that the 
time of the transaction will be furnished on written request.
    The Commission does not believe that any federal rules duplicate, 
overlap with, or conflict with proposed Rule 11Ac1-5.

F. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objectives, 
while minimizing any significant adverse impact on small entities. In 
connection with the proposed rules, the Commission considered the 
following alternatives: (1) The establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (2) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rules for small entities; (3) the use of 
performance rather than design standards; and (4) an exemption from 
coverage of the rules, or any part thereof, for small entities.
1. Alternatives to Proposed Rule 11Ac1-5
    Proposed Rule 11Ac1-5 is designed to provide uniform order 
execution information from the different market centers to allow 
investors and broker-dealers to compare execution quality across 
markets. Accordingly, the Commission believes that establishing 
differing reporting requirements for small entities may be inconsistent 
with the objectives of the proposed rule. Similarly, the Commission 
believes that the clarification, consolidation, or simplification of 
reporting requirements for small entities may be inconsistent with the 
objective of providing uniform order execution information from the 
different market centers. However, the Commission is considering 
whether it would be feasible to allow small market centers to provide 
raw data rather than the statistical measures required by the proposed 
rule.
    Regarding the use of performance standards rather than design 
standards, the proposed rule specifies the statistical measures that 
must appear in the monthly order execution reports. The Commission is 
considering, however, whether the proposed rule could require market 
centers only to make available electronic files with raw data on an 
order-by-order basis. Under this alternative, market centers would 
provide the necessary fields of information, and analysts could 
calculate the statistical measures of execution quality that they 
consider appropriate. The proposed rule does not establish a particular 
technology for disseminating the required reports to the public, other 
than requiring the use of an electronic format. The proposed rule would 
direct the SROs to act jointly in establishing procedures for market 
centers to follow in making their reports available to the public in a 
readily accessible, uniform, and usable electronic format.
    As to whether the rule should exempt small entities from the rule's 
coverage,

[[Page 48432]]

the Commission is considering several alternatives that could minimize 
the impact of the rule on small entities. Specifically, the Commission 
is considering an exemption for market centers that execute relatively 
few orders in total. Also, the Commission is considering an exemption 
to eliminate the disclosure requirement for individual securities in 
which a market center executes relatively few orders. Finally, as 
discussed above, the Commission is considering whether it would be 
feasible to allow small market centers to provide raw data rather than 
the statistical measures required by the proposed rule. The Commission 
requests comment on these alternatives in this release.
2. Alternatives to Proposed Rule
11Ac1-6
    Proposed Rule 11Ac1-6 is designed to provide investors with 
information on the order routing practices of their broker-dealers. The 
proposed rule requires broker-dealers to prepare quarterly order 
routing reports and respond to requests from individual investors for 
information on how their orders were routed. The Commission is 
requesting comment, however, on whether to exclude from the proposed 
rule broker-dealers that route a relatively small number of customer 
orders. As to the clarification, consolidation, or simplification of 
reporting requirement for small entities, the Commission does not 
believe that the proposal could be formulated differently for small 
entities and still achieve the stated objectives.
    Regarding the use of performance standards rather than design 
standards, the proposed rule requires that the quarterly reports be 
disseminated through the Internet (or by written copy on request). The 
purpose of using the Internet is to assure ready access to the reports 
and to ease the burden of compliance on broker-dealers. However, the 
Commission is requesting comment on alternative methods of 
disseminating the reports.
    An exemption from the rule for small entities might be inconsistent 
with the objectives of the rule. The primary objective of the rule is 
to afford customers a greater opportunity to monitor their broker-
dealer's order routing practices. All broker-dealers currently have an 
obligation to periodically review their order routing practices to meet 
their duty of best execution to their customers. As noted above, 
however, the Commission is requesting comment on whether to exclude 
from the proposed rule broker-dealers that route a relatively small 
number of customer orders.

G. Solicitation of Comments

    The Commission encourages the submission of comments with respect 
to any aspect of this IRFA. In particular, the Commission requests 
comment 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. 
Commentators 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 rules themselves.

X. Statutory Authority

    Pursuant to the Exchange Act and particularly Sections 3(b), 5, 6, 
11A, 15, 17, 19 and 23(a) thereof, 15 U.S.C. 78c, 78e, 78f, 78k-1, 78o, 
78q, 78s and 78w(a), the Commission proposes to adopt Sections 
240.11Ac1-5 and 240.11Ac1-6 of Chapter II of Title 17 of the Code of 
Federal Regulations in the manner set forth below.

List of Subjects in 17 CFR Part 240

    Broker-dealers, Reporting and recordkeeping requirements, 
Securities.

Text of Proposed Rules

    For the reasons set forth in the preamble, the Commission proposes 
to amend Chapter II of Title 17 of the Code of Federal Regulations 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. Sections 240.11Ac1-5 and 240.11Ac1-6 are added before the 
undesignated center heading ``Securities Exempted from Registration'' 
to read as follows:


Sec. 240.11Ac1-5  Disclosure of order execution information.

    (a) Definitions. For the purposes of this section:
    (1) The term alternative trading system shall have the meaning 
provided in Sec. 242.300(c) of this chapter.
    (2) The term average effective spread shall mean the share-weighted 
average of effective spreads for order executions calculated, for buy 
orders, as double the amount of difference between the execution price 
and the midpoint of the consolidated best bid and offer at the time of 
order receipt and, for sell orders, as double the amount of difference 
between the midpoint of the consolidated best bid and offer at the time 
of order receipt and the execution price.
    (3) The term average realized spread shall mean the share-weighted 
average of realized spreads for order executions calculated, for buy 
orders, as double the amount of difference between the execution price 
and the midpoint of the consolidated best bid and offer thirty minutes 
after the time of order execution and, for sell orders, as double the 
amount of difference between the midpoint of the consolidated best bid 
and offer thirty minutes after the time of order execution and the 
execution price; provided, however, that the midpoint of the final 
consolidated best bid and offer disseminated for a day shall be used to 
calculate a realized spread if it is disseminated less than thirty 
minutes after the time of order execution.
    (4) The term categorized by order size shall mean dividing orders 
into separate categories for sizes from 100 to 499 shares, from 500 to 
1999 shares, from 2000 to 4999 shares, and 5000 or greater shares.
    (5) The term categorized by order type shall mean dividing orders 
into separate categories for market orders, marketable limit orders, 
inside-the-quote limit orders, at-the-quote limit orders, and near-the-
quote limit orders.
    (6) The term categorized by security shall mean dividing orders 
into separate categories for each national market system security that 
is included in a report.
    (7) The term consolidated best bid and offer shall mean the highest 
firm bid and the lowest firm offer for a security that is calculated 
and disseminated on a current and continuous basis pursuant to a 
national market system plan.
    (8) The term covered order shall mean any market order or any limit 
order received by a market center during the time that a consolidated 
best bid and offer is being disseminated, but shall exclude any order 
for which the customer requests special handling for execution, 
including, but not limited to, orders to be executed at a market 
opening price or a market closing price,

[[Page 48433]]

orders submitted with stop prices, orders that are to be executed on a 
particular type of tick or bid, orders that are submitted on a ``not 
held'' basis, orders for other than regular settlement, and orders that 
are to be executed at prices unrelated to the market price of the 
security at the time of execution.
    (9) The term exchange market maker shall mean any member of a 
national securities exchange that is registered as a specialist or 
market maker pursuant to the rules of such exchange.
    (10) The term executed at the quote shall mean, for buy orders, 
execution at a price equal to the consolidated best offer at the time 
of order receipt and, for sell orders, execution at a price equal to 
the consolidated best bid at the time of order receipt.
    (11) The term executed outside the quote shall mean, for buy 
orders, execution at a price higher than the consolidated best offer at 
the time of order receipt and, for sell orders, execution at a price 
lower than the consolidated best bid at the time of order receipt.
    (12) The term executed with price improvement shall mean, for buy 
orders, execution at a price lower than the consolidated best offer at 
the time of order receipt and, for sell orders, execution at a price 
higher than the consolidated best bid at the time of order receipt.
    (13) The terms inside-the-quote limit order, at-the-quote limit 
order, and near-the-quote limit order shall mean buy orders with limit 
prices that are, respectively, higher than, equal to, and lower by 
$0.10 or less than the consolidated best bid at the time of order 
receipt, and sell orders with limit prices that are, respectively, 
lower than, equal to, and higher by $0.10 or more than the consolidated 
best offer at the time of order receipt.
    (14) The term market center shall mean any exchange market maker, 
OTC market maker, alternative trading system, national securities 
exchange, and national securities association.
    (15) The term marketable limit order shall mean any buy order with 
a limit price equal to or greater than the consolidated best offer at 
the time of order receipt, and any sell order with a limit price equal 
to or less than the consolidated best bid at the time of order receipt.
    (16) The term national market system plan shall have the meaning 
provided in Sec. 240.11Aa3-2(a)(1).
    (17) The term national market system security shall have the 
meaning provided in Sec. 240.11Aa2-1.
    (18) The term OTC market maker shall mean any dealer that holds 
itself out as being willing to buy from and sell to its customers, or 
others, in the United States, a national market system security for its 
own account on a regular or continuous basis otherwise than on a 
national securities exchange in amounts of less than block size.
    (19) The term time of order execution shall mean the time (to the 
second) that an order was executed at any venue.
    (20) The term time of order receipt shall mean the time (to the 
second) that an order was received by a market center for execution.
    (b) Monthly electronic reports by market centers. 
    (1) Every market center shall make available for each calendar 
month, in accordance with the procedures established pursuant to 
paragraph (b)(2) of this section, a report on the covered orders in 
national market system securities that it received for execution from 
any person. Such report shall be in electronic form; shall be 
categorized by security, order type, and order size; and shall include 
the following columns of information:
    (i) For market orders, marketable limit orders, inside-the-quote 
limit orders, at-the-quote limit orders, and near-the-quote limit 
orders:
    (A) The number of covered orders;
    (B) The cumulative number of shares of covered orders;
    (C) The cumulative number of shares of covered orders cancelled 
prior to execution;
    (D) The cumulative number of shares of covered orders executed at 
the receiving market center;
    (E) The cumulative number of shares of covered orders executed at 
any other venue;
    (F) The cumulative number of shares of covered orders executed from 
0 to 9 seconds after the time of order receipt;
    (G) The cumulative number of shares of covered orders executed from 
10 to 29 seconds after the time of order receipt;
    (H) The cumulative number of shares of covered orders executed from 
30 seconds to 59 seconds after the time of order receipt;
    (I) The cumulative number of shares of covered orders executed from 
60 seconds to 299 seconds after the time of order receipt;
    (J) The cumulative number of shares of covered orders executed from 
5 minutes to 30 minutes after the time of order receipt; and
    (K) The average realized spread for executions of covered orders; 
and
    (ii) For market orders and marketable limit orders:
    (A) The average effective spread for executions of covered orders;
    (B) The cumulative number of shares of covered orders executed with 
price improvement;
    (C) For shares executed with price improvement, the share-weighted 
average amount per share that prices were improved;
    (D) For shares executed with price improvement, the share-weighted 
average period from the time of order receipt to the time of order 
execution;
    (E) The cumulative number of shares of covered orders executed at 
the quote;
    (F) For shares executed at the quote, the share-weighted average 
period from the time of order receipt to the time of order execution;
    (G) The cumulative number of shares of covered orders executed 
outside the quote;
    (H) For shares executed outside the quote, the share-weighted 
average amount per share that prices were outside the quote; and
    (I) For shares executed outside the quote, the share-weighted 
average period from the time of order receipt to the time of order 
execution.
    (2) Every national securities exchange and national securities 
association shall act jointly in establishing procedures for market 
centers to follow in making available to the public the reports 
required by paragraph (b)(1) of this section in a uniform, readily 
accessible, and usable electronic form.
    (3) A market center shall make available the report required by 
paragraph (b)(1) of this section within one month after the end of the 
month addressed in the report.


Sec. 240.11Ac1-6  Disclosure of order routing information.

    (a) Definitions. For the purposes of this section:
    (1) The term covered security shall mean:
    (i) 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 defined in 
Section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)); and
    (ii) Any option contract traded on a national securities exchange 
for which last sale reports and quotation information are made 
available pursuant to a national market system plan.
    (2) The term customer order shall mean an order to buy or sell a 
covered security that is not for the account of a broker or dealer, but 
shall not include any order for a quantity of a security having a 
market value of at least $50,000 for a covered security that is an 
option contract and a market value of at least $200,000 for any other 
covered security.

[[Page 48434]]

    (3) The term directed order shall mean a customer order that the 
customer specifically instructed the broker or dealer to route to a 
particular venue for execution.
    (4) The term make publicly available shall mean posting on an 
Internet web site that is free to the public, furnishing a written copy 
to customers on request, and notifying customers at least annually in 
writing that a written copy will be furnished on request.
    (5) The term non-directed order shall mean any customer order other 
than a directed order.
    (6) The term national market system plan shall have the meaning 
provided in Sec. 240.11Aa3-2(a)(1).
    (7) The term payment for order flow shall have the meaning provided 
in Sec. 240.10b-10(d)(9).
    (8) The term profit-sharing relationship shall mean any ownership 
or other type of affiliation under which the broker or dealer, directly 
or indirectly, may share in any profits that may be derived from the 
execution of non-directed orders.
    (9) The term time of the transaction shall have the meaning 
provided in Sec. 240.10b-10(d)(3).
    (b) Quarterly report on order routing.
    (1) Every broker or dealer shall make publicly available for each 
calendar quarter a report that discusses and analyzes its routing of 
non-directed orders in covered securities in that quarter. Such report 
shall include the following information:
    (i) The percentage of total customer orders that were non-directed 
orders, and the percentages of non-directed orders that were market 
orders, limit orders, and other orders;
    (ii) The identity of each venue to which non-directed orders were 
routed for execution, the percentage of non-directed orders routed to 
the venue, and the percentages of non-directed market orders, non-
directed limit orders, and non-directed other orders that were routed 
to the venue;
    (iii) A discussion of the material aspects of the broker's or 
dealer's relationship with each venue to which non-directed orders were 
routed for execution, including a description of any arrangement for 
payment for order flow and any profit-sharing relationship; and
    (iv) A discussion and analysis of the order routing practices of 
the broker or dealer, including the significant objectives that the 
broker or dealer considered in determining where to route non-directed 
orders, the extent to which order executions achieved those objectives, 
a comparison of the quality of executions actually obtained with those 
produced by other venues for comparable orders during the relevant time 
period, and whether the broker or dealer has made or intends to make 
any material changes in its order routing practices in the succeeding 
quarter.
    (2) A broker or dealer shall make the report required by paragraph 
(b)(1) of this section publicly available within two months after the 
end of the quarter addressed in the report.
    (c) Customer requests for information on order routing.
    (1) Every broker or dealer shall, on request of a customer, 
disclose to its customer the identity of the venue to which the 
customer's orders were routed for execution in the six months prior to 
the request, whether the orders were directed orders or non-directed 
orders, and the time of the transactions, if any, that resulted from 
such orders.
    (2) A broker or dealer shall notify customers in writing at least 
annually of the availability on request of the information specified in 
paragraph (c)(1) of this section.

    Dated: July 28, 2000.
    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-19729 Filed 8-7-00; 8:45 am]
BILLING CODE 8010-01-P