[Federal Register Volume 65, Number 232 (Friday, December 1, 2000)]
[Rules and Regulations]
[Pages 75439-75462]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30132]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-43591; File No. S7-17-00]
RIN 3235-AH96


Firm Quote and Trade-Through Disclosure Rules for Options

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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

Effective Date: February 1, 2001.

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

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Executive Summary
II. Background
     A. Prior Attempts to Limit Intermarket Trade-Throughs
    B. Application of the Quote Rule in the Options Market
III. Description of Proposed Rulemaking
    A. Proposed Trade-Through Disclosure Rule
    B. Proposed Amendments to the Quote Rule
IV. Discussion
    A. Trade-Through Disclosure Rule
    1. Minimum Requirements for Linkage Plans
    2. Mandatory Participation in a Linkage Plan
    3. Exception from Disclosure Requirement for Block Trades
    4. Definition of Trade-Through
    a. OPRA Delays
    b. Systems Malfunctions
    c. Relief from Firm Quote Obligation
    d. Thirty-Second Delay
    e. Trades Not Excluded from the Definition of Trade-Through
    5. Compliance Date
    B. Amendments to the Quote Rule
    1. Collecting and Making Available Quotation Sizes
    2. Firm Quote Sizes for Customer and Broker-Dealer Orders
    3. Minimum Quote Size
    4. Automatic Execution Systems
    5. Exception During Trading Rotations
    6. Thirty-Second Response
    7. One-Percent Exception
    8. Amendments to Defined Terms
    9. Compliance Date
V. Paperwork Reduction Act
    A. Use and Disclosure of the Information Collected
    B. Trade-Through Disclosure Rule
    1. Capital Costs
    2. Burden Hours
    C. Amendments to the Quote Rule
    1. Capital Costs
    2. Burden Hours
VI. Costs and Benefits of Final Rules
    A. Costs and Benefits of the Trade-Through Disclosure Rule
    1. Comments
    2. Benefits
    3. Costs
    B. Costs and Benefits of Amendments to the Quote Rule
    1. Comments
    2. Benefits
    1. Costs
    C. Conclusion
VII. Effects on Competition, Efficiency, and Capital Formation
VIII. Final Regulatory Flexibility Analysis
    A. Need for, and Objectives of, the Rules
    B. Significant Issues Raised by Public Comment
    C. Small Entities Subject to the Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    E. Agency Action to Minimize Effect on Small Entities
IX. Statutory Authority

I. Executive Summary

    Recent increases in the multiple listing of options classes 
previously listed on a single exchange have intensified the competition 
among the option exchanges and heightened the need to further integrate 
the options markets into the national market system. The marked 
increase in multiple trading is indicative of the dynamic environment 
in which the options markets currently operate.\1\ While the growth in 
multiple trading has increased the competition between markets, it also 
has dramatically altered the environment in which options market 
participants conduct their trading. In particular, multiple trading 
raises new best execution challenges for brokers.\2\ When an option is 
listed on only one exchange, brokers do not have to decide where to 
route an order, and consequently, satisfying their best execution 
obligations is simpler than when they must consider the relative merits 
of routing an order to two or more market centers. With as many as five 
options exchanges currently trading

[[Page 75440]]

certain options classes, brokers are required to regularly and 
rigorously evaluate the execution quality available at each options 
exchange.
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    \1\ For example, in August 1999, only 32% of equity options 
classes were traded on more than one exchange. By the end of 
September 2000, the number of equity options classes that were 
multiply-traded had risen to 45%. In addition, aggregate options 
volume traded only on a single exchange fell from 61% to 15% over 
this same period. :
    \2\ In accepting orders and routing them to an exchange for 
execution, brokers act as agents for their customers and owe them a 
duty of best execution. A broker's duty of best execution is derived 
from common law agency principles and fiduciary obligations. It is 
incorporated both in self-regulatory organizations' rules and in the 
antifraud provisions of the federal securities laws through judicial 
and Commission decisions. This duty requires a broker to seek the 
most favorable terms reasonably available under the circumstances 
for a customer's transaction. As a result, brokers must periodically 
assess the quality of competing markets. See Securities Exchange Act 
Release No. 37619A (September 6, 1996), 61 FR 48290 (September 12, 
1996). :
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    Directly relevant to a broker's ability to obtain best execution 
for its customers is the ability to get the best price available. The 
considerable growth in the number of options classes traded on more 
than one exchange has significantly increased the likelihood that an 
order may be executed at a price that is inferior to a quoted price 
available on another exchange (``intermarket trade-through''). 
According to preliminary data analyzed by the Commission's Office of 
Economic Analysis, during the week of June 26, 2000, 5 percent of all 
trades in the 50 most active multiply-traded equity options were 
executed at prices inferior to the best price quoted on a competing 
market. Currently, it is difficult to ensure that a customer order sent 
to one exchange will receive the best available price because of the 
absence of fair access and an efficient mechanism allowing a market 
participant at one exchange to reach a better price published by 
another exchange. As a result, better prices quoted on another exchange 
do not always receive price priority, and customer orders may receive 
inferior executions.
    Because of our concerns about the increasing likelihood of 
intermarket trade-throughs in the options markets, on October 19, 1999, 
the Commission issued an Order directing the options exchanges to act 
jointly to file a national market system plan for linking the options 
markets.\3\ On July 28, 2000, the Commission approved an intermarket 
linkage plan proposed by three of the options exchanges (``Linkage 
Plan'') \4\ and subsequently, the other two exchanges filed with the 
Commission amendments to permit their participation in the Linkage 
Plan. \5\
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    \3\ See Securities Exchange Act Release No. 42029, 64 FR 57674 
(October 26, 1999) (``October 19, 1999 Order''). The October 19, 
1999 Order directed the American Stock Exchange LLC (``Amex''), 
Chicago Board Options Exchange, Inc. (``CBOE''), Pacific Exchange, 
Inc. (``PCX''), and Philadelphia Stock Exchange, Inc. (``Phlx'') to 
act jointly in discussing, developing, and submitting for Commission 
approval an intermarket linkage plan. The Commission's Order also 
requested the International Securities Exchange LLC (``ISE'') to 
participate with the options exchanges in the development of an 
intermarket linkage plan. The ISE was subsequently registered as a 
national securities exchange for options trading on February 24, 
2000. See Securities Exchange Act Release No. 42455, 65 FR 11387 
(March 2, 2000).
    \4\ See Securities Exchange Act Release No. 43086, 65 FR 48023 
(August 4, 2000). As originally approved, the Amex, CBOE, and ISE 
were the only participants in the Linkage Plan.
    \5\ See Securities Exchange Act Release Nos. 43573 (November 16, 
2000); and 43574 (November 16, 2000). The Commission issued orders 
to permit Phlx and PCX to participate in the Linkage Plan.
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    In conjunction with its approval of the Linkage Plan, the 
Commission proposed a new rule, Exchange Act Rule 11Ac1-7 (``Trade-
Through Disclosure Rule''),\6\ to require a broker-dealer to disclose 
to its customer when the customer's order for a listed option is 
executed at a price inferior to a better published quote and that 
better quote, unless the transaction was effected on a market that 
participates in an intermarket linkage plan approved by the 
Commission.\7\ In addition, the Commission proposed to amend Exchange 
Act Rule 11Ac1-1 (``Quote Rule'') \8\ to require options exchanges and 
options market makers to publish firm quotes. \9\ These proposed rules 
were intended to facilitate the ability of market participants to 
obtain the best price for customer orders without mandating a specific 
linkage.
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    \6\ Exchange Act Rule 11Ac1-7, 17 CFR 240.11Ac1-7.
    \7\ See Securities Exchange Act Release No. 43085 (July 28, 
2000), 65 FR 47918 (August 4, 2000) (``Proposing Release'').
    \8\ Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
    \9\ See Proposing Release, supra note 7.
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    With the current expansion of multiple trading in options, the 
Commission is increasingly concerned about intermarket trade-throughs 
of customer orders. The Commission believes that adoption of the new 
rule and amendment to the Quote Rule are necessary at this time to 
encourage the removal of barriers to access to, and the use of 
efficient vehicles to reach, better prices on another market. 
Consequently, as discussed below, the Commission today is adopting the 
Trade-Through Disclosure Rule \10\ and amending the Quote Rule,\11\ 
substantially as proposed, with certain modifications recommended by 
commenters.
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    \10\ Exchange Act Rule 11Ac1-7, 17 CFR 240.11Ac1-7.
    \11\ Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
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II. Background

    Section 11A of the Exchange Act,\12\ enacted as part of the 
Securities Acts Amendments of 1975,\13\ sets forth Congress' findings 
concerning the establishment of a national market system. Congress 
found, among other things, that it was in the public interest and 
appropriate for the protection of investors and the maintenance of fair 
and orderly markets to assure the availability to brokers, dealers, and 
investors of quote and transaction information.\14\ Congress also found 
that linking all of the markets for qualified securities would ``foster 
efficiency, enhance competition, increase the information available to 
brokers, dealers, and investors, facilitate the offsetting of 
investors' orders, and contribute to best execution of such orders.'' 
\15\
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    \12\ 15 U.S.C. 78k-1.;
    \13\ Pub. L. No. 94-29, 89 Stat. 97 (1975) (``1975 
Amendments''). In the 1975 Amendments, Congress directed the 
Commission to oversee the development of a national market system. 
Congress granted the Commission broad, discretionary powers to 
oversee the development of a fully integrated national market system 
for the processing and settlement of securities transactions. See 
also infra note 16.
    \14\ Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C).
    \15\ Section 11A(a)(1)(D) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(D).
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    The national market system was intended by Congress to potentially 
encompass ``all segments of corporate securities including all types of 
common and preferred stocks, bonds, debentures, warrants, and 
options.'' \16\ Congress included all types of securities because it 
believed that many of the goals of a national market system, such as 
the availability of information with respect to price, volume, and 
quotations, would be universally beneficial.\17\
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    \16\ Senate Committee on Banking, Housing, and Urban Affairs, 
Report to Accompany S. 249, S. Rep. 94-75, 94th Cong., 1st Sess. 7 
(1975) (``Senate Report''). See also Committee of Conference, Report 
to Accompany S. 249, H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 2 
(1975) (``Conference Report'').
    \17\ Id.
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    Congress did, however, recognize the differences between the 
markets and granted the Commission broad powers to implement a national 
market system without forcing all securities markets into a single 
mold.\18\ Accordingly, Congress granted the Commission the authority to 
implement the objectives of the 1975 Amendments,\19\ while allowing the 
Commission to recognize and classify markets, firms, and securities in 
any manner appropriate or necessary in the public interest or for the 
protection of investors.\20\
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    \18\ See Senate Report. See also Conference Report. In the 
Conference Report, the Committee stated that the unique 
characteristics of securities other than common stocks may require 
different treatment in a national market system.
    \19\ The two primary objectives of the 1975 Amendments were (1) 
``the maintenance of stable and orderly markets with maximum 
capacity for absorbing trading imbalances without undue price 
movements,'' and (2) ``the centralization of all buying and selling 
interest so that each investor will have the opportunity for the 
best execution of his order, regardless of where in the system it 
originates.'' See Senate Report.
    \20\ Section 11A(a)(2) of the Exchange Act authorizes the 
Commission to designate, by rule, securities qualified for trading 
in the national market system. 15 U.S.C. 78k-1(a)(2).
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    Many of the national market system initiatives were implemented in 
the equities markets at a time when

[[Page 75441]]

standardized options trading was relatively new.\21\ Therefore, even 
though Congress had intended to include options in a national market 
system, the Commission deferred applying many of the national market 
system initiatives to options to give options trading an opportunity to 
develop.\22\ Today, the options markets continue to operate with 
limited market integration facilities.\23\
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    \21\ The trading of standardized options on securities exchanges 
began in 1973 with the organization of the CBOE as a national 
securities exchange. See Securities Exchange Act Release No. 9985 
(February 1, 1973) 1 S.E.C. Doc. 11 (February 13, 1973). Currently, 
Amex, CBOE, ISE, PCX, and Phlx are the only national securities 
exchanges that trade standardized options.
    \22\ In October 1977, in response to allegations of widespread 
manipulation in the market for exchange-traded options, the 
Commission initiated an investigation and special study of the 
options markets. The result of the Commission's investigation was 
The Report of the Special Study of the Options Markets, issued on 
December 22, 1978 (``Options Study''). Report of the Special Study 
of the Options Markets to the Securities and Exchange Commission, 
96th Cong., 1st Sess. (Comm. Print No. 96-IFC3, December 22, 1978) 
(examining the major issues of market structure in standardized 
options markets, including multiple trading). In the Options Study, 
the Commission acknowledged that Congress had intended to include 
options in a national market system, and set forth a number of 
issues to be explored before the options markets could be fully 
integrated into the national market system. Options Study at 1029-
1030. The Options Study delineated the following as among the issues 
to be explored in the options market: (1) A comprehensive quotation 
system for the dissemination of firm quotes; (2) market linkage and 
order routing systems to enable the best execution of orders; (3) 
nationwide limit order protection to ensure that agency orders 
receive auction-type trading protections; and (4) off-board trading 
restrictions. Subsequently, the Commission approved, pursuant to 
Section 11A of the Exchange Act and Rule 11Aa3-2 thereunder, a 
national market system plan that collects and disseminates 
consolidated quotes and trades for the options markets, the Options 
Price Reporting Authority (``OPRA'') Plan for Reporting of 
Consolidated Options Last Sale Reports and Quotation Information 
(``OPRA Plan''). See Securities Exchange Act Release No. 17638 
(March 18, 1981).
    \23\ The Commission has repeatedly called for increased national 
market system initiatives in the options markets. See Securities 
Exchange Act Release No. 16701 (March 26, 1980), 45 FR 21426 (April 
1, 1980) (deferring expansion of multiple trading to afford the 
options exchanges an opportunity to consider the development of 
market integration facilities); Securities Exchange Act Release No 
22026 (May 8, 1985), 50 FR 20310 (May 15, 1985) (urging options 
market participants to consider the development of market 
integration facilities); Directorate of Economic and Policy 
Analysis, ``The Effects of Multiple Trading on the Market for OTC 
Options'' (November 1986); Office of the Chief Economist, 
``Potential Competition and Actual Competition in the Options 
Market'' (November 1986); and Securities Exchange Act Release No. 
26871 (May 26, 1989), 54 FR 24058 (June 5, 1989) (requesting comment 
on three measures, including an intermarket linkage). In 1989, the 
Commission adopted Exchange Act Rule 19c-5, which generally 
prohibits any exchange from adopting rules limiting its ability to 
list any stock options class because that options class is listed on 
another exchange. See Securities Exchange Act Release No. 26870 (May 
26, 1989), 54 FR 23963 (June 5, 1989). In 1990, then Chairman 
Breeden requested that the options exchanges develop an intermarket 
linkage plan. See letter from Chairman Breeden to the Registered 
Options Exchanges dated January 9, 1990.
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A. Prior Attempts To Limit Intermarket Trade-Throughs

    To address the limited market integration facilities in the options 
market, the Commission has repeatedly encouraged the exchanges to 
implement mechanisms to limit trade-throughs.\24\ For example, in 1980, 
at the time the Commission ended the voluntary moratorium on expansion 
of standardized options trading, it asked for comment on several 
approaches to more fully integrate the options markets into the 
national market system, including a market linkage system similar to 
the Intermarket Trading System (``ITS''),\25\ requiring brokerage firms 
to route retail orders on an order-by-order basis to the market center 
showing the best quotation, and an order exposure system for options 
public limit orders.\26\
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    \24\ Id.
    \25\ In the equity markets, the ITS Plan includes a trade-
through rule protecting displayed bids and offers for ITS-eligible 
exchange-listed securities. See Securities Exchange Act Release No. 
17703 (April 9, 1981), 22 S.E.C. Doc. 707. In conformance with the 
ITS Plan, each participating exchange and the National Association 
of Securities Dealers (``NASD'') has adopted rules that limit trade-
throughs in exchange-listed securities. See Securities Exchange Act 
Release No. 17704 (April 9, 1981), 46 FR 22520 (April 17, 1981). The 
NASD submitted a proposed trade-through rule for exchange-listed 
stocks, which the Commission approved on May 6, 1982. See Securities 
Exchange Act Release No. 18714, 47 FR 20429 (May 12, 1982). On June 
21, 1985, the Commission requested comment on, among other things, 
the extent to which securities listed on The Nasdaq Stock Market, 
Inc. (``Nasdaq'') should be subject to trade-through rules. See 
Securities Exchange Act Release No. 22127 (June 21, 1985), 50 FR 
26584 (June 27, 1985). In addition, in recently adopting amendments 
to the ITS Plan to expand the linkage to all listed securities, the 
Commission concluded that the NASD should continue to consider 
modifications to its existing trade-through rule to cover non-ITS 
participants, but that such modifications were not a precondition to 
approval of the expanded linkage. See Securities Exchange Act 
Release No. 42212 (December 9, 1999), 64 FR 70297 (December 16, 
1999).
    \26\ See Securities Exchange Act Release No. 16701 (March 26, 
1980), 45 FR 21426 (April 1, 1980) (``Moratorium Termination 
Release'').
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    Subsequently, the Commission's adoption of Exchange Act Rule 19c-5 
in 1989 \27\ created the need for some mechanism to ensure that 
customers' orders for multiply-traded options could be executed at the 
best available price. Accordingly, in 1990, the Amex, CBOE, New York 
Stock Exchange (``NYSE''),\28\ and PCX filed with the Commission a 
proposed Joint Industry Plan providing for the creation and operation 
of an Options Intermarket Communications Linkage (``Proposed 
Plan'').\29\ The Commission sought comment on the Proposed Plan,\30\ 
but neither the Proposed Plan nor its Model Trade-Through Rule was 
adopted, in part, because the options exchanges could not reach a 
consensus on several critical elements.
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    \27\ Exchange Act Rule 19c-5, 17 CFR 240.19c-5. See Securities 
Exchange Act Release No. 26870, supra note 23.
    \28\ The NYSE has since sold its options business to the CBOE. 
See Securities Exchange Act Release No. 38542 (April 23, 1997), 62 
FR 23521 (April 30, 1997).
    \29\ The filing was amended on April 29, 1991, when the 
signatories to the Proposed Plan submitted a Model Option Trade-
Through Rule as Exhibit A to the Proposed Plan (``Model Trade-
Through Rule''). The Model Trade-Through Rule would have been 
incorporated into each of the options exchanges' rules. The Model 
Trade-Through Rule provided that, absent reasonable justification or 
excuse, a member in a participant market should avoid initiating a 
trade-through when purchasing or selling an options contract 
permitted to be transmitted through the proposed linkage.
    \30\ See Securities Exchange Act Release No. 30187 (January 14, 
1992), 57 FR 2612 (January 22, 1992).
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    During the comment period on the Proposed Plan, an alternative plan 
was considered that involved the gradual phase-in of multiple trading, 
along with the adoption of exchange rules and operational enhancements 
linking the markets non-electronically (``Phase-In Plan'').\31\ 
Specifically, the Phase-In Plan would have provided for the re-routing 
of orders received through automated systems to other execution 
facilities, in conjunction with a trade-or-fade rule.\32\ Again, 
however, the exchanges did not agree to the Phase-In Plan and it was 
not adopted.
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    \31\ The Phase-In Plan was put forth by the Securities Industry 
Association (``SIA'') and endorsed by the Committee on Options 
Proposals (``COOP''). See letters to Jonathan G. Katz, Secretary, 
SEC, from Thomas P. Hart, Chairman, SIA Options and Derivative 
Products Committee, dated March 10, 1992; and Michael Schwartz, 
Chairman, COOP, dated March 11, 1992.
    \32\ Id. See also letter from Richard C. Breeden, Chairman, SEC, 
to Alger B. Chapman, Chairman & CEO, CBOE, dated June 30, 1992 
(setting forth the Commission's understanding of the elements of the 
Phase-In Plan).
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    In 1994, the markets adopted trade-or-fade rules, which require a 
market maker to revise its quote if it is unwilling to trade at its 
published quote with an order sent to it by a market maker from another 
exchange.\33\ The trade-or-fade rules do not provide efficient means of 
access between the markets. They also provide little incentive to try 
to reach a better quote

[[Page 75442]]

in another market, because that quote need not be firm when reached. 
Thus, the trade-or-fade rules have done little to promote price 
priority or discourage intermarket trade-throughs. As described below, 
the rules adopted by the Commission today respond to changes in the 
options markets and reflect a different approach to limiting 
intermarket trade-throughs and promoting price priority.
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    \33\ See Securities Exchange Act Release Nos. 34431, 34432, 
34444, 34434, and 34435 (July 22, 1994), 59 FR 38994 (August 1, 
1994) (orders approving proposed rule changes filed by Amex, CBOE, 
NYSE, Phlx, and PCX, respectively). See also Amex Rule 958A, 
Commentary 01; CBOE Rule 8.51(b); PCX Rule 6.37(d); Phlx Rule 
1015(b); and ISE Rule 804.
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B. Application of the Quote Rule in the Options Market

    As a testament to the importance of firm quotes in the securities 
markets, one of the first national market system initiatives 
implemented by the Commission in the equity markets was the Quote 
Rule.\34\ The Quote Rule requires all national securities exchanges and 
associations to establish procedures for collecting from their members 
bids, offers, and quotation sizes with respect to reported securities, 
and for making such bids, offers, and sizes available to quotation 
vendors. It also requires that quotation information made available to 
vendors be ``firm,'' subject to certain exceptions.
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    \34\ Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1. The 
reliability and availability of quotation information are basic 
components of a national market system and are needed so that 
broker-dealers are able to make best execution decisions for their 
customers' orders, and customers are able to make order entry 
decisions. See Securities Exchange Act Release No. 12670 (July 29, 
1976), 41 FR 32856 (August 5, 1976) (proposing Exchange Act Rule 
11Ac1-1).
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    By its terms, the Quote Rule currently does not apply to options. 
At the time the Quote Rule was adopted in 1978,\35\ standardized 
options had been listed and traded on the options exchanges for only a 
few years, and the Commission had imposed a moratorium that restricted 
the expansion of options trading.\36\ For example, in 1980, when the 
Commission lifted the moratorium on options listings, it also set forth 
its vision on the future of options multiple trading, including the 
feasibility of firm quotes.\37\ Successful implementation of a linkage 
among the markets was thought to depend upon the quality and 
reliability of quotation information disseminated by each market 
center. At that time, however, the Commission believed that the 
imposition of a firm quote requirement on the options markets and 
market participants was unworkable.\38\
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    \35\ See Securities Exchange Act Release No. 14415 (January 26, 
1978), 43 FR 4342 (February 1, 1978), as amended in Securities 
Exchange Act Release Nos. 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996); and 40760 (December 8, 1998), 63 FR 70844 
(December 22, 1998).
    \36\ See supra notes 21 and 22 and accompanying text.
    \37\ See Moratorium Termination Release, supra note 26.
    \38\ In 1980, quotes were updated manually; thus, the options 
exchanges argued that it would be virtually impossible for a market 
maker to update its quotes in a timely fashion each time the 
underlying stock price moved.
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    In conjunction with the Commission's adoption in 1989 of Rule 19c-5 
\39\ relating to multiple trading of options, the Commission published 
a staff concept release that discussed options market structure issues 
associated with multiple trading, and outlined suggestions for possible 
market structure enhancements.\40\ The release emphasized that the 
availability and reliability of comprehensive quotation information for 
options are important elements in considering the concerns 
traditionally associated with multiple trading.
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    \39\ See Securities Exchange Act Release No. 26870, supra note 
23.
    \40\ See Securities Exchange Act Release No. 26871, supra note 
23.
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    The release discussed whether the then-existing quote and trade 
reporting mechanism for options needed to be adapted for multiple 
trading by requiring that equity options quotes be firm. Market 
participants had, in the past, argued against a firm quote requirement 
in the options markets for a number of reasons.\41\ These concerns, 
however, were recognized as largely moot due to the development of 
autoquote \42\ and automatic execution \43\ systems, which indicated 
that firm quotes were, at the very least, possible.\44\
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    \41\ One major concern of market participants was that due to 
the derivative nature of options, and the need to adjust quotes in 
numerous series in response to a single price change in the 
underlying security, it would be impossible, or at least 
impractical, to require options market makers to honor their 
disseminated quotes. Further, it was thought to be difficult for an 
exchange to identify which member of a trading crowd was responsible 
for a quote and to provide a mechanism for quotes to be modified or 
withdrawn.
    \42\ Autoquote systems enable options market professionals to 
update their quotes in numerous options series simultaneously.
    \43\ Automatic execution systems provide, in effect, firm quotes 
for public customer orders.
    \44\ See Securities Exchange Act Release No. 26871, supra note 
23..
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    Today, each options market requires its market makers to have firm 
quotes for some types of orders. \45\Therefore, the Commission believes 
that imposing a market-wide firm quote obligation on options market 
participants should not be unduly burdensome. While the exchanges' firm 
quote rules and automatic execution systems provide their public 
customers with firm quote guarantees, these rules currently do not 
extend to other market participants. As described below, the amendments 
to the Quote Rule adopted by the Commission today require that options 
quotes be firm for broker-dealer orders for at least one contract.
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    \45\ See generally Amex Rule 958A (requiring a specialist to 
sell/buy at least 10 contracts at the offer/bid displayed when the 
order reaches the trading post); CBOE Rule 8.51 (generally requiring 
a trading crowd to sell/buy at least the RAES contract limit 
applicable to a particular options class at the offer/bid displayed 
when a customer order reaches the trading station); PCX Rule 6.86 
(generally requiring a trading crowd to provide a depth of 20 
contracts for all non-broker-dealer orders at the bid/offer 
disseminated at the time an order is announced at the trading post); 
Phlx Rule 1015 (requiring that public customer orders be filled at 
the best market for a minimum of 10 contracts); and ISE Rule 804 
(requiring a market maker to enter the number of contracts it is 
willing to buy or sell at its quote and prohibiting a market maker 
from entering a bid or offer for less than 10 contracts).
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III. Description of Proposed Rulemaking \46\
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    \46\ In response to the Proposing Release, the Commission 
received comment letters from fourteen commenters representing the 
views of four exchanges, seven firms, and four other interested 
parties. See letters to Jonathan G. Katz, Secretary, SEC, from 
Samuel F. Lek, Chief Executive Officer, Lek Securities Corporation, 
dated September 20, 2000 (``Lek Letter''); Michael J. Simon, Senior 
Vice President and Secretary, ISE, dated September 18, 2000 (``ISE 
Letter''); George Brunelle, Brunelle & Hadjikow, dated September 15, 
2000 (``Brunelle Letter''); Juan Carlos Pinilla, Managing Director, 
J.P. Morgan Securities, Inc. (``JPMorgan Letter''); Thomas A. Bond, 
CBOE, dated October 9, 2000 (``CBOE Letter''); Phillip D. DeFeo, 
Chairman and Chief Executive Officer, PCX, dated October 10, 2000 
(``PCX Letter''); Michael G. Vitek, President, Botta, dated 
September 29, 2000 (``Botta Letter''); Joel Greenberg, Managing 
Director, Susquehanna Investment Group, dated September 22, 2000 
(``Susquehanna Letter''); Chris Delzio, Amex Member, dated August 
15, 2000 (``Delzio Letter''); Lewis Singletary, Journeyman Holdings 
Corporation, dated September 30, 2000 (``Singletary Letter''); Meyer 
S. Frucher, Phlx, dated September 18, 2000 (``Phlx Letter''); Edward 
Provost, Executive Vice President, Business Development Division, 
CBOE, dated September 13, 2000 (asking for an extension of the 
comment period); Robert Bellick, Co-Managing Partner, Wolverine 
Trading, L.L.P., dated October 25, 2000 (``Wolverine Letter''); 
Robin Roger, Managing Director and Counsel, Morgan Stanley Dean 
Witter, dated October 25, 2000 (``Morgan Stanley Letter''); and 
William McGowen, Chairman, Options Committee, SIA, dated October 31, 
2000 (``SIA Letter'').
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A. Proposed Trade-Through Disclosure Rule

    In the Proposing Release, the Commission proposed new Rule 11Ac1-7 
under the Exchange Act \47\ to require a broker-dealer to disclose to a 
customer when the customer's order to buy or sell a listed option is 
executed at a price inferior to the best quote published at the time of 
execution of the customer's order. The proposal identified seven 
circumstances in which a trade executed at a price inferior to a 
published price on another market would, nevertheless, not be 
considered a trade-through for purposes of the

[[Page 75443]]

rule.\48\ In addition, as an incentive for markets to cooperate in 
developing effective means to access the quotes of other markets to 
avoid intermarket trade-throughs, the Commission's proposal excepted 
broker-dealers from the proposed disclosure requirements if they 
effected their customer orders on options markets that participated in 
an intermarket linkage plan approved by the Commission that had 
provisions reasonably designed to limit intermarket trade-throughs.
---------------------------------------------------------------------------

    \47\ See Proposing Release, supra note.
    \48\ The seven exceptions to the proposed definition of a trade-
through included when: (1) The market publishing the better price 
was experiencing systems problems, which made the quote 
inaccessible; (2) OPRA was experiencing queuing; (3) the market 
publishing the better price was experiencing unusual market 
conditions; (4) the market showing the better price was in a trading 
rotation; (5) the customer order was executed as part of a trading 
rotation in that options class; (6) the customer order was executed 
as part of a complex trade; or (7) the market publishing the better 
quote fails to respond to an order routed to it within 30 seconds of 
receiving the order. See Proposing Release, supra note.
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B. Proposed Amendments to the Quote Rule

    The Commission also proposed to amend Exchange Act Rule 11Ac1-1 to 
require options exchanges and options market makers to publish firm 
quotes.\49\ Because OPRA currently does not have the ability to collect 
from the exchanges and disseminate to quotation vendors size 
information, the Commission proposed to amend the Quote Rule so that 
broker-dealers would not be required to communicate, and options 
exchanges would not be required to collect and make available on a 
quote-by-quote basis, the size associated with each quotation in listed 
options. Instead, an options exchange would be required to establish by 
rule and periodically publish the size for which its best bid or offer 
in each options series that is listed on the exchange is firm. If, 
however, an exchange does collect quotations with size from its broker-
dealers, it would have to make such information available as currently 
required under the rule.\50\
---------------------------------------------------------------------------

    \49\ See Proposing Release, supra note.
    \50\ As noted above, OPRA does not have the capability to 
collect size information from the options exchanges, but it 
anticipates implementing systems changes to accommodate quotes with 
size in January 2001.
---------------------------------------------------------------------------

    In addition, the Commission proposed two alternatives relating to 
the flexibility an exchange would have to establish the size for which 
its quotes were firm for different types of orders. Specifically, under 
proposed Alternative A, the size for which an exchange's best bid or 
offer is firm would have to be the same for orders received from 
customers as for orders received from broker-dealers. Under proposed 
Alternative B, however, an exchange could allow market makers to 
establish different firm quote sizes for broker-dealer orders and for 
customer orders.
    Finally, the Commission proposed to require a responsible broker or 
dealer to respond to an order within 30 seconds by either executing the 
entire order or executing at least that portion of the order equal to 
its applicable firm quote size and revising its quote.

IV. Discussion

A.Trade-Through Disclosure Rule

    After carefully reviewing the comment letters, the Commission has 
decided to adopt the Trade-Through Disclosure Rule, with several 
modifications from the proposal. Under this rule, a broker is required 
to disclose to its customer when the customer's order for listed 
options is executed at a price inferior to a better published quote, 
and to disclose the better published quote available at that time.\51\ 
This disclosure must be made to the customer in writing at or before 
the completion of the transaction,\52\ and may be provided in 
conjunction with the confirmation statement routinely sent to 
investors. Such disclosure must be displayed as prominently as the 
transaction price disclosed to the customer.
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    \51\ Exchange Act Rule 11Ac1-7(b)(1), 17 CFR 240.11Ac1-7(b)(1). 
The Commission believes that a broker-dealer should be allowed to 
rely on the market of execution to notify the broker-dealer when a 
trade-through has occurred and the best quote available at that 
time. One commenter suggested that the Trade-Through Disclosure Rule 
require that exchanges provide all relevant information to the 
broker-dealers, including a determination of whether a trade-through 
has occurred. See Morgan Stanley Letter. The Commission does not 
believe it is necessary at this time to impose such a requirement 
and expects that an exchange that does not participate in a linkage 
plan will have strong incentives to provide a broker-dealer 
executing orders on its market with any information the broker-
dealer needs to comply with disclosure obligations.
    \52\ The term ``completion of the transaction'' in the Trade-
Through Disclosure Rule shall have the meaning provided in Exchange 
Act Rule 15c1-1(b)(1), 17 CFR 240.15c1-1(b)(1). Exchange Act Rule 
11Ac1-7(b), 17 CFR 11Ac1-7(b).
---------------------------------------------------------------------------

    The Trade-Through Disclosure Rule provides, however, that a broker-
dealer is not required to disclose to its customer an intermarket 
trade-through if the broker-dealer effects the transaction on an 
exchange that participates in an approved linkage plan that includes 
provisions reasonably designed to limit customers' orders from being 
executed at prices that trade through a better published price.\53\ In 
addition, broker-dealers will not be required to provide the disclosure 
required by the Trade-Through Disclosure Rule if the order is executed 
as part of a block trade.\54\
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    \53\ Exchange Act Rule 11Ac1-7(b)(2)(i), 17 CFR 240.11Ac1-
7(b)(2)(i). The Trade-Through Disclosure Rule also provides the 
Commission with the authority to exempt any broker or dealer from 
the requirements of the rule. Exchange Act Rule 11Ac1-7(c), 17 CFR 
240.11Ac1-7(c).
    \54\ Exchange Act Rule 11Ac1-7(b)(2)(ii), 17 CFR 240.11Ac1-
7(b)(2)(ii). The Commission sought comment on whether broker-dealers 
should be excepted from the trade-through disclosure requirement if 
they systematically route customer orders on an order-by-order basis 
to the exchange with the best price at the time the order is routed. 
Only one commenter addressed this issue, noting that simply routing 
orders to an exchange displaying the best price at the time the 
order is routed is not sufficient because of variances in the 
national best bid and offer (``NBBO''), the possibility that the 
receiving market does not offer trade-through protection, or the 
possibility of price improvement. At this time, the Commission has 
decided not to provide broker-dealers with an exemption from the 
disclosure requirements of the Trade-Through Disclosure Rule on this 
basis.
---------------------------------------------------------------------------

    A number of commenters supported the Commission's proposal to 
require broker-dealers to disclose trade-throughs.\55\ In particular, 
one commenter believed that intermarket trade-throughs virtually would 
be eliminated if a broker-dealer were required to disclose to a 
customer that an order was executed at a price that was inferior to the 
best-published quote.\56\ Another commenter disagreed with this view, 
however, stating that the imposition of a disclosure requirement would 
not have a significant impact on the frequency of intermarket trade-
throughs.\57\
---------------------------------------------------------------------------

    \55\ See Lek Letter; PCX Letter; JPMorgan Letter; and ISE 
Letter.
    \56\ See Lek Letter.
    \57\ See CBOE Letter.
---------------------------------------------------------------------------

    In addition, several commenters noted that the disclosure required 
by the Trade-Through Disclosure Rule would never need to be made by 
broker-dealers if all exchanges join the Linkage Plan.\58\ The 
Commission notes, however, that under the current terms of the Linkage 
Plan, any participant may withdraw from the plan with 30 days prior 
written notice to each of the other plan participants and the 
facilities manager, if any.\59\ In addition, there may be new options 
exchanges entering the market in the future and those exchanges may 
decide not to participate in the Linkage Plan or any other intermarket 
linkage plan approved by

[[Page 75444]]

the Commission. Moreover, as discussed further below, the Linkage Plan 
approved by the Commission must still be amended before the Commission 
would consider it to be reasonably designed to limit intermarket trade-
throughs and, therefore, satisfy the exception from trade-through 
disclosure. Therefore, the Commission continues to believe that the 
Trade-Through Disclosure Rule is needed to ensure that, if the exchange 
on which their orders are executed does not belong to an approved 
linkage plan designed to limit intermarket trade-throughs, investors 
receive disclosure when their orders are not executed at the best 
price.
---------------------------------------------------------------------------

    \58\ See JPMorgan Letter; ISE Letter; CBOE Letter; Phlx Letter; 
and Wolverine Letter. Another commenter argued that the focus of the 
Commission and the options industry should be on preventing the 
occurrence of intermarket trade-throughs by moving ahead 
aggressively on implementing the Linkage Plan, rather than by 
disclosing intermarket trade-throughs to investors after the fact. 
See SIA Letter.
    \59\ See Linkage Plan, Section 12.
---------------------------------------------------------------------------

    It is an important feature of the Trade-Through Disclosure Rule 
adopted today that it does not prohibit intermarket trade-throughs. At 
times, investors may value speed, size, or liquidity over price. By not 
prohibiting intermarket trade-throughs, the rule permits investors to 
achieve their goals and provides them with information that will 
facilitate their ability to actively monitor whether the quality of 
executions they receive is satisfactory.\60\ Therefore, the Commission 
believes that the rule will help to ensure that the decision not to 
pursue publicly-displayed, superior prices is rooted in the interests 
of customers, not that of intermediaries. In addition, the Commission 
believes that in the absence of direct linkages, the rule will 
encourage broker-dealers to develop effective means of accessing better 
quotes published by other markets and thereby, avoid intermarket trade-
throughs.\61\
---------------------------------------------------------------------------

    \60\ One commenter contended that the proposal would do nothing 
to improve the transparency of execution quality. See Wolverine 
Letter. The Commission disagrees with this assertion. Although the 
disclosures about execution quality adopted today for the equity 
markets provides much more information to investors than the Trade-
Through Disclosure Rule does, the Commission believes that, before 
execution quality disclosures could be required for options trading, 
potentially difficult issues, such as the absence of a consolidated 
NBBO in the options market, would have to be resolved. See 
Securities Exchange Act Release No. 43590 (November 17, 2000).
    \61\ The Commission notes, however, that the Trade-Through 
Disclosure Rule does not replace the well-established duty that 
brokers provide best execution to their customers. To the contrary, 
brokers remain obligated to seek the most favorable terms possible 
under the circumstances for their customers. See supra note.
---------------------------------------------------------------------------

    1. Minimum Requirements for Linkage Plans
    The Trade-Through Disclosure Rule excepts from its requirements any 
broker-dealer that executes customer orders on exchanges that 
participate in an intermarket linkage plan that is reasonably designed 
to limit intermarket trade-throughs. The Commission believes that to be 
reasonably designed to limit intermarket trade-throughs, a plan should 
contain, at a minimum, provisions to: (1) Limit participants from 
trading through, not only the quotes of other linkage plan 
participants, but also, the quotes of exchanges that are not 
participants in an approved linkage plan; (2) require plan participants 
to actively surveil their markets for trades executed at prices 
inferior to those publicly quoted on other exchanges; and (3) make 
clear that the failure of a market with a better quote to complain 
within a specified period of time that its quote was traded-through may 
affect potential liability, but does not signify that a trade-through 
has not occurred. Accordingly, the Linkage Plan must be amended before 
broker-dealers effecting transactions on exchanges participating in the 
plan would be excepted from the disclosure requirements of the Trade-
Through Disclosure Rule.\62\ The Commission does not agree that these 
modifications to the Linkage Plan would add significant costs without 
adding significant additional deterrence to intermarket trade-throughs, 
as stated by one commenter,\63\ and believes that the minimum 
requirements are important factors to consider in assessing whether a 
linkage plan is ``reasonably designed to limit trade-throughs'' and 
therefore, vitiate the need for broker-dealers to provide disclosure to 
their customers.
---------------------------------------------------------------------------

    \62\ In addition, to comply with these standards, an exchange 
participating in a linkage would have to adopt rules to allow the 
exchange to sanction specialists or market makers that trade through 
better prices of other exchanges, maintain policies and procedures 
that would limit the occurrence of intermarket trade-throughs, and 
maintain records that would identify intermarket trade-throughs and 
any review or remedial action taken by the exchange in response to 
such intermarket trade-throughs.
    \63\ See JPMorgan Letter.
---------------------------------------------------------------------------

    The Commission requested comment on what provisions a linkage plan 
should include and whether the minimum factors set forth above are 
sufficient. In particular, the Commission asked for comment on whether, 
instead of requiring that a linkage plan limit intermarket trade-
throughs of the quotes disseminated by markets that do not participate 
in an approved linkage plan, a linkage should only be required to limit 
intermarket trade-throughs of markets that participate in an approved 
linkage plan. In this regard, one commenter asserted that the 
Commission should not require a linkage plan to protect against trading 
through those markets that are not participants of the same linkage 
plan because those markets would be difficult to access effectively. 
This commenter noted that a linkage plan provides an efficient and 
almost instantaneous means by which one exchange participating in the 
plan can access another exchange participating in the plan, as well as 
minimum size guarantees for orders routed through the linkage, and 
therefore, assures customers and dealers access to the best bid or 
offer. In contrast, for markets that do not participate in the linkage 
plan, the lack of effective access simply increases the time needed to 
execute a customer order without any corresponding guarantee of 
execution.\64\
---------------------------------------------------------------------------

    \64\ See CBOE Letter.
---------------------------------------------------------------------------

    Other commenters, however, supported the notion that a linkage plan 
must provide some form of protection against trading through any 
exchanges that do not participate in the linkage plan.\65\ One of the 
commenters stated that options exchanges should adopt reasonable rules 
and procedures to address trade-throughs of markets that do not 
participate in an approved linkage plan because, to instill investor 
confidence in the options market, there must be the same basic 
protections against trade-throughs as are available in the equity 
market.\66\ Another commenter argued that firms that do not execute 
transactions on an exchange that participates in a linkage plan should 
be required to disclose intermarket trade-throughs of both participant 
and non-participant markets, particularly in light of the possibility 
that a market could opt out of the plan.\67\
---------------------------------------------------------------------------

    \65\ See ISE Letter and Phlx Letter.
    \66\ See ISE Letter.
    \67\ See Phlx Letter.
---------------------------------------------------------------------------

    In proposing this rule, the Commission recognized that, by 
providing an incentive for markets to cooperate in developing effective 
means to access other markets, intermarket trade-throughs would be 
minimized. However, the value of the Trade-Through Disclosure Rule 
would be greatly diminished to the extent that: (1) One or more options 
exchanges decide not to participate in an approved linkage plan; (2) 
intermarket trade-throughs were not minimized by the implementation of 
a linkage plan because the plan fails to provide protection across all 
markets, including markets that do not participate in the linkage plan; 
(3) away markets fail to complain about intermarket trade-throughs; or 
(4) market makers or specialists were not subject to potential 
sanctions for intermarket trade-throughs. Accordingly, the Commission 
believes that to provide sufficient

[[Page 75445]]

incentives to markets to avoid intermarket trade-throughs under the 
Trade-Through Disclosure Rule, an intermarket linkage plan must contain 
the provisions described above provide broker-dealers executing orders 
on markets participating in the plan with an exception to the 
disclosure requirements of the rule. Specifically, the Commission 
believes that to maintain the integrity and value of a Trade-Through 
Disclosure Rule, a linkage plan must provide protection against orders 
trading through the quotes of all markets, regardless of whether that 
market participates in the plan. However, to allow the options 
exchanges to retain greater flexibility, the Commission is not 
mandating participation in a particular intermarket linkage plan.
2. Mandatory Participation in a Linkage Plan
    The Commission also sought comment on whether it should order the 
options exchanges to become participants in the Linkage Plan or any 
other intermarket linkage plan. In response, several commenters 
expressed their view that the proposed Trade-Through Disclosure Rule 
was a vehicle to compel options exchanges to join an intermarket 
linkage plan,\68\ and one argued that the Commission should directly 
require all options exchanges to become participants in a qualified 
linkage plan rather than ``creating a disclosure-based exception that 
accomplishes de facto the same result.'' \69\ Another commenter, 
however, expressly stated that it did not believe that participation in 
a single linkage plan should be mandatory. This commenter concurred 
with the Commission's contention in the Proposing Release that a single 
linkage may fail to adapt over time and may impede the entry of new 
market participants.\70\
---------------------------------------------------------------------------

    \68\ See ISE Letter; Phlx Letter; and CBOE Letter.
    \69\ See CBOE Letter.
    \70\ See PCX Letter. On the other hand, another commenter 
expressed concern that a disclosure-based approach to creating 
incentives for markets to link will not be as effective in fostering 
quote and order competition and interaction as a direct Commission 
role in mandating a universal linkage. See Morgan Stanley Letter. 
The Commission is not, however, attempting to foster quote and order 
interaction by adopting the Trade-Through Disclosure Rule, but is, 
instead, trying to achieve the more limited goal of reducing the 
possibility for investors' orders to be executed at a price inferior 
to the best available price.
---------------------------------------------------------------------------

    The Commission intends for the intermarket linkage plan exception 
to the Trade-Through Disclosure Rule to encourage options markets to 
participate in a Commission-approved intermarket linkage plan. In fact, 
all five options exchanges are now participants in the Linkage 
Plan.\71\ However, at this time, the Commission continues to be 
reluctant to force, by government mandate, all options exchanges to 
participate in a single linkage system that may, for example, fail to 
maintain up-to-date technology. The Commission believes that, in the 
absence of barriers to access, the growth of electronic order-routing 
systems may enable the options exchanges to access one another's 
markets directly through agreed-upon methods, or indirectly through 
broker-dealers. As a result, the Commission continues to believe that, 
given effective access, there may well be a variety of equally 
effective, or more effective, ways in which technology may be employed 
by the markets to encourage price priority and decrease the likelihood 
of intermarket trade-throughs in the options markets. Consequently, 
rather than mandating exchange participation in any one linkage plan, 
the Commission is adopting the more flexible approach, as proposed, 
that provides incentives for the markets and their members to develop 
mechanisms to reduce the frequency of intermarket trade-throughs, while 
allowing market participants to choose the form of mechanism employed.
---------------------------------------------------------------------------

    \71\ See supra notes 4 and 5.
---------------------------------------------------------------------------

3. Exception From Disclosure Requirement for Block Trades
    Finally, in response to comments, the Commission is adopting an 
exclusion from the trade-through disclosure requirement for block 
trades.\72\ The Commission sought comment on whether to except block 
trades from the trade-through definition because of their size in 
relation to the quote, their special handling needs, and the greater 
resources of customers placing block orders to monitor the quality of 
executions they receive. Two commenters specifically supported such an 
exception.\73\
---------------------------------------------------------------------------

    \72\ Exchange Act Rule 11Ac1-7(b)(2)(ii), 17 CFR 240.11Ac1-
7(b)(2)(ii). The term ``block trade'' is defined as a transaction in 
an options series that is for 500 or more contracts and has a 
premium value of at least $150,000. Exchange Act Rule 11Ac1-7(a)(1), 
17 CFR 240.11Ac1-7(a)(1).
    \73\ See JPMorgan Letter and SIA Letter.
---------------------------------------------------------------------------

    For ease of administration, the Commission has adopted, in part, 
the definition of ``block trade'' used in the Linkage Plan,\74\ which 
was developed by the options exchanges. Because a block trade would 
involve 500 contracts or more and a premium value of at least $150,000, 
the Commission anticipates that only highly sophisticated investors 
will place such trades. Moreover, as noted by commenters, because of 
the size of these block orders, market participants placing such orders 
do not necessarily expect execution of the full order at the best-
quoted price.\75\ As a result, the Commission believes that the value 
of a trade-through disclosure for market participants placing such 
orders likely would be minimal.
---------------------------------------------------------------------------

    \74\ See Linkage Plan, Section 2 (3).
    \75\ See JPMorgan Letter and SIA Letter. One of these commenters 
noted that with respect to block-sized orders, the quote bears 
``little relationship to the average price that the customer could 
get for the entire order.'' See JPMorgan Letter. The other of these 
commenters argued that ``because large orders are far more dependent 
on liquidity than smaller orders, the ability to get a block off on 
a timely, efficient basis may be severely impacted by strict 
adherence to a trade-through rule.'' See SIA Letter.
---------------------------------------------------------------------------

4. Definition of Trade-Through
    The Commission is adopting the definition of a trade-through and 
the exceptions to the definition of a trade-through, substantially as 
proposed. Specifically, a trade-through occurs when a customer order is 
executed at a price inferior to a quote published by another market at 
the time of execution.\76\ The rule also identifies four circumstances 
in which a trade executed at a price inferior to a published price on 
another market would, nevertheless, not be considered a trade-through 
for purposes of the rule.\77\
---------------------------------------------------------------------------

    \76\ Exchange Act Rule 11Ac1-7(b)(3), 17 CFR 240.11Ac1-7(b)(3).
    \77\ Exchange Act Rule 11Ac1-7(b)(4), 17 CFR 240.11Ac1-7(b)(4).
---------------------------------------------------------------------------

    a. OPRA Delays. Because a broker-dealer should not be required to 
disclose to its customer that its order was executed at a price 
inferior to a ``stale'' quote, a trade will not be considered a trade-
through if it occurs while OPRA is experiencing queuing.\78\ In the 
past, the aggregate message traffic generated by the options exchanges 
has, at times, surpassed OPRA systems capacity, which could result in 
the dissemination of quotes that are no longer accurate or accessible.
---------------------------------------------------------------------------

    \78\ Exchange Act Rule 11Ac1-7(b)(4)(ii), 17 CFR 240.11Ac1-
7(b)(4)(ii).
---------------------------------------------------------------------------

    b. Systems Malfunctions. Similarly, the Commission believes that it 
is appropriate to exclude from the definition of trade-through trades 
that are executed at a time when an exchange has verified that the 
market publishing the better price was experiencing systems 
malfunctions, thus resulting in inaccessible quotes.\79\ For example, 
this may occur when a broker-dealer has attempted to access the 
superior published quote and has been unsuccessful because of systems

[[Page 75446]]

problems in the quoting market. The Commission believes that there is 
no value in requiring a broker-dealer to disclose an inability to 
access a market's quote that has been verified as inaccessible.
---------------------------------------------------------------------------

    \79\ Exchange Act Rule 11Ac1-7(b)(4)(i), 17 CFR 240.11Ac1-
7(b)(4)(i).
---------------------------------------------------------------------------

    c. Relief from Firm Quote Obligation. The definition of trade-
through also excludes a trade executed at a price inferior to a price 
published by another exchange if the other exchange or its members were 
relieved of their obligations under the Quote Rule because the exchange 
has determined, for example, that, as a result of unusual market 
conditions,\80\ it is incapable of accurately collecting and 
disseminating quotes.\81\
---------------------------------------------------------------------------

    \80\ Exchange Act Rule 11Ac1-1(b)(3), 17 CFR 240.11Ac1-1(b)(3). 
Currently, each options exchange has rules that allow the exchange 
to suspend its firm quote requirements if, for example, a systems 
malfunction or other circumstance impairs the exchange's ability to 
disseminate or update market quotes in a timely and accurate manner. 
See Amex Rule 958A; CBOE Rule 8.51(a); PCX Rule 6.86(d); Phlx Rule 
1015(a)(ix); and ISE Rule 804(d). The options exchanges may have to 
amend these rules to conform to the Quote Rule's exception for 
unusual market conditions.
    \81\ Exchange Act Rule 11Ac1-7(b)(4)(iii), 17 CFR 240.11Ac1-
7(b)(4)(iii).
---------------------------------------------------------------------------

    One commenter recommended that the Commission provide brokers with 
discretion to interpret the exceptions broadly in light of their duty 
of best execution, instead of forcing a broker to incur the risk of 
subsequently providing an inferior price to a public customer against 
its better judgment. This commenter argued that a broker should have 
discretion to ``use the `unusual market circumstances' exception to 
refuse to route a trade to an exchange that has a history of 
disseminating `flickering' quotes, rather than being forced to disclose 
to the customer a trade-through of a phantom `better' price that, in 
all likelihood, never existed.'' \82\
---------------------------------------------------------------------------

    \82\ See JPMorgan Letter.
---------------------------------------------------------------------------

    The Commission agrees that brokers must always consider their best 
execution obligations to their customers.\83\ The Trade-Through 
Disclosure Rule does not prohibit intermarket trade-throughs; it merely 
requires a firm to provide information to its customer about the market 
at the time of execution. Therefore, the Commission does not agree that 
broker-dealers should be granted discretion to avoid disclosure if they 
trade through another market quote because of their discomfort with the 
quality of that market's quote. While the Commission appreciates the 
commenter's concerns regarding ``flickering quotes,'' the Quote Rule 
amendments adopted today are designed to address this issue by 
requiring that disseminated quotes be firm up to the applicable firm 
quote size.
---------------------------------------------------------------------------

    \83\ See supra note 2. One commenter asserted that under the 
Commission's proposal, brokers would no longer have to make best 
execution evaluations. See Wolverine Letter. The Commission strongly 
disagrees with this view and expects brokers to continue to fulfill 
their obligations to seek the most favorable terms reasonably 
available under the circumstances for a customer's order.
---------------------------------------------------------------------------

    d. Thirty-Second Delay. In addition, the Trade-Through Disclosure 
Rule excludes from the definition of trade-through a trade that occurs 
after an exchange member attempts to access a better-published quote 
for a customer order and the market publishing the better quote fails 
to respond to the order routed to it in a timely fashion.\84\
---------------------------------------------------------------------------

    \84\ Exchange Act Rule 11Ac1-7(b)(4)(iv), 17 CFR 240.11Ac1-
7(b)(4)(iv).
---------------------------------------------------------------------------

    Although one commenter contended that the Commission should not 
adopt this exception to the definition of a trade-through because it 
condones the actions of a market maker who simply ignores an incoming 
customer order that is unfavorable or inconvenient,\85\ the Commission 
believes that a broker-dealer should not be obligated to disclose a 
trade-through in the event that an exchange member attempted to access 
a better published quote for a customer order, but the market 
publishing the better quote failed to respond to the order routed to it 
within 30 seconds of receiving the order. In this instance, the 
exchange member has attempted to access the superior published quote 
and has been unsuccessful. The Commission believes that the originating 
broker-dealer should not be obligated to provide the disclosure when 
the member of another exchange has failed to satisfy its obligations 
under the Quote Rule. In addition, the Commission believes that there 
is no value in requiring an exchange member to repeatedly attempt to 
access an inaccessible quote, especially in a volatile market where 
substantial delays may result in far inferior executions for the 
investor. Further, the Commission believes that the amendments to the 
Quote Rule adopted today will ensure that responsible broker-dealers 
honor their quotes up to the size for which they are required to be 
firm, and expects exchanges to surveil their members to ensure 
compliance with the amended Quote Rule.
---------------------------------------------------------------------------

    \85\ See Brunelle Letter. Another commenter, however, supported 
this proposed exception. See ISE Letter.
---------------------------------------------------------------------------

    e. Trades Not Excluded from the Definition of Trade-Through. In the 
Proposing Release, the Commission sought comment on whether a trade-
through disclosure requirement should apply to all trade-throughs, or 
only when an order is executed at a price that trades through a better 
price by a certain price increment or amount. The Commission noted that 
this question is particularly important in a decimals trading 
environment, where quotes may be for a smaller size and the trade-
through price for smaller increments, and with respect to large orders, 
where the quote size may be small in relation to the order size.
    Several commenters supported such a ``materiality'' standard.\86\ 
For example, one commenter argued that all orders would benefit, 
regardless of size, from an exception to the disclosure requirement for 
trade-throughs of price increments immaterial in relation to the 
spread. This commenter believed that any trade-though disclosure should 
include the size of the traded-through quote, but that a materiality 
exception would be preferable to disclosure of the size of the quote, 
because such size disclosure would be more costly for market 
participants, including customers.\87\ Another of these commenters 
believed the disclosure requirement should not apply if the price and 
size of the trade-through was de minimus. Although this commenter did 
not define de minimus, the commenter argued that given the imminent 
conversion to decimal pricing, the burdens of disclosing when an order 
trades through a quote that is better by a very small amount or is only 
for a small size would not be justified.\88\ On the other hand, one 
commenter opposed adopting a de minimus exception to the trade-through 
definition due to the inherent difficulty in defining what constitutes 
de minimus, and the possibility that opportunities for the unbundling 
of orders to avoid trade-though liability would be created.\89\
---------------------------------------------------------------------------

    \86\ See JPMorgan Letter; CBOE Letter; and PCX Letter.
    \87\ See JPMorgan Letter.
    \88\ See PCX Letter.
    \89\ See CBOE Letter.
---------------------------------------------------------------------------

    The Commission believes that it is inappropriate at this time to 
attempt to establish a materiality standard. The Commission notes that, 
as of September 25, 2000, only 36 options are trading in decimals. As a 
result, the Commission does not believe that it, the options exchanges, 
or other market participants has had sufficient experience with a 
decimals environment. The Commission notes, however, that it will 
continue to evaluate this issue as decimal pricing is expanded to all 
options classes and the markets adapt to the decimals environment.

[[Page 75447]]

    In addition, a few commenters recommended that the trade-through 
disclosure requirement not be applied to orders from upstairs broker-
dealers and orders of customers who consent to the potential for an 
execution at an inferior price.\90\
---------------------------------------------------------------------------

    \90\ See PCX Letter and Brunelle Letter.
---------------------------------------------------------------------------

    Because upstairs broker-dealers' orders are not eligible to be 
transmitted through the linkage pursuant to the Linkage Plan, one 
commenter argued that broker-dealers should not be required to disclose 
an execution at a price inferior to the best price. \91\ The Commission 
notes that the trade-through disclosure requirement would not require 
disclosure to upstairs broker-dealers because it only applies when a 
broker-dealer executes a non-broker-dealer order.
---------------------------------------------------------------------------

    \91\ See PCX Letter
---------------------------------------------------------------------------

    A commenter also recommended including an exception for trades of 
customers who request that their orders be executed on a particular 
market, regardless of whether a better price is available on another 
market. This commenter contended that a customer may give such consent 
because of its greater interest, for example, in the speed of 
execution. \92\ Another commenter suggested an exception for when 
customers provide instructions to route, or avoid routing, their orders 
to a particular exchange, irrespective of price. \93\
---------------------------------------------------------------------------

    \92\ See PCX Letter.
    \93\ See Brunelle Letter.
---------------------------------------------------------------------------

    The Commission does not believe that it is appropriate to except 
broker-dealers from the requirement to disclose a trade-through to its 
customer even when a customer requests that its order be executed on a 
particular market, regardless of price. While one commenter suggested 
that a trade-through disclosure to a customer that has explicitly 
requested an execution at an inferior price may be superfluous, the 
Commission is concerned that the adoption of such an exception may 
result in broker-dealers entering into blanket adhesion contracts with 
customers, solely to allow the broker-dealer to execute order flow on a 
particular options exchange even though that exchange does not provide 
the best price. \94\ The Commission believes that such an exception 
would raise investor protection concerns, particularly with respect to 
unsophisticated investors who may not fully appreciate the impact of 
the agreement and may lack the ability to negotiate preferable terms. 
In addition, the Commission believes that in those instances where a 
customer has expressed a desire to have its order executed on a 
particular exchange regardless of a better published price available on 
another market, the customer will not perceive the disclosure of a 
trade-through as problematic.
---------------------------------------------------------------------------

    \94\ Payment for order flow and other similar arrangements 
increase the likelihood that such contracts could become 
commonplace.
---------------------------------------------------------------------------

    Finally, the Commission's definition of a trade-through also 
includes transactions executed as part of a complex trade. Although the 
Commission proposed to exclude complex trades, which were defined as 
transactions in an option series that are executed in conjunction with 
related transactions occurring at or near the same time for the purpose 
of executing a particular investment strategy, \95\ the Commission now 
believes that such an exclusion is not appropriate. \96\ On further 
consideration, the Commission has determined that such disclosure is 
important, even to customers executing more complex trades. Because 
retail customers use these types of investment strategies, information 
about the execution price relative to other prices may be invaluable to 
their understanding and decision-making. Even the most sophisticated 
investors may find this information useful.
---------------------------------------------------------------------------

    \95\ See Proposing Release, supra note 7.
    \96\ One commenter recommended narrowing the proposed definition 
of complex trades to exclude certain investment strategies that 
include stock trades, such as ``buy-writes,'' in which an investor 
buys stock and writes a call on that stock. See ISE Letter. The 
Commission believes, however, that other strategies, such as spreads 
(the simultaneous purchase or sale of options on the same underlying 
stock with different strike prices or expiration dates or both) and 
straddles (simultaneous purchase and sale of an equal number of 
calls and puts on the same underlying security with identical strike 
prices and expiration dates), are sufficiently similar to buy-writes 
to warrant similar treatment.
---------------------------------------------------------------------------

5. Compliance Date
    The Trade-Through Disclosure Rule will become effective on February 
1, 2001, and its compliance date is April 1, 2001. On April 1, 2000, 
broker-dealers will be required to make the required disclosures unless 
their transactions are effected on markets that are participants in an 
effective national market system options linkage plan that includes 
provisions reasonably designed to limit intermarket trade-throughs. The 
Commission believes that a linkage plan is not reasonably designed to 
limit intermarket trade-throughs unless it has been implemented and is 
operating. While one commenter expressed its view that the Commission 
should not require compliance with the Trade-Through Disclosure Rule 
until the Linkage Plan has been implemented, \97\ the Commission is 
concerned that tying the compliance date to this event may provide a 
disincentive for the options markets to fully implement the Linkage 
Plan. Accordingly, the Commission does not, at this time, believe that 
it is necessary to delay the compliance date of this rule until the 
linkage is fully implemented and operating. The Commission will 
consider granting temporary exemptive relief to broker-dealers from the 
requirements of the rule if the markets continue to make substantial 
progress towards implementing the Linkage Plan.
---------------------------------------------------------------------------

    \97\ See PCX Letter.
---------------------------------------------------------------------------

B. Amendments to the Quote Rule

    As discussed above, the Commission is adopting amendments to the 
Quote Rule to extend its application to options traded on national 
securities exchanges. Generally, the Quote Rule requires exchanges to 
collect quotations, and sizes associated with those quotations, from 
their members who are responsible broker-dealers and make those 
quotations and sizes available to quotation vendors for each subject 
security listed and admitted to unlisted trading privileges on the 
exchange. \98\
---------------------------------------------------------------------------

    \98\ Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------

    The Commission received several comment letters addressing the 
proposed Quote Rule amendments. A number of commenters voiced their 
support for amending the Quote Rule to include listed options, \99\ 
stating, for example, that firm quotes will promote efficiency and 
increase customer confidence in the markets. \100\ One commenter noted 
that the lack of such a rule in the options markets impeded firms' 
ability to execute customer orders in an efficient manner because they 
have to explore posted quotes to determine if a quote is firm for an 
entire order or only for an order of minimal size. \101\
---------------------------------------------------------------------------

    \99\ See JPMorgan Letter; ISE Letter; PCX Letter; Lek Letter; 
Wolverine Letter; and SIA Letter.
    \100\ See Lek Letter and PCX Letter.
    \101\ See JPMorgan Letter.
---------------------------------------------------------------------------

    Other commenters, however, opposed the proposed amendments to the 
Quote Rule. \102\ Two of these commenters argued that the current 
exchange rules and exchange automatic execution systems sufficiently 
guarantee firm quotes to public customers. Thus, they contended that 
amending the Quote Rule would simply extend its application to broker-
dealer orders, a result they opposed. \103\ One commenter noted that 
current competition among market makers for public customer

[[Page 75448]]

orders is intense, and believed that the proposed amendments would 
force allocation of capital into areas of unacceptable risk, such as 
trading against other broker-dealers, and away from the facilitation of 
public customer orders. \104\
---------------------------------------------------------------------------

    \102\ See Botta Letter; Susquehanna Letter; Brunelle Letter; and 
Phlx Letter.
    \103\ See Botta Letter and Susquehanna Letter.
    \104\ See Susquehanna Letter.
---------------------------------------------------------------------------

    The Commission has carefully considered the issues raised by 
commenters and believes it is appropriate to adopt amendments to the 
Quote Rule to extend its application to the options markets. The 
Commission, however, has made accommodations for the way in which the 
options markets operate. The Commission believes that the amendments 
will provide significant and immediate benefits to investors. In 
particular, market participants, including customers and broker-
dealers, will be able to rely on quotes up to their published size in 
routing orders that are not eligible for execution in the automatic 
execution systems. The Commission believes that this result should lead 
to increased competition on the basis of size among the options 
exchanges, which should enable investors to receive better executions 
for their orders. It will also enable market makers and other broker-
dealers to more easily trade with displayed quotes, increasing the 
accuracy and efficiency of displayed quotes.
    As noted above, the availability of quotation information is one of 
the key components of a national market system. While options quotation 
information is provided to market participants today through OPRA, the 
Commission believes that this information will be substantially 
enhanced by the amendments to the Quote Rule. Quotes are not useful to 
market participants if they are not honored. Further, because market 
participants will be required to disclose trade-throughs of superior 
quotes (unless an exception applies), these superior quotes must be 
firm for all market participants, including broker-dealers. Otherwise, 
the Trade-through Disclosure Rule would be unworkable, and market 
makers would be forced to either route customers' orders to anomalous 
quotes, or unwillingly match that quote to avoid trade-through 
disclosure. The Commission believes that requiring options quotes to be 
firm furthers the national market system goals of Section 11A \105\ and 
will benefit all options market participants.
---------------------------------------------------------------------------

    \105\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

    Because of developments in technology and changes in the options 
markets, the Commission also believes that the current exchange rules 
and automatic execution systems alone are no longer sufficient to 
provide adequate investor protections. Currently, the options markets 
are permitted to fade from their quotes without consequence, pursuant 
to their trade-or-fade rules.\106\ In addition, as noted by one 
commenter, options market makers frequently change the terms of trades 
or ``break'' trades subsequent to execution, without prior notice to 
the customer.\107\ Thus, options investors and their brokers cannot 
fully rely on the disseminated quotation information on which they base 
their order routing decisions. The Commission believes that options 
investors deserve the same protections as equity investors and 
therefore, the Commission is adopting amendments to extend the coverage 
of the Quote Rule to the options market with modifications to 
accommodate certain unique aspects of the options market. The 
Commission also believes that a market maker that executes a trade at 
its disseminated quote and then changes the terms or ``breaks'' the 
trade may well, absent exceptional circumstances, be in violation of 
the firm quote obligation adopted today.
---------------------------------------------------------------------------

    \106\ See supra note and accompanying text. The Commission 
expects the options exchanges will seek approval from the Commission 
to amend their existing rules to conform to the Quote Rule.
    \107\ See Brunelle Letter. This commenter believes that because 
options trades are broken so frequently, public investors, who are 
required to honor all of their commitments, are held to a much 
higher standard than exchange market makers. This commenter 
recommends that in addition to the rules proposed, the Commission 
require market makers to disclose their failures to honor quotes and 
completed transactions.
---------------------------------------------------------------------------

1. Collecting and Making Available Quotation Sizes
    Because the options markets currently do not disseminate to 
quotation vendors the size associated with their bids and offers \108\ 
and due to the existing limitations on OPRA system capacity, the 
Commission is adopting amendments to the Quote Rule so that options 
exchanges may decide not to collect from their members and make 
available to vendors the size associated with each quotation in listed 
options. Instead, exchanges may choose to establish by rule and 
periodically publish the size for which their best bid and offer in 
each options series \109\ that is listed on the exchange is firm. \110\ 
If the rules of an exchange do not require its members to communicate 
to it quotation sizes for listed options, then responsible brokers or 
dealers that are members of that exchange will be relieved of their 
obligations under the Quote Rule to communicate to such exchange their 
quotation sizes. Instead, each such responsible broker or dealer may 
satisfy its firm quote obligation by executing any order to buy or sell 
a listed option that is a subject security, in an amount up to the size 
established by the exchange's rules. \111\ An options exchange may, of 
course, choose to establish procedures for collecting from its members, 
and making available to vendors, the sizes of such members' quotes.
---------------------------------------------------------------------------

    \108\ Currently, OPRA does not have the systems capability to 
collect and disseminate quotes with size. OPRA is, however, 
scheduled to have this capability by January 2001. Some options 
markets may, however, choose to continue not to disseminate quote 
size.
    \109\ The Commission is including the definition of the term 
``option series'' in the Quote Rule. Under Exchange Act Rule 11Ac1-
1(a)(29), the term ``option series'' means contracts in an options 
class that have the same unit of trade, expiration date, and 
exercise price, and other terms or conditions. 17 CFR 240.11Ac1-
1(a)(29).
    \110\ Exchange Act Rule 11Ac1-1(d)(2), 17 CFR 11Ac1-1(d)(2).
    \111\ Exchange Act Rule 11Ac1-1(d)(2), 17 CFR 11Ac1-1(d)(2).
---------------------------------------------------------------------------

    The Commission is not adopting the recommendation of a few 
commenters that exchanges be required to disseminate quotation sizes as 
soon as OPRA is capable of doing so. \112\ One commenter raised the 
concern that the proposed amendments to the Quote Rule would result in 
each exchange using its portion of OPRA bandwidth differently, which 
could benefit exchanges that show relatively limited size information, 
and have a significant adverse effect on exchanges that collect and 
disseminate the ``real'' size of their trading interest. \113\ This 
commenter suggested that the Commission use its exemptive authority 
under the Quote Rule to require all exchanges to disseminate size with 
their quotations, even if an exchange determines to establish by rule 
and periodically publish its firm quote size.
---------------------------------------------------------------------------

    \112\ In this regard, several commenters suggested that the 
Commission wait until OPRA is able to disseminate size before 
proceeding with the amendments. See Susquehanna Letter; Botta 
Letter; PCX Letter; Phlx Letter; and JPMorgan Letter. One commenter 
suggested that the Commission adopt this approach to quote size only 
temporarily. See Morgan Stanley Letter. Another commenter 
characterized the Commission's approach as an ``appropriate 
solution,'' arguing that the Commission should refrain from 
mandating that size be disseminated with each quotation until the 
existing limitations on OPRA systems capacity have been remedied. 
See SIA Letter.
    \113\ See ISE Letter.
---------------------------------------------------------------------------

    Another commenter, while also acknowledging OPRA capacity 
constraints, argued that the concept of the periodic publication of 
firm quote sizes is contrary to OPRA's plan to require the 
dissemination of size with every options quote by January 2001. \114\ 
Thus, this commenter believed that the

[[Page 75449]]

proposed amendments to the Quote Rule appeared to be unnecessary. 
Finally, one commenter recommended that any amendment to the Quote Rule 
require on-floor specialists and market makers, as well as the options 
exchanges, to publish on a quote-by-quote basis the size associated 
with each quote. \115\
---------------------------------------------------------------------------

    \114\ See Phlx Letter.
    \115\ See Brunelle Letter.
---------------------------------------------------------------------------

    The Commission has decided, at this time, not to require the 
options exchanges to disseminate quotes with size. Currently, OPRA does 
not have the capability to accept size with options quotes, although it 
does anticipate disseminating quotes with size in January 2001. The 
Commission notes that the options exchanges generate significantly more 
quotes than the equity exchanges. Adding size to quote messages will 
increase the bandwidth necessary to disseminate options market data, 
and possibly, increase the number of messages if a new quote is 
required every time its associated size is modified. As discussed 
above, over the past year, OPRA has suffered serious capacity 
constraints due to the tremendous amount of quote message traffic 
generated by the exchanges. Due to the limitations on OPRA systems 
capacity, the Commission, while supporting OPRA's efforts to modify its 
systems to accommodate size, does not believe that it is appropriate to 
mandate further burdens on OPRA systems capacity at this time.
    Pursuant to the amendments to the Quote Rule adopted by the 
Commission today, the options exchanges will be required to publicize 
the size for which its quotes will be firm either on a quote-by-quote 
basis or by publicizing its rule establishing its firm quote sizes. The 
Commission believes that periodic publication will be sufficient to 
inform options market participants of the relevant size information 
they need to make informed order routing decisions. Although the 
Commission recognizes one commenter's concerns that disseminating 
quotes with size may require more OPRA systems capacity, the Commission 
believes that this is a competitive issue and consequently, so long as 
investors have access to the size information that they require, it is 
not necessary for the Commission to require the dissemination of quotes 
with size at this time.
2. Firm Quote Sizes for Customer and Broker-Dealer Orders
    The Commission proposed two alternatives regarding the size for 
which responsible broker-dealers' quotes for listed options would be 
required to be firm. Under proposed Alternative A, the size for which a 
responsible broker-dealer's best bid or offer is firm would be required 
to be the same for orders received from customers and for orders 
received from broker-dealers. Proposed Alternative B would permit an 
exchange to establish different firm quote sizes for broker-dealer 
orders than for customer orders. The Commission requested commenters' 
views on these two alternatives.
    Several commenters supported Alternative A under which the 
Commission proposed that the firm quote size be the same for both 
customer and broker-dealer proprietary orders. \116\ One of these 
commenters argued that providing the same firm quote size to all market 
participants emboldens investor confidence in fair pricing because if 
the price of a security is too low, then another professional will be 
ready and able to bring the price in line by entering buy orders, and 
vice versa for sell orders. This commenter opposed a different firm 
quote sizes because it believed that this would permit a two-tiered 
market -- one consisting of displayed quotes for non-professionals 
only, and another, ``shadow'' market for professionals. Further, the 
commenter argued that the supposition that market makers would widen 
their spreads if their quotes were exposed to other market 
professionals is unjustified and unsupported by empirical data, and in 
any case, the public is more harmed by non-competitive, un-real quotes 
than by wider spreads. \117\ Another of these commenters, however, 
believed that applying the Quote Rule equally to all market 
participants would prove unworkable at this time because of the 
structure of the options market. \118\
---------------------------------------------------------------------------

    \116\ See JPMorgan Letter; ISE Letter; Lek Letter; Wolverine 
Letter; and Morgan Stanley Letter.
    \117\ See Lek Letter.
    \118\ See ISE Letter.
---------------------------------------------------------------------------

    On the other hand, several commenters preferred allowing 
responsible broker-dealers to be firm for different sizes for customers 
and broker-dealers, as proposed in Alternative B.\119\ Some commenters 
argued that if market makers were required to establish a single 
quotation size for all market participants, they would likely decrease 
the disseminated size of their quotes and their execution guarantees, 
limiting liquidity available to customers.\120\ They argued that the 
ability to establish differing quote sizes for broker-dealer and 
customer orders would allow market makers to provide customers with 
greater liquidity, while limiting their exposure to non-customers.\121\ 
Other commenters argued that market makers, not the Commission, should 
determine how much liquidity they want to guarantee to 
professionals.\122\
---------------------------------------------------------------------------

    \119\ See Botta Letter; CBOE Letter; PCX Letter; Susquehanna 
Letter; and SIA Letter.
    \120\ See Botta Letter; CBOE Letter; PCX Letter; ISE Letter; 
Susquehanna Letter; and SIA Letter.
    \121\ See PCX Letter; CBOE Letter; and ISE Letter.
    \122\ See Susquehanna Letter and Botta Letter.
---------------------------------------------------------------------------

    One commenter explained that market makers provide different 
liquidity guarantees to professional orders to protect against being 
``picked off,'' and noted that if market makers quote less 
aggressively, public customers whose orders are generally automatically 
executed at the NBBO could be adversely affected.\123\ This commenter 
noted that market makers compete against each other by guaranteeing 
different sizes, which would be eliminated if only one quote size 
applied to all types of orders. Another commenter argued that options 
market makers are at far greater risk than stock specialists of being 
picked off by professionals and that it would be exponentially more 
difficult for an options market maker than for a stock specialist to 
provide continuously updated quotes that would be firm against 
professional interest.\124\ However, another commenter noted that the 
equity market does not exempt traders and market makers from the Quote 
Rule when dealing with other broker-dealers.\125\
---------------------------------------------------------------------------

    \123\ See Botta Letter.
    \124\ See Susquehanna Letter.
    \125\ See Lek Letter.
---------------------------------------------------------------------------

    After careful review of the commenters' observations and 
suggestions, the Commission is adopting amendments to the Quote Rule 
that allow the options exchanges to establish different firm quote 
sizes for broker-dealer orders than for customer orders.\126\ An 
exchange that chooses not to collect from their members and make 
available to vendors the size associated with each quotation in listed 
options may establish by rule and periodically publish the size at 
which its best bid or offer in each options series listed on the 
exchange is firm for orders from customers and orders from broker-
dealers.\127\ An exchange would also have the flexibility to collect 
from its members and make available to quotation vendors the quotation 
sizes at which such members are firm for customer orders and, at the 
same time, to establish by rule and periodically

[[Page 75450]]

publish a different size for which their members' quotes must be firm 
for broker-dealer orders.\128\
---------------------------------------------------------------------------

    \126\ Exchange Act Rule 11Ac1-1(d)(1), 17 CFR 240.11Ac1-1(d)(1). 
Exchange rules must require responsible broker-dealers to be firm 
for orders for the accounts of broker-dealers for at least one 
contract.
    \127\ Exchange Act Rule 11Ac1-1(d)(1)(ii), 17 CFR 240.11Ac1-
1(d)(1)(ii).
    \128\ Exchange Act Rule 11Ac1-1(d)(1)(iii), 17 CFR 240.11Ac1-
1(d)(1)(iii).
---------------------------------------------------------------------------

    The Commission believes that the unique structure of the options 
markets, specifically, the tremendous number of products that must be 
continuously quoted by options market makers or specialists, warrants 
this specific accommodation. Currently, there are approximately 178,000 
options series for which options market makers and specialists 
continuously provide two-sided quotations. Consequently, the Commission 
believes that permitting different quote size guarantees is the best 
course of action at this time to help ensure the continued availability 
of liquidity, which facilitates the maintenance of fair and orderly 
markets. The Commission will, however, continue to evaluate the markets 
to determine if, in fact, this provision is warranted.
3. Minimum Quote Size
    In the Proposing Release, the Commission requested commenters' 
views on whether the Commission should establish a minimum number of 
contracts for which quotes should be firm. The Commission received no 
comments in support of mandating a minimum firm quote size.\129\
---------------------------------------------------------------------------

    \129\ See PCX Letter; Phlx Letter; JPMorgan Letter; ISE Letter; 
CBOE Letter; and Susquehanna Letter.
---------------------------------------------------------------------------

    Two commenters did suggest that in absence of a mandated minimum 
firm quote size, quotes should be firm for at least one contract, which 
has the economic equivalent of 100 shares of stock, the minimum quote 
size in the equities markets.\130\ One of these commenters believed 
that the minimum firm quote size should be viewed as a competitive, 
rather than a regulatory, issue.\131\ Other commenters argued against a 
minimum firm quote size because any such minimum would facilitate and 
encourage wide-scale proprietary trading by broker-dealers on markets 
in which they are not members.\132\ One of these commenters believed 
that non-members of an exchange should not be allowed to gain free 
access to the exchange, because such access could dilute the value of 
exchange memberships.\133\
---------------------------------------------------------------------------

    \130\ See PCX Letter and SIA Letter.
    \131\ See PCX Letter.
    \132\ See Phlx Letter and Morgan Stanley Letter.
    \133\ See Phlx Letter.
---------------------------------------------------------------------------

    The Commission agrees that quote size is a competitive issue and 
should not be dictated by regulation. Under the Quote Rule adopted 
today, each options exchange will be required to publicize the size at 
which their market makers or specialists are firm. The Commission 
believes that competitive market forces will dictate appropriate firm 
quote sizes for customer and broker-dealer orders in the options 
markets.
    Nevertheless, the Commission believes that each disseminated quote 
must represent at least one contract -- any less would mean that a 
quote was not actually firm. For this reason, the Commission is 
adopting a requirement that if an exchange allows quotes to be firm in 
different sizes for broker-dealer orders than for customer orders, its 
rules must require its market makers to be firm for a minimum of one 
contract. As noted by one of the commenters, one contract is the 
economic equivalent of 100 shares of stock and therefore, this 
requirement establishes in the options market a standard equivalent to 
that applied in the equities market.
    On a related note, the Commission believes that in those instances 
in which a quote is disseminated by an exchange that collects and 
aggregates quotation sizes from several responsible broker-dealers, 
each responsible broker-dealer would be required to be firm for at 
least one contract for broker-dealer orders.\134\ Therefore, for 
example, if an exchange collects and disseminates a quote, the size of 
which reflects the aggregate size of three competing responsible 
broker-dealers, the exchange quote must be firm to orders from broker-
dealers for at least three contracts, one for each responsible broker-
dealer.\135\
---------------------------------------------------------------------------

    \134\ For customer orders, each responsible broker-dealer will 
be firm for its published size.
    \135\ In comparison, exchanges that disseminate one quote for a 
trading crowd, based on a single, automatically generated quote 
would be required to be firm only for a minimum of one contract.
---------------------------------------------------------------------------

4. Automatic Execution Systems
    The amendments to the Quote Rule adopted today do not affect the 
ability of the options exchanges to provide execution guarantees 
through their automatic execution systems. The exchanges' automatic 
execution systems are generally used for small, public customer market 
and marketable limit orders. Options exchanges will continue to have 
the flexibility to publish a different firm quote size for a particular 
options class than its automatic execution guarantee size. The 
Commission, however, may reevaluate this approach if it results in a 
decrease in liquidity available for customer orders.
5. Exception During Trading Rotations
    Under the Quote Rule, responsible brokers or dealers are relieved 
of their obligations if, for example, the responsible broker or dealer 
is in the process of effecting a transaction and immediately 
thereafter, communicates a revised quotation. The amendments to the 
Quote Rule being adopted today also relieve responsible brokers or 
dealers from their firm quote obligations when an order for listed 
options is presented during a trading rotation in that listed 
option.\136\ During trading rotations, market makers may be unable to 
generate quotes in a timely fashion. The Commission is adopting as part 
of the Quote Rule the definition of ``trading rotation'' proposed in 
the Trade-Through Disclosure Rule, with a slight modification.\137\ 
Specifically, the definition of trading rotation has been modified to 
include references to reopening and closing rotations, as well as to 
opening rotations as proposed, because the same difficulties in 
providing firm quotes during opening rotations apply during those other 
types of trading rotations.\138\
---------------------------------------------------------------------------

    \136\ Exchange Act Rule 11Ac1-1(d)(4)(ii), 17 CFR 240.11Ac1-
1(d)(4)(ii).
    \137\ The Commission did not propose in the Proposing Release to 
include a definition of the term ``trading rotation'' in the Quote 
Rule.
    \138\ Exchange Act Rule 11Ac1-1(a)(30), 17 CFR 240.11Ac1-
1(a)(30).
---------------------------------------------------------------------------

6. Thirty-Second Response
    As discussed above, if a responsible broker or dealer fails to 
respond to an incoming order within the 30 seconds, the Trade-Through 
Disclosure Rule permits the routing broker or dealer to execute its 
customer's order at an inferior quote without being required to 
disclose the better, but unresponsive, quote to its customer.\139\ The 
Commission is adopting an amendment to the Quote Rule \140\ to require 
a responsible broker or dealer to respond to an order to buy or sell a 
listed option in an amount greater than the firm quote size within 30 
seconds by either: (i) executing the entire order; or (ii) executing at 
least that portion of the order equal to the applicable firm quote size 
and revising its bid or offer.\141\ The

[[Page 75451]]

Quote Rule requires responsible brokers and dealers to immediately 
execute an order to buy or sell listed options in an amount equal to or 
less than its firm quote size.\142\
---------------------------------------------------------------------------

    \139\ Exchange Act Rule 11Ac1-7(b)(4)(iv), 17 CFR 240.11Ac1-
7(b)(4)(iv).
    \140\ Exchange Act Rule 11Ac1-1(d)(3), 17 CFR 240.11Ac1-1(d)(3). 
A responsible broker's or dealer's applicable firm quote size would 
be its published quote size or, if a responsible broker or dealer 
has been relieved of the obligation to communicate its quotation 
sizes, the minimum firm quote size established by its exchange's 
rules. One commenter noted that the proposed amendments to the Quote 
Rule failed to incorporate the use of a defined term, ``published 
quotation size,'' where applicable. See ISE Letter. In response to 
the comment, the Commission is adopting technical amendments to the 
Quote Rule to more uniformly apply the defined term, published 
quotation size.
    \141\ When a responsible broker-dealer chooses to respond to an 
order in an amount greater than the firm quote size by executing 
only that portion of the order equal to the firm quote size, and 
thereafter, revising its bid or offer to an inferior price, the 
Commission expects that, in the absence of a price movement in the 
underlying security, the responsible broker-dealer will not 
reinstate its original bid or offer for at least thirty seconds. A 
responsible broker-dealer may not reinstate its bid or offer for at 
least thirty seconds even if a competing market maker independently 
quotes at the original price during the thirty second period.
    \142\ Exchange Act Rule 11Ac1-1(c)(2), 17 CFR 240.11Ac1-1(c)(2).
---------------------------------------------------------------------------

    The Commission requested comment on its proposal to require 
responsible broker-dealers, within 30-seconds, to either execute an 
entire order or execute that portion of an order that is equal to its 
firm quote size, and thereafter revise its bid or offer. One commenter 
stated that, ultimately, the Commission should require that quotes be 
subject to automatic or nearly automatic executions.\143\ Similarly, 
several other commenters considered 30 seconds too long because it 
imposed unnecessary market risk on customers and could result in market 
makers abusing the time period by holding orders until the last second 
in an attempt to gain an advantage.\144\ One commenter suggested that 
market makers be required to immediately respond to orders that are not 
larger than the disseminated quote size and respond within 15 seconds, 
which is the turnaround time in the Linkage Plan, to orders of greater 
size.\145\ Another commenter suggested a 10-second response time would 
be more appropriate.\146\
---------------------------------------------------------------------------

    \143\ See Morgan Stanley Letter.
    \144\ See Phlx Letter; ISE Letter; and Brunelle Letter.
    \145\ See ISE Letter.
    \146\ See Brunelle Letter.
---------------------------------------------------------------------------

    Further, because different types of orders require different 
handling procedures, which means that execution times will be 
different, one commenter opposed any requirement that would institute 
an across-the-board 30-second reporting requirement for all 
orders.\147\ This commenter suggested that the Commission defer any 
decision on this issue until the Linkage Plan has been implemented and 
the exchanges have gained some experience and data regarding turnaround 
times. In addition, this commenter suggested that if the Commission 
extends trade-through protection to markets that do not participate in 
any approved linkage plan, 30 seconds may be too long a time period for 
those instances in which an order is routed to a market that does not 
participate in any approved linkage plan, because there may not be a 
guarantee of an execution in the event that such market backs away from 
its quote or is not firm for the entire order.
---------------------------------------------------------------------------

    \147\ See CBOE Letter.
---------------------------------------------------------------------------

    Finally, another commenter believed that the 30-second response 
time would not delay trades but suggested that the Commission make an 
exception for fast market conditions, and remain open to changing the 
response time as technology improves.\148\
---------------------------------------------------------------------------

    \148\ See JPMorgan Letter.
---------------------------------------------------------------------------

    For orders greater than an exchange's firm quote size, the 
Commission is adopting the 30-second response requirement, as proposed. 
The Commission believes that the Quote Rule currently requires 
responsible broker-dealers to immediately execute orders in a size up 
to its firm quote size and is not amending that requirement as applied 
to options. Accordingly, orders equal to or smaller than a responsible 
broker-dealers' firm quote size must be immediately executed.
    The Commission believes that it is appropriate to establish a time 
limit by which a recipient market maker must execute an order larger 
than its quote, or change its quote. The Commission believes that a 
time period must be set forth in the rule to prevent broker-dealers 
from waiting an inordinate amount of time before executing an order or 
changing their quote. In this regard, the Commission is concerned that 
in the absence of a set time frame, the execution of orders may be 
unduly delayed. Therefore, at this time, the Commission believes that 
the 30-second time limit appropriately balances the need for price 
priority against the need for efficient execution of orders. The 
Commission will, however, evaluate this time frame as the exchanges 
implement these amendments and as technology progresses to determine if 
another time frame is more appropriate.
7. One-Percent Exception
    Under the Quote Rule exchanges are required to collect and make 
available the quotes communicated to them by responsible broker-dealers 
for subject securities. A subject security is any exchange-traded 
security except a security for which an exchange's executed volume 
during the most recent calendar quarter comprised one percent or less 
of the aggregate trading volume for such security as reported to OPRA, 
and any security actually quoted by an exchange.\149\ One commenter 
believed that this exception was not necessary for listed options.\150\ 
This commenter argued that the possibility of a chilling effect on the 
liquidity of inactively-traded securities would not justify the 
monitoring burden that the exception would impose on brokers, who would 
be forced to keep track of which quotes were firm and which, due to the 
one percent exception, were not.
---------------------------------------------------------------------------

    \149\ See Exchange Act Rule 11Ac1-1(a)(25), 17 CFR 240.11Ac1-
1(a)(25).
    \150\ See JPMorgan Letter.
---------------------------------------------------------------------------

    The Commission believes that the options markets and options market 
makers should be permitted to make use of the one percent exception. 
The Commission is not persuaded that this exception, applied for years 
in the equity markets, will impose significant compliance burdens on 
market participants. Any quote actually published by the exchange must 
be firm.
8. Amendments to Defined Terms
    To effectuate the application of the Quote Rule to listed options, 
the Commission is amending several defined terms used in that rule. In 
particular, the Commission is expanding application of the Quote Rule 
to include transactions in listed options \151\ by amending the 
definition of the term ``reported security,'' \152\ to include any 
security or class of securities for which transaction reports are 
collected, processed, and made available pursuant to an effective 
transaction reporting plan \153\ or an effective national market system 
plan for reporting transactions in listed options.\154\ Consequently, 
listed options are now also included within the definitions of 
``covered security,'' \155\

[[Page 75452]]

``exchange-traded security,'' \156\ and ``subject security.'' \157\ 
Thus, options exchanges and market makers are obligated to publish 
their quotes and, as importantly, be firm for those quotes.
---------------------------------------------------------------------------

    \151\ The Commission defines the term ``listed option'' in the 
Quote Rule as any option traded on a registered national securities 
exchange or automated facility of a registered national securities 
association. See Exchange Act Rule 11Ac1-1(a)(27), 17 CFR 240.11Ac1-
1(a)(27).
    \152\ One commenter noted that by changing the definition of 
reported security in the Quote Rule, options would be subject to the 
Limit Order Display Rule, Exchange Act Rule 11Ac1-4, 17 CFR 
240.11Ac1-4, which incorporates by reference the definition of 
reported security in the Quote Rule. See JPMorgan Letter. As the 
Commission did not intend to amend the Limit Order Display Rule in 
this manner, the Commission is adopting a conforming amendment to 
the definition of reported security in the Limit Order Display Rule, 
to retain the existing definition in that rule.
    \153\ All national securities exchanges and national securities 
associations must file with the Commission a transaction reporting 
plan regarding transactions in listed equity and Nasdaq securities. 
See Exchange Act Rule 11Aa3-1(b)(1), 17 CFR 240.11Aa3-1(b)(1).
    \154\ Currently, the OPRA Plan is the only effective national 
market system plan that collects, processes, and makes available 
transaction reports for listed options.
    \155\ The term ``covered security'' is defined as any reported 
security and any other security for which a transaction report, last 
sale data or quotation information is disseminated through an 
automated quotation system as described in Section 3(a)(51)(A)(ii) 
of the Exchange Act, 15 U.S.C. 78c(a)(51)(A)(ii). See Exchange Act 
Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1(a)(6).
    \156\ The term ``exchange-traded security'' is defined as any 
covered security or class of covered securities listed and 
registered, or admitted to unlisted trading privileges, on an 
exchange. See Exchange Act Rule 11Ac1-1(a)(10), 17 CFR 240.11Ac1-
1(a)(10).
    \157\ The term ``subject security'' is defined to include any 
exchange-traded security other than a security for which the 
executed volume of such exchange, during the most recent calendar 
quarter, comprised one percent or less of the aggregate trading 
volume for such security as reported in the consolidated system. See 
Exchange Act Rule 11Ac1-1(a)(25), 17 CFR 240.11Ac1-1(a)(25).
---------------------------------------------------------------------------

    In addition, the Commission is amending the definition of 
``consolidated system'' under Rule 11Ac1-1(a)(5) \158\ to include a 
transaction reporting system operating pursuant to an effective 
national market system plan, as proposed. The effect of this amendment 
is to make clear that listed options would be ``subject securities'' 
with respect to an exchange or association only if, during the most 
recent calendar quarter, the exchange or association chooses to publish 
quotes or the aggregate trading volume on such exchange or association 
is more than one percent of the aggregate trading volume as reported by 
OPRA.
---------------------------------------------------------------------------

    \158\ Exchange Act Rule 11Ac1-1(a)(5), 17 CFR 240.11Ac1-1(a)(5).
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9. Compliance Date
    The amendments to the Quote Rule become effective on February 1, 
2001, and have a compliance date of April 1, 2001. Although several 
commenters recommended that market makers and exchanges not be required 
to comply with the amendments to the Quote Rule until OPRA is able to 
disseminate quotes with size,\159\ the Commission believes that these 
amendments will provide significant benefits to options market 
participants and does not believe that they should be delayed while 
OPRA develops new systems changes. Further, because the options 
exchanges will not be required to disseminate size on a quote-by-quote 
basis, market makers and exchanges can comply with the amendments to 
the Quote Rule even if OPRA is unable to accept quotes with size by 
April 1, 2001.
---------------------------------------------------------------------------

    \159\ See Susquehanna Letter; Botta Letter; PCX Letter; Phlx 
Letter; and JPMorgan Letter.
---------------------------------------------------------------------------

V. Paperwork Reduction Act

    Certain provisions of the new rules contain ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (``PRA'').\160\ Accordingly, the Commission 
submitted them to the Office of Management and Budget (``OMB'') for 
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The 
Commission proposed, and OMB approved, amendments to the collection of 
information titled ``Rule 11Ac1-1, Dissemination of Quotations'' (OMB 
Control Number 3235-0461). The Commission also proposed to create a new 
information collection entitled ``Rule 11Ac1-7, Trade-Through 
Disclosure Rule.'' OMB has approved the new collection, and has 
assigned it OMB Control Number 3235-0543, with an expiration date of 
November 30, 2003. 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.
---------------------------------------------------------------------------

    \160\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    The Proposing Release solicited comments on these collection of 
information requirements.\161\ No comments were received that addressed 
the PRA portion of the Proposing Release. The Commission believes that 
its previously published estimates of the information collection 
burdens associated with the new rule and rule amendments are 
appropriate.
---------------------------------------------------------------------------

    \161\ See Proposing Release, supra note .
---------------------------------------------------------------------------

    Any collection of information pursuant to the new rules would be 
mandatory. Market centers that are national securities exchanges or 
national securities associations would be required to retain the 
required collections of information for not less than five years, the 
first two years in an easily accessible place. Broker-dealers would be 
required to retain the collections of information for not less than 
three years, the first two years in an easily accessible place.

A. Use and Disclosure of the Information Collected

    The information collected pursuant to the Trade-Through Disclosure 
Rule would be sent to customers and retained by broker-dealers. No 
information, however, will be collected or retained under this rule if 
all of the options exchanges participate in an effective national 
market system options linkage plan that is reasonably designed to limit 
intermarket trade-throughs. This information would be used by customers 
to evaluate the quality of the executions they receive. It would also 
be used by broker-dealers to evaluate and make determinations related 
to their best execution obligations. The Commission and the options 
markets would use the information collected pursuant to the rule for 
inspections, examinations, trading reconstructions, enforcement 
inquiries or investigations.
    The information collected pursuant to the Quote Rule would be held 
by broker-dealers and markets. Customers of broker-dealers, as well as 
other market participants, would use this information to determine the 
sizes associated with the best prices available for listed options. The 
Commission and self-regulatory organizations (``SROs'') would use the 
information collected pursuant to the rule for inspections, 
examinations, trading reconstructions, enforcement inquiries or 
investigations.
    The Commission and other securities regulatory authorities would 
obtain possession of the information only upon request. Any collection 
of information received by the Commission, SROs, and other securities 
regulatory authorities would not be disclosed under the terms of the 
proposal, subject to the provisions of the Freedom of Information Act, 
5 U.S.C. 552.

B. Trade-Through Disclosure Rule

1. Capital Costs
    As the Commission noted in the Proposing Release, if a broker-
dealer effects trades on a market that participates in an approved 
linkage plan with provisions reasonably designed to limit intermarket 
trade-throughs, including trade-throughs of prices on markets not 
participating in a linkage plan, the broker-dealer will have no 
paperwork capital costs or paperwork burdens under the Trade-Through 
Disclosure Rule. The same will hold true if all options markets 
participate in such a linkage plan. As noted above, all five options 
exchanges are currently participants in the Linkage Plan approved by 
the Commission on July 28, 2000.\162\ Only minor modifications to the 
Linkage Plan are necessary for it to be considered reasonably designed 
to limit intermarket trade-throughs.
---------------------------------------------------------------------------

    \162\ See Linkage Plan, supra note 4.
---------------------------------------------------------------------------

    The Trade-Through Disclosure Rule would require broker-dealers to 
make certain disclosures to customers if the broker-dealer effects 
trades on markets that do not participate in an approved linkage plan. 
Broker-dealers would incur paperwork costs to modify systems to permit 
them to: (1) Receive information about when a trade-through has 
occurred and the price that was traded through; (2) match information 
about trade-throughs with customer accounts; and (3) disclose to 
customers when trade-throughs occur. The Commission has estimated that 
it would take a computer programmer at an

[[Page 75453]]

hourly rate of approximately $50 \163\ between 500 and 1,000 hours to 
modify the average broker-dealer's systems to receive trade-through 
information, at a cost of between $25,000 and $50,000 for each broker-
dealer. Approximately 7,500 broker-dealers were registered with the 
Commission as of December 31, 1999. Of those, approximately 3,800 
conduct business with the general public. Most introducing firms, 
however, rely on their clearing firms to generate confirmation 
statements for customers.\164\ As a result, fewer than 330 broker-
dealers would actually have to modify their systems, should any 
modifications be necessary. However, if all 330 registered broker-
dealers that clear customer accounts pursuant to Exchange Act Rule 
15c3-3 \165\ were required to make these systems modifications, the 
one-time paperwork cost would be between $8,250,000 and $16,500,000.
---------------------------------------------------------------------------

    \163\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See Report on 
Management and Professional Earnings in the Securities Industry 
1999, published by the SIA (``SIA Report'').
    \164\ The Commission estimates that none of the 41 small broker-
dealers who do not have a relationship with a clearing firm 
regularly represent customer options orders.
    \165\ 17 CFR 240.15c3-3.
---------------------------------------------------------------------------

2. Burden Hours
    If a broker-dealer effects trades on markets that do not 
participate in an approved linkage plan with provisions reasonably 
designed to limit intermarket trade-throughs, including trade-throughs 
of prices on markets not participating in an approved linkage plan, the 
broker-dealer would be required to disclose trade-throughs to its 
customers. However, because broker-dealers' systems would have already 
been reprogrammed to receive information about trade-throughs and to 
appropriately disclose such trade-throughs to customers, the Commission 
has estimated that the paperwork burden of the disclosure for broker-
dealers would be nominal, since it would merely require a small amount 
of additional information to be provided to customers at or before the 
completion of the transaction on confirmation statements, or in some 
equivalent fashion.\166\
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    \166\ The Commission's adoption of an exception to the 
disclosure requirement of the Trade-Through Disclosure Rule for 
block orders would only reduce this burden. Because this burden was 
already determined to be nominal, this change does not affect the 
Commission's initial burden estimate. See Proposing Release, supra 
note 6.
---------------------------------------------------------------------------

C. Amendments to the Quote Rule

1. Capital Costs
    In the Proposing Release, the Commission noted that options 
exchanges are obligated already, pursuant to their participation in the 
OPRA Plan, to collect bids and offers, and send them to OPRA for 
dissemination. However, under the amended Quote Rule, the options 
exchanges will be required to either collect and make available to 
vendors quotation sizes associated with such bids and offers, or to 
establish by rule and periodically publish the sizes for which a quote 
must be firm, and to file proposed rule changes to identify unusual 
market conditions.
    If an exchange chooses not to collect and make available to vendors 
quotation sizes associated with its members' bids and offers, but 
instead chooses to implement rules and periodically publish such rules 
establishing the sizes for which its quotes will be firm, it would 
incur one-time costs to file and obtain approval of these rule changes, 
as well as other related rules. The Commission estimated that each of 
the five options exchanges would need to file two rule changes to 
comply with the proposed amendments to the Quote Rule, for a total of 
10 rule changes. The Commission has estimated that a routine rule 
change requires approximately 25 hours of legal review at an hourly 
cost of $98.25,\167\ plus one hour of secretarial time at an hourly 
cost of $30.40,\168\ for a total cost of $2,487 per proposed rule 
change submitted for Commission approval. Therefore, the Commission has 
estimated that the aggregate cost of two proposed rule changes filed by 
each of the five options exchanges would total approximately $24,867.
---------------------------------------------------------------------------

    \167\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See SIA Report 
supra note 163.
    \168\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See Report on 
Office Salaries in the Securities Industry 1999.
---------------------------------------------------------------------------

    Also, as noted in the Proposing Release, broker-dealers that are 
market makers or specialists have existing obligations under exchange 
rules to communicate their bids and offers to their exchanges, and 
already do so. Therefore, they would incur no additional paperwork 
costs from the amended Quote Rule beyond those related to systems 
changes, discussed below, to comply with the amended Quote Rule. Market 
makers and specialists may, to comply with the amended Quote Rule, 
change their quote-setting practices by changing the factors used to 
establish quotes through automated quoting systems (i.e., resetting the 
parameters). The Commission notes that almost all option quotes are 
currently set by automated quoting systems. The Commission estimated 
broker-dealer systems changes made to comply with the amended Quote 
Rule would require changes estimated to take approximately three to 
five minutes per options class. As there are approximately 3,000 
options classes eligible for multiple listing, the Commission estimated 
that the total burden for one market could range from 180 to 250 hours. 
For all five markets, the total burden could range from 900 to 1,255 
hours. The hourly rate of an exchange clerk that would make the 
required system changes is $32.50;\169\ therefore, the total cost for 
these changes could range from $29,250 to $40,787.
---------------------------------------------------------------------------

    \169\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See SIA Report 
supra note 163.
---------------------------------------------------------------------------

2. Burden Hours
    The Commission estimated that the five options exchanges may, to 
comply with the Quote Rule, amend their rules at most once per year, 
for a total of five proposed rule changes. The Commission estimated 
that a routine proposed rule change takes 25 hours of legal review at 
an hourly cost of $98.25 \170\ plus one hour of secretarial time at an 
hourly cost of $30.40,\171\ for a total cost of $2,487 per proposed 
rule change. Therefore, the total annual cost of five exchanges' 
proposed rule changes would impose a burden of $12,433.
---------------------------------------------------------------------------

    \170\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See SIA Report 
supra note 163.
    \171\ The hourly rate contains 35% overhead, which includes, 
among other costs, telephone, postage and copying. See Report on 
Office Salaries in the Securities Industry 1999.
---------------------------------------------------------------------------

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

VI. Costs and Benefits of Final Rules

    Recent increases in the multiple listing of options classes 
previously listed on a single exchange have

[[Page 75454]]

intensified the competition among the option exchanges and heightened 
the need to further integrate the options markets into the national 
market system. While the growth in multiple trading has increased the 
competition between markets, it also has dramatically altered the 
environment in which options market participants conduct their trading. 
In particular, multiple trading raises new best execution challenges 
for brokers. When an option is listed on only one exchange, brokers do 
not have to decide where to route an order, and consequently, 
satisfying their best execution obligations is less complex than when 
they must consider the relative merits of routing orders to two or more 
market centers. With as many as five options exchanges currently 
trading certain options classes, brokers are required to regularly and 
rigorously evaluate on a more frequent basis the execution quality 
available at each options exchange.
    Directly relevant to a broker's ability to obtain best execution 
for its customers is the ability to get the best price available. The 
considerable growth in the number of options classes traded on more 
than one exchange has significantly increased the likelihood of 
intermarket trade-throughs. With the current expansion of multiple 
trading in options, the Commission is increasingly concerned about 
customer orders, which are sent to one exchange, and executed at prices 
that are inferior to quotes published by another market. As a result, 
the Commission believes that adoption of the Trade-Through Disclosure 
Rule and amendments to the Quote Rule are necessary at this time to 
encourage the removal of barriers to access to, and the use of 
efficient vehicles to reach, better prices on another market.

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

    Under the Trade-Through Disclosure Rule, a broker generally will be 
required to disclose to its customer, in writing at or before the 
completion of the transaction, when the customer's order for listed 
options was executed at a price inferior to a better published quote 
and the better published quote available at that time.\172\ A broker-
dealer will not be required to make this disclosure if any of the four 
exceptions to the definition of a trade-through apply, which include 
when: (1) The market on which the order is executed has verified that 
the market publishing the better price is experiencing systems 
problems, which make the quote inaccessible, (2) OPRA is experiencing 
queuing, (3) the market publishing the better price is relieved of its 
obligations to publish firm quotes, or (4) the market publishing the 
better quote fails to respond to an order routed to it within 30 
seconds.
---------------------------------------------------------------------------

    \172\ Exchange Act Rule 11Ac1-7(b)(1), 17 CFR 240.11Ac1-7(b)(1). 
The Commission believes that a broker-dealer should be allowed to 
rely on the market of execution to notify the broker-dealer of when 
a trade-through has occurred and the best quote at that time.
---------------------------------------------------------------------------

    A broker-dealer also will not be required to provide such 
disclosure to its customer if it effects the transaction on an exchange 
that participates in an approved linkage plan that includes provisions 
reasonably designed to limit customers' orders from being executed at 
prices that trade through a better published price or the customer 
order was executed as part of a block trade.\173\ Exchanges also will 
be required to surveil and sanction specialists or market makers that 
trade through better prices published by other exchanges, particularly 
because under the intermarket linkage plan exception, broker-dealers 
need not disclose to their customers if their orders are executed at a 
price inferior to a quote published by another market.
---------------------------------------------------------------------------

    \173\ Exchange Act Rule 11Ac1-7(b)(2), 17 CFR 240.11Ac1-7(b)(2).
---------------------------------------------------------------------------

1. Comments
    In the Proposing Release, the Commission requested comments on all 
aspects of the costs and benefits of the rule, including identification 
of additional costs or benefits of the new rule. In addition, the 
Commission encouraged commenters to identify or supply any relevant 
data concerning the costs or benefits of the new rule.
    None of the commenters specifically addressed the costs or benefits 
of the proposed Trade-Through Disclosure Rule. However, several 
commenters discussed certain aspects of the Commission's proposal, 
which implicitly addressed the costs or benefits of the proposal, such 
as the likelihood that the rule would help to prevent trade-throughs 
and therefore, implicitly the associated costs of trade-throughs to 
investors. For example, one commenter believed that trade-throughs 
would be virtually eliminated if a broker-dealer were required to 
disclose to a customer that an order was executed at a price that was 
inferior to the best-published quote.\174\ In addition, another 
commenter believed that a linkage plan must provide some form of 
protection against trading through exchanges that do not participate in 
an approved linkage plan to instill investor confidence in the options 
markets.\175\
---------------------------------------------------------------------------

    \174\ See Lek Letter.
    \175\ See ISE Letter.
---------------------------------------------------------------------------

    One commenter, however, did not believe that the imposition of a 
disclosure requirement would have a significant impact on the frequency 
of trade-throughs.\176\ In addition, another commenter believed that 
the Commission should modify the provisions it requires for a linkage 
plan to satisfy the exception to the disclosure rule so that the 
recently approved Linkage Plan \177\ qualified as reasonable without 
further amendment.\178\ The commenter believed that the additional 
factors proposed as elements of a plan reasonably designed to limit 
trade-throughs would add significant costs to the Linkage Plan without 
adding significant additional deterrence.\179\ In addition, this 
commenter believed that if all or almost all of the options exchanges 
are expected to join the Linkage Plan, the Commission should delay the 
adoption of the rule, because it would not be cost-effective to require 
firms to re-design their confirmation systems to comply with such a 
rule if the rule then became obsolete because all of the exchanges were 
members of an approved linkage that meets the rule's requirements. 
Another commenter believed that the Commission should not extend trade-
through protection to those markets that are not members of the same 
linkage plan because they would be difficult to access 
effectively.\180\
---------------------------------------------------------------------------

    \176\ See CBOE Letter.
    \177\ See supra notes 4 and 5 and accompanying text.
    \178\ See JPMorgan Letter.
    \179\ See JPMorgan Letter.
    \180\ See CBOE Letter.
---------------------------------------------------------------------------

2. Benefits
    An intermarket trade-through may be costly to an investor primarily 
because the investor receives an execution at a price that is not the 
best price available. An intermarket trade-through also has potential 
costs for the broker-dealer or customer responsible for the best quote 
because that quote or customer order does not receive the execution it 
would have if the order that was executed at the inferior price were 
instead routed to it.\181\ Consequently, intermarket trade-throughs may 
increase the incidence of unexecuted customer limit orders not being 
executed in a timely manner.
---------------------------------------------------------------------------

    \181\ It is possible that an order may not be routed to the 
market publishing the best quote, if the original market matches the 
better quote. However, the Commission believes that the Trade-
Through Disclosure Rule may ensure that the customer submitting the 
order will at least receive an execution at the better published 
price.

---------------------------------------------------------------------------

[[Page 75455]]

    To attempt to gauge the incidence of intermarket trade-throughs, 
the staff looked at trading involving the 50 most active, multiple-
listed options classes, in which there is a great deal of investor 
interest. The staff's review of these trades showed that approximately 
5% of all trades (or 7,964 trades for a total of 156,403 contracts) in 
the 50 most active multiple-listed option classes took place at prices 
inferior to the best price quoted on a competing exchange during the 
week of June 26, 2000.\182\ To better evaluate the execution quality of 
small customer orders, the staff also examined automatic execution 
trades in the 50 most active multiple-listed options classes. The staff 
also found that approximately 1% of all automatic execution trades (or 
464 automatic execution trades for a total of 2,336 contracts) in the 
50 most active multiple-listed option classes took place at prices 
inferior to the best price quoted on a competing exchange during the 
week of June 26, 2000.\183\
---------------------------------------------------------------------------

    \182\ The staff relied on data from OPRA for this analysis. All 
trades marked as spreads, straddles, late, or stopped were excluded 
from the sample. To determine the quote in effect at the time of the 
trade, the highest offer and lowest bid on each competing exchange 
for a period of one minute prior and two minutes after the reported 
execution were identified. Quotes from an exchange that indicated it 
was experiencing fast market conditions during the time when the 
trade was executed were not included. Quotes that indicated that an 
option class was in rotation were also excluded. The staff 
recognizes that not all these trades in the sample could be fully 
executed at the best available quoted price because of size or other 
factors.
    \183\ Trades executed through automatic execution systems 
account for about 36% of all trades and about 12% of all contracts 
traded in the 50 most active multiple-traded options classes during 
the week of June 26, 2000. The procedure used for the analysis of 
automatic execution trades is similar to that described for all 
trades, except only trades executed through the exchanges' automatic 
execution systems are included.
---------------------------------------------------------------------------

    Investors would benefit from the Trade-Through Disclosure Rule 
because they would be informed when their orders are executed at a 
price inferior to the best available price. With that information, 
investors would have the opportunity to reduce the likelihood that 
their orders would be executed at a price inferior to a price displayed 
by another market by selecting broker-dealers that effect their 
transactions on markets that are participants in an approved linkage 
plan with provisions reasonably designed to limit trade-throughs. Even 
if only one-half of all orders executed through automatic execution 
systems were executed at the best-published quote (i.e., trade-throughs 
of automatic execution trades were eliminated), the estimated annual 
savings to investors trading through exchanges' automatic execution 
systems would be approximately $5,500,000 each year.\184\ If all trades 
were considered, the elimination of trade-throughs would result in 
substantially higher annual savings to investors.\185\
---------------------------------------------------------------------------

    \184\ The annual benefit estimate is obtained by applying the 
staff's trade-through findings for automatic execution trades in the 
50 most active multiple-traded options classes to all multiple-
listed classes and extending the results from one week to a full 
year. In the options market, market makers are almost always on the 
other side of the transaction and therefore, investors benefit from 
avoiding trade-throughs. If investors were on both sides of the 
transactions, any savings for avoiding trade-throughs would be 
offset by losses to investors on the opposite side of the 
transactions.
    \185\ The staff estimates the benefits of executing a maximum of 
20 contracts at the best-quoted price for those trades identified as 
trade-throughs could total several hundred million dollars per year.
---------------------------------------------------------------------------

3. Costs
    The Trade-Through Disclosure Rule may require broker-dealers and 
markets to incur capital costs, such as one-time costs to modify 
existing systems. For example, the new rule could impose one-time costs 
on markets and broker-dealers that must modify systems to determine 
when trade-throughs have occurred and to issue notifications to 
customers of trade-throughs. Further, to identify when an order trades 
through a posted quote, information systems would need to be developed 
that could identify the displayed quotes at the time of execution. 
Because the Commission would allow broker-dealers to rely on 
notifications from the markets when trade-throughs occur and the better 
available quote at that time, the costs of such information systems may 
be borne by the options markets.
    In addition, implementing the rule could require broker-dealers to 
provide customer notifications at or before the completion of the 
transaction. A broker-dealer may provide this disclosure to its 
customers in conjunction with the confirmation statements routinely 
sent to customers and could be issued in either electronic or paper 
form.\186\ An alternative to changing confirmation statements would be 
for broker-dealers to route orders to exchanges participating in an 
approved linkage plan.\187\ Although the new rule does not require the 
implementation of such a plan, it does envision that an approved plan 
could be implemented. Thus, one possible cost to the options markets of 
the Trade-Through Disclosure Rule could be the capital investment to 
establish a linkage. In addition to the capital costs of establishing 
the linkage, costs could include regulatory costs, such as obtaining 
Commission approval of a linkage and of SRO rule changes necessary to 
implement a linkage. Further, there may be economic implications if a 
market chooses to participate in an approved linkage plan, because 
members may then be more likely to use the linkage to route orders to 
other exchanges that are quoting a better price. The Commission 
estimates that capital costs for a linkage plan range from $1,000,000 
to $1,500,000 initially, and yearly costs could range from $300,000 to 
$1,000,000.\188\
---------------------------------------------------------------------------

    \186\ See Securities Exchange Act Release No. 37182 (May 9, 
1996), 61 FR 24644 (May 15, 1996).
    \187\ The Commission notes that Trade-Through Disclosure Rule 
creates strong incentives for the options exchanges to participate 
in an approved intermarket linkage plan to attract order flow from 
broker-dealers wishing to avoid the disclosure requirement.
    \188\ The Commission published these numbers in the Proposing 
Release and specifically solicited comment on the costs of 
developing a linkage between the markets, as well as the costs for 
individual markets to integrate their systems into such a plan. The 
Commission did not receive any comments on the above data.
---------------------------------------------------------------------------

    The Commission recognizes that broker-dealers may incur certain 
capital costs to implement the Trade-Through Disclosure Rule. While the 
Commission recognizes that these costs cannot be avoided, the 
Commission believes that most of these costs will be one-time costs for 
broker-dealers with continuing savings to investors through the 
elimination of trade-throughs. Also, as members of the options 
exchanges, broker-dealers may have input into a decision by an exchange 
to participate in an options linkage plan and therefore, influence 
decisions that will impact their costs, including potential exchange 
fees.
    The Commission is also sympathetic to the comment that the rule may 
become obsolete if all the options exchanges participate in an approved 
intermarket linkage plan.\189\ The Commission is not mandating 
participation in a particular intermarket linkage plan to allow the 
options exchanges to retain greater flexibility. Because participation 
in an options linkage plan is voluntary and because, under the current 
terms of the Linkage Plan, any participant may withdraw from the plan 
at any time with 30 days prior written notice to each of the other plan 
participants and the facilities manager, if any,\190\ the Commission 
continues to believe that the Trade-Through Disclosure Rule is needed 
to ensure that, if the exchange on which their orders are executed do 
not belong to an approved linkage plan with provisions designed to 
limit trade-throughs, investors at least receive

[[Page 75456]]

disclosure if their orders are not executed at the best price.
---------------------------------------------------------------------------

    \189\ See JPMorgan Letter.
    \190\ See Linkage Plan, Section 12.
---------------------------------------------------------------------------

    The Commission recognizes that by providing an incentive for 
markets to cooperate in developing effective means to access other 
markets, trade-throughs will be minimized. However, to the extent that: 
(1) One or more options exchanges decide not to participate in a 
linkage plan; (2) trade-throughs are not minimized by the 
implementation of an intermarket linkage plan because the plan fails to 
provide protection across all markets, including markets that do not 
participate in a linkage plan; (3) away markets fail to complain about 
trade-throughs; or (4) broker-dealers are not subject to potential 
sanctions for trade-throughs, the value of the Trade-Through Disclosure 
Rule would be greatly diminished. Therefore, the Commission believes 
that despite the existing exchanges' participation in the Linkage Plan, 
the Trade-Through Disclosure Rule adopted by the Commission is also 
needed for the protection of investors. The Commission believes that 
the rule can only be effective if trade-throughs of any market are 
disclosed to investors, or effectively limited by an approved linkage 
plan.

B. Costs and Benefits of Amendments to the Quote Rule

    The Commission is adopting amendments to the Quote Rule to extend 
its application to options traded on national securities exchanges. 
Generally, the Quote Rule requires exchanges to collect quotations and 
sizes from its responsible broker-dealers and make those quotations and 
sizes available to quotation vendors for each subject security listed 
and admitted to unlisted trading privileges on the exchange.
    The Commission is adopting amendments to the Quote Rule to 
accommodate the unique structure of the options market to permit 
options exchanges to decide whether or not to collect from their 
members and make available to vendors the size associated with each 
quotation in listed options. Instead, exchanges may choose to establish 
by rule and periodically publish the size for which its best bid or 
offer in each options series that is listed on the exchange is firm. If 
the rules of the exchange do not require its members to communicate 
quotation sizes for listed options, responsible broker-dealers that are 
members of that exchange will be relieved of their obligations under 
the Quote Rule to communicate to that exchange their quotation sizes. 
Instead, each responsible broker-dealer may satisfy its firm quote 
obligation by executing any order to buy or sell a listed option that 
is a subject security, in an amount up to the size established by the 
exchange's rules.\191\ An exchange may establish in its rules different 
firm quote sizes for broker-dealer orders than for customer 
orders.\192\
---------------------------------------------------------------------------

    \191\ Exchange Act Rule 11Ac1-1(d)(2), 17 CFR 240.11Ac1-1(d)(2).
    \192\ Exchange Act Rule 11Ac1-1(d)(1), 17 CFR 240.11Ac1-1(d)(1). 
Exchange rules must require responsible broker-dealers to be firm 
for orders for the account of broker-dealers for at least one 
contract.
---------------------------------------------------------------------------

    If, on the other hand, an options exchange chooses to establish 
procedures for collecting from its members, and making available to 
vendors, the sizes of its members' quotes, the exchange may permit its 
members' quotes to be firm for different sizes for customer orders than 
for broker-dealer orders.\193\ In addition, an exchange will have the 
flexibility to collect and disseminate quote sizes for customer orders 
and establish by rule quote sizes for broker-dealer orders.
---------------------------------------------------------------------------

    \193\ Exchange Act Rule 11Ac1-1(d)(1)(iii), 17 CFR 240.11Ac1-
1(d)(1)(iii).
---------------------------------------------------------------------------

    As discussed above, under the Trade-Through Disclosure Rule, if a 
responsible broker-dealer fails to respond to an incoming order within 
the 30 seconds, the routing broker-dealer may execute its customer's 
order at its own inferior quote and would not be required to disclose 
the trade-through to its customer because the quote traded through was 
unavailable. The Commission also is adopting an amendment to the Quote 
Rule to require a responsible broker-dealer to respond to an order to 
buy or sell a listed option in an amount greater than its firm quote 
size within 30 seconds by either: (1) executing the entire order; or 
(2) executing at least that portion of the order equal to the 
applicable firm quote size and revising its bid or offer.\194\ The 
Quote Rule requires responsible brokers and dealers to immediately 
execute an order to buy or sell listed options in an amount equal to or 
less than its firm quote size.\195\
---------------------------------------------------------------------------

    \194\ Exchange Act Rule 11Ac1-1(d)(3)(i), 17 CFR 240.11Ac1-
1(d)(3)(i). A responsible broker's or dealer's applicable firm quote 
size would be its published quote size or, if a responsible broker 
or dealer has been relieved of the obligation to communicate its 
quotation sizes, the minimum firm quote size established by its 
exchange's rules.
    \195\ Exchange Act Rule 11Ac1-1(c)(2), 17 CFR 240.11Ac1-1(c)(2).
---------------------------------------------------------------------------

1. Comments
    One commenter stated that the lack of a Quote Rule in the options 
markets has impeded firms' ability to execute customer orders in an 
efficient manner while they explore posted quotes to see whether they 
are firm for the entire order or only for an order of minimal 
size.\196\ Another commenter suggested that a true linkage cannot occur 
so long as market makers are permitted to refuse to honor displayed 
quotes.\197\ Two commenters also believe that the Quote Rule will 
promote efficiency and increase customer confidence in our 
markets.\198\ In addition, another commenter argued that the 
supposition that market makers would widen their spreads if their 
quotes were exposed to other market professionals is unjustified and 
unsupported by empirical data, and in any case, the public is more 
harmed by non-competitive un-real quotes than by wider spreads.\199\
---------------------------------------------------------------------------

    \196\ See JPMorgan Letter.
    \197\ See Lek Letter.
    \198\ See Lek Letter and PCX Letter.
    \199\ See Lek Letter.
---------------------------------------------------------------------------

    Alternatively, one commenter stated that extending the Quote Rule 
to options will not significantly improve the current situation because 
the options markets are already subject to exchange-created firm quote 
rules, and despite such rules, public investors have often found that 
quotations in these markets are not firm, and neither are many of their 
transactions.\200\ In addition, one commenter suggested that current 
competition among market makers for public customer orders is intense, 
but the proposed amendments will force the allocation of capital into 
areas of unacceptable risk, such as trading against other broker-
dealers, and away from the facilitation of public customer orders.\201\ 
Two commenters believed that to compensate for the increased exposure 
to broker-dealers the amendments will cause market makers to be less 
aggressive, widen spreads, limit quote size, and reduce overall 
liquidity to public customers, despite the fact that the proposal is 
suppose to draw more liquidity into the market by requiring market 
makers to be firm to broker-dealers.\202\
---------------------------------------------------------------------------

    \200\ See Brunelle Letter. This commenter noted that subsequent 
to execution, specialists or market makers frequently change the 
terms of the transaction or ``break'' the trade.
    \201\ See Susquehanna Letter.
    \202\ See Susquehanna Letter and Botta Letter.
---------------------------------------------------------------------------

    One commenter also believed there is no need for an exception to 
the Quote Rule for exchanges whose aggregate trading volume in a listed 
option is less than or equal to one percent of the total trading volume 
reported by OPRA.\203\ This commenter argues that the possibility of a 
chilling effect on the liquidity of inactively traded securities does 
not justify the monitoring burden that the exception would impose on 
brokers, who would be forced to keep

[[Page 75457]]

track of which quotes were firm and which, because of the one percent 
exception, were not.
---------------------------------------------------------------------------

    \203\ See JPMorgan Letter.
---------------------------------------------------------------------------

2. Benefits
    Amending the Quote Rule would reduce discrepancies between the 
treatment of quotes in the options markets and the equity markets.\204\ 
Although options trading is not currently covered by the Commission's 
Quote Rule, each exchange's rules require their members' quotes to be 
firm up to a certain minimum size and establish the process for 
handling orders in excess of the exchange's firm quote size. Exchange 
rules also establish whether members' quotes must be firm for all 
orders or only some orders, such as only for public customer orders.
---------------------------------------------------------------------------

    \204\ The equities markets have been subject to a firm quote 
requirement since 1978. See Securities Exchange Act Release No. 
14415, supra note and accompanying text.
---------------------------------------------------------------------------

    The Commission believes that applying the Quote Rule to the options 
market would provide a number of benefits. Firm quotes reduce 
uncertainty surrounding order routing decisions for broker-dealers that 
are seeking to fill customer orders at the best available price. If 
broker-dealers are confident that quotes are firm, investor orders may 
be routed to the market with the best price and receive an execution at 
that price. Under current practices, because broker-dealers cannot be 
confident that a price on another market is firm (due to existing 
market rules, including trade-or-fade rules), orders do not always 
receive the best available price. As discussed above, the staff 
estimates that five percent of all trades in the 50 most active 
multiply-listed classes took place at prices inferior to the best price 
quoted on a competing market during a one-week period in June 2000. 
Broker-dealers often state that such trade-throughs occur when market 
makers believe the better price on the other market may not be firm and 
the quote may ``fade'' if the broker-dealer were to attempt to execute 
against it. By requiring that posted prices be firm up to a published 
size, a great deal of uncertainty about order execution quality could 
be reduced. This would be true even if the quote were permitted to be 
firm for different sizes for customer orders than for broker-dealer 
orders.
    In addition to providing certainty to broker-dealers making order 
routing decisions and seeking to fill orders at the best available 
price, extending the Quote Rule to the options markets may benefit 
broker-dealers by enhancing their ability to satisfy their regulatory 
obligations, including best execution. The Commission believes that the 
Quote Rule may help broker-dealers to satisfy their best execution 
obligations by providing firm quote information and reducing concerns 
about ``fading'' quotes. In addition, the Commission believes that 
enhancing the ability of broker-dealers to satisfy their best execution 
obligations may reduce the liability exposure faced by broker-dealers 
as to their best execution obligations.
    The Commission also believes that the proposed amendments to the 
Quote Rule would bolster investor confidence in the options markets by 
ensuring that quotes made by market makers or specialists are available 
for a specified number of options contracts, thus providing greater 
certainty for investors. The Commission believes that as a result of 
increased investor confidence, more investors may trade options and 
thereby, increase volume and reduce spreads on the options exchanges. 
In addition, by requiring the quotations in listed options to be firm, 
the amendments may also lead to better-informed investors, which should 
increase investor confidence in the market.
    Another benefit of applying the Quote Rule to options trading is 
that it would likely increase competition between markets. Because all 
quotes would be firm, a market participant would know that a posted 
quote would be recognized as firm. Therefore, the posted quote may 
attract order flow. The ability to attract order flow with a market-
improving quote encourages intermarket price competition, which 
benefits investors. In addition, the Commission believes that its 
proposal would result in (1) fewer unexecuted investor orders due to 
quote changes after order arrival, or (2) fewer orders executed at 
prices less favorable to the investor than those prevailing at the time 
of order arrival.
3. Costs
    Applying the Quote Rule to the options market would require 
exchanges to collect bids and offers from their members. This would not 
impose a significant burden on the exchanges because bids and offers 
generally are collected already by the markets and sent to (and 
disseminated through) OPRA. Currently, each of the options markets has 
rules that establish the maximum size of orders that its automatic 
execution system will execute. The exchanges would, however, be 
required to publish the size (or sizes, if different categories are 
used) for which their quotes must generally be firm. There are likely 
to be expenses incurred by the markets related to collecting and making 
available to quotation venders or periodically publishing their firm 
quote sizes.
    Amendment of the Quote Rule to include options may require markets 
to incur one-time costs. For example, options markets may need to 
enhance surveillance and enforcement mechanisms to ensure that its 
members are complying with the Quote Rule. Further, options market 
makers and specialists may need to reevaluate and change their quotes 
in light of the obligation to be firm that would be imposed by the 
amendment to the Quote Rule.\205\
---------------------------------------------------------------------------

    \205\ In the Proposing Release, the Commission stated that it 
was unable to quantify these costs and further solicited comments on 
these costs. See Proposing Release, supra note 7. No commenters 
explicitly addressed this issue.
---------------------------------------------------------------------------

    The Commission recognizes that these costs cannot be avoided, 
although the impact of the costs may be minimized to the extent that a 
market already has surveillance and enforcement procedures in place to 
monitor its members for compliance with the existing rules of the 
Commission and the exchange. However, the Commission believes that the 
current situation, wherein the options markets are permitted to fade 
from their quotes without consequence, pursuant to their trade-or-fade 
rules,\206\ is no longer acceptable. Currently, options investors 
cannot fully rely on the disseminated quotation information on which 
they base their order routing decisions. The Commission believes that 
options investors deserve the same protections as equity investors and 
therefore, the Commission is adopting amendments to extend the coverage 
of the Quote Rule to the options market.
---------------------------------------------------------------------------

    \206\ See supra note 33.
---------------------------------------------------------------------------

    In addition, with respect to the concern raised by two commenters 
regarding the increased financial exposure of broker-dealers under the 
Quote Rule, the Commission notes that under the rule being adopted 
today, the options exchanges may establish different quote sizes for 
broker-dealers' orders than for customer orders. The Commission also 
believes that the options markets and options market makers should be 
permitted to make use of the one percent exception. The Commission is 
not persuaded that this exception, applied for years in the equity 
markets, will impose significant compliance burdens on market 
participants.

C. Conclusion

    With the current expansion of multiple trading in options, the 
Commission is increasingly concerned

[[Page 75458]]

about customer orders, which are sent to one exchange, and executed at 
prices that are inferior to quotes published by another market. The 
Commission, therefore, believes that adoption of the Trade-Through 
Disclosure Rule and amendments to the Quote Rule are necessary at this 
time to encourage the removal of barriers to access to, and the use of 
efficient vehicles to reach, better prices on other markets. The 
Commission recognizes that there may be some costs associated with the 
implementation of these rules, however, the Commission believes that 
the likely benefits justify the possible costs.

VII. Effects on Competition, Efficiency, and Capital Formation

    Section 3(f) of the Exchange Act \207\ 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. In the Proposing Release, the Commission 
requested comment on these issues.\208\
---------------------------------------------------------------------------

    \207\ 15 U.S.C. 78c(f).
    \208\ See Proposing Release, supra note 7.
---------------------------------------------------------------------------

    With regards to the amendments to the Quote Rule, several 
commenters supported the Commission's proposals because they believed 
that the amendments would promote efficiency and enhance public 
confidence in the options markets.\209\ Another commenter that argued 
that the current lack of a Quote Rule in the options markets impeded 
firms' ability to execute customer orders in an efficient manner 
because firms are forced to explore quotes to determine the size for 
which the quotes represent.\210\
---------------------------------------------------------------------------

    \209\ See Lek Letter; PCX Letter; and CBOE Letter.
    \210\ See JPMorgan Letter.
---------------------------------------------------------------------------

    The Commission believes that the amendments to the Quote Rule are 
necessary and appropriate in the public interest. The amendments to the 
Quote Rule should bolster investor confidence in the options markets by 
ensuring that quotes made by market participants are available for a 
specified number of contracts, thus providing greater certainty for 
investors. Similarly, the increased investor confidence should promote 
market efficiency and capital formation.
    The amendments to the Quote Rule should also assist broker-dealers 
in making their best execution determinations. Further, the amendment 
to the Quote Rule will help to ensure that important information 
relating to the size associated with disseminated quotes is available 
to all market participants. This should promote market efficiency, 
competition, and capital formation.
    With regards to the Trade-Through Disclosure Rule, the Commission 
believes that it will bolster confidence in the options markets by 
better informing investors about the quality of their executions and 
the implications of their broker-dealers' execution decisions. This 
increased investor confidence should promote market efficiency and 
capital formation. The Trade-Through Disclosure Rule also should help 
to minimize the number of customer orders that do not receive an 
execution at the best available quote.
    The Commission also believes that the Trade-Through Disclosure Rule 
will assist broker-dealers in evaluating and complying with their best 
execution obligations. Moreover, the Trade-Through Disclosure Rule will 
provide an incentive to develop effective means of access between the 
markets to avoid trade-throughs. One commenter agreed, stating that the 
Trade-Through Disclosure Rule should assure that the options markets 
participate in either the Linkage Plan or that they will develop 
alternative plans that will effectively address and limit trade-
throughs.\211\ The Commission believes that this will result in the 
more efficient execution of orders in the options markets.
---------------------------------------------------------------------------

    \211\ See PCX Letter. See also ISE Letter.
---------------------------------------------------------------------------

    Section 23(a)(2) of the Exchange Act \212\ requires that the 
Commission, when promulgating rules under the Exchange Act, to consider 
the impact any rule would have on competition and not to adopt any rule 
that would impose a burden on competition that is not necessary or 
appropriate in the public interest. In the Proposing Release, the 
Commission noted that because both the proposed amendments to the Quote 
Rule and the proposed Trade-Through Disclosure Rule would apply equally 
to all relevant market participants, the Commission believed the 
proposals would not have any anti-competitive impact.\213\ The 
Commission, however, requested comment on any anti-competitive effects 
of the proposals. The Commission did not receive any comments regarding 
the competitive impact of the Trade-Through Disclosure Rule. Thus, the 
Commission continues to believe that the Trade-Through Disclosure Rule 
adopted today will not have an anti-competitive impact on the options 
markets because the rules apply equally to each options market and 
other relevant options market participants.
---------------------------------------------------------------------------

    \212\ 15 U.S.C. 78w(a)(2).
    \213\ See Proposing Release, supra note 7.
---------------------------------------------------------------------------

    The Commission did, however, receive comments on the potential 
competitive impact of the amendments to the Quote Rule. Several 
commenters that addressed the potential competitive impact of a 
Commission-mandated firm quote size believed that the Commission should 
not mandate a firm quote size because they argued that competitive 
market forces should dictate an appropriate firm quote size 
minimum.\214\ Another commenter, however, argued that the Commission 
should mandate that the exchanges be firm for one contract for non-
customer orders, which would permit the exchanges to compete by 
providing greater than the one contract minimum to attract non-customer 
order flow.\215\
---------------------------------------------------------------------------

    \214\ See Botta Letter; CBOE Letter; PCX Letter; and Susquehanna 
Letter.
    \215\ See ISE Letter.
---------------------------------------------------------------------------

    While agreeing that the Commission should not dictate a firm quote 
size minimum, two commenters disagreed on whether the options exchanges 
or options market makers should be permitted to establish firm quote 
minimums.\216\ For example, one commenter noted that the options 
exchanges compete for order flow by establishing firm quote 
guarantees.\217\ Another commenter, however, argued that it is the 
options market makers that compete for order flow by establishing quote 
sizes for which they are willing to guarantee and that requiring the 
exchanges to set minimum quote sizes would eliminate this 
competition.\218\
---------------------------------------------------------------------------

    \216\ See CBOE Letter and Botta Letter.
    \217\ See CBOE Letter.
    \218\ See Botta Letter.
---------------------------------------------------------------------------

    As discussed above, the Commission agrees that the minimum firm 
quote size for each exchange should be determined independently by each 
exchange as a competitive issue and should not be dictated by 
government regulation. Further, the Commission also agrees that each 
disseminated quote must be firm for at least one contract. The 
Commission believes that this approach will encourage competition among 
the exchanges, which should benefit all investors.
    The amendments to the Quote Rule adopted by the Commission today 
permit the options exchanges to establish by rule and periodically 
publish the sizes for which quotes will be firm for listed options. 
While one commenter argued that options market makers should be able to 
compete on this basis, the Commission believes, at this time, that it 
is appropriate to permit the exchanges to determine firm quote

[[Page 75459]]

sizes. Currently, the options exchanges, other than the ISE, do not 
accept quotes from each competing market maker on their floors. 
Further, OPRA does not, at this time, have the capability to accept and 
disseminate to vendors quotes with size, although it plans to have such 
capability early next year. Thus, the Commission believes that, at this 
time, it is appropriate for the exchanges to establish by rule and 
periodically publish the size associated with quotes in listed options. 
The Commission will continue to consider this issue as technology 
advances because the Commission believes that permitting individual 
market makers to compete on the basis of size on each exchange floor as 
well as among competing exchanges could further enhance the 
competitiveness of the options markets.
    Finally, the Commission received two comments on the potential 
competitive impact of the two alternative proposals regarding 
establishing firm quote sizes for broker-dealer orders and customer 
orders. As discussed above, proposed Alternative A would have required 
that firm quote size minimums be the same for all orders, while 
proposed Alternative B would have permitted the options exchanges to 
establish different firm quote size minimums for broker-dealer and 
customer orders. One commenter, while supporting proposed Alternative 
A, suggested that it believed that distinctions between broker-dealer 
and customer orders would ultimately be eliminated through competitive 
measures of the exchanges.\219\ Another commenter, who supported 
Alternative A, argued that broker-dealers play an important role in 
keeping prices fair and should be permitted to participate in the 
competitive pricing process.\220\
---------------------------------------------------------------------------

    \219\ See PCX Letter.
    \220\ See Lek Letter.
---------------------------------------------------------------------------

    As noted above, the amendments to the Quote Rule adopted today 
permit the exchanges to establish different firm quote sizes for 
broker-dealer orders than for customer orders. Due to the tremendous 
number of options products that must be continuously quoted by options 
market makers and specialists, the Commission believes that this 
distinction is appropriate at this time. The Commission will continue 
to consider whether this distinction is appropriate. The Commission 
notes, however, that the amendments to the Quote Rule do not mandate 
that the exchanges establish different quote sizes for broker-dealer 
orders and customer orders, it only permits the distinction. Thus, the 
options exchanges are free to establish their individual firm quotes 
sizes for broker-dealer and customer orders as they deem 
appropriate.\221\ The Commission thinks that it is likely that the 
options exchanges will compete on this basis.
---------------------------------------------------------------------------

    \221\ Of course, Exchange Act Rule 11Ac1-1(d)(1) requires that 
exchange rules must require responsible broker-dealers to be firm 
for orders for the accounts of broker-dealers for at least one 
contract. 17 CFR 240.11Ac1-1(d)(1).
---------------------------------------------------------------------------

VIII. Final Regulatory Flexibility Analysis

    This Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with the Regulatory Flexibility Act.\222\ It 
relates to the adoption of the Trade-Through Disclosure Rule and 
amendments to the Quote Rule. An Initial Regulatory Flexibility 
Analysis (``IRFA'') was prepared in accordance with 5 U.S.C. 603 and 
was made available to the public.\223\ The Commission is adopting the 
Trade-Through Disclosure Rule and the amendments to the Quote Rule 
substantially as proposed.
---------------------------------------------------------------------------

    \222\ 5 U.S.C. 604.
    \223\ See Proposing Release supra note 7.
---------------------------------------------------------------------------

    The Trade-Through Disclosure Rule, Exchange Act Rule 11Ac1-7,\224\ 
will require a broker-dealer to disclose to its customer when the 
customer's order is executed at a price inferior to a price published 
by another market. However, a broker-dealer will not be required to 
provide such disclosure to its customer if it effects the customer's 
transaction on a market that participates in an approved linkage plan 
that includes provisions reasonably designed to limit customers' orders 
from being executed at prices that trade through a better published 
price, even if the better price is on a market that is not part of the 
linkage plan.
---------------------------------------------------------------------------

    \224\ See Exchange Act Rule 11Ac1-7, 17 CFR 240.11Ac1-7.
---------------------------------------------------------------------------

    The Quote Rule, Exchange Act Rule 11Ac1-1,\225\ currently requires 
exchanges to establish procedures for collecting from their members 
bids, offers, and quotation sizes for certain equity securities 
available to quotation venders. It also requires that the quotation 
information made available to vendors be firm, subject to certain 
exceptions. The amendments to the Quote Rule adopted by the Commission 
today apply the Quote Rule to options traded on a national securities 
exchange or an automated facility of a national securities association.
---------------------------------------------------------------------------

    \225\ See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------

A. Need for, and Objectives of, the Rules

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

[[Page 75460]]

in the options markets by ensuring that quotes made by market 
participants are available for a specified number of options contracts, 
thus providing greater certainty for investors. The amendments to the 
Quote Rule also will assist broker-dealers in making their best 
execution determinations. Further, the amendments will provide 
information to the market as a whole as to the various factors 
affecting the market, including the current levels of buying and 
selling interest.

B. Significant Issues Raised by Public Comment

    As required by the Regulatory Flexibility Act, this section (i) 
summarizes the significant issues raised by public comments in response 
to the IRFA, (ii) summarizes the Commission's assessment of such 
issues, and (iii) states any changes made in the proposed rules as a 
result of such comments.\226\
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    \226\ See 5 U.S.C. 604(a)(2).
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    No comments were received in response to the IRFA.

C. Small Entities Subject to the Rules

    Commission rules generally define a broker-dealer as a small entity 
for purposes of the Exchange Act and the Regulatory Flexibility Act if 
the broker-dealer had a total capital (net worth plus subordinated 
liabilities) of less than $500,000 on the date in the prior fiscal year 
as of which its audited financial statements were prepared, and it is 
not affiliated with any person (other than a natural person) that is 
not a small entity.\227\ The Commission estimates that as of December 
31, 1999, approximately 41 Commission-registered broker-dealers were 
small entities that would be subject to the Trade-Through Disclosure 
Rule.\228\ However, the Commission estimates that none of the 41 
registered broker-dealers that would be considered small entities for 
purposes of the statute regularly represent options orders on behalf of 
their customers. In addition, the Commission notes that only those 
broker-dealers that are also options specialists or market makers will 
be required to comply with the amendments to the Quote Rule. As of 
December 31, 1999, our data indicates that only one broker-dealer that 
was a small entity was an options specialist or market maker.
---------------------------------------------------------------------------

    \227\ 17 CFR 240.0-10(c).
    \228\ The Commission's estimate of 41 small entities includes 
all of the registered broker-dealers that do not have relationships 
with clearing firms.
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    The amendments to the Quote Rule also will directly affect the 
national securities exchanges that trade listed options, none of which 
is a small entity as defined by Commission rules. Paragraph (e) of 
Exchange Act Rule 0-10 \229\ states that the term ``small business,'' 
when referring to an exchange, means any exchange that has been 
exempted from the reporting requirements of Exchange Act Rule 11Aa3-
1.\230\ The amendments to the Quote Rule also will directly affect 
national securities associations. There is one national securities 
association, which is not a small entity, as defined by 13 CFR 121.201.
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    \229\ 17 CFR 240.0-10(e).
    \230\ Exchange Act Rule 11Aa3-1, 17 CFR 240.11Aa3-1.
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D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

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

E. Agency Action To Minimize Effect on Small Entities

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

[[Page 75461]]

``small entities'' because they are all national securities exchanges 
or national securities associations that do not meet the definition of 
small entity. Therefore, the Commission does not believe the 
alternatives to the rules are applicable to the markets.

IX. Statutory Authority

    The Commission is adopting the Trade-Through Disclosure Rule and 
amendments to the Quote Rule pursuant to its authority under Exchange 
Act Sections 3(b), 5, 6, 15, 11A, 17 (a) and (b), 19, and 23(a).

List of Subjects in 17 CFR Part 240

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

Text of the Final Rules

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

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

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

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 
80b-11, unless otherwise noted.
* * * * *

    2. Section 240.11Ac1-1 is amended by revising paragraphs (a)(5), 
(a)(20) and (d); in the second sentence of paragraph (b)(3)(i) by 
revising the phrase ``under paragraph (c)(2)'' to read ``under 
paragraphs (c)(2) and (d)(3)'', and adding paragraphs (a)(26), (a)(27), 
(a)(28), (a)(29), and (a)(30), and (e) to read as follows:


Sec. 240.11Ac1-1  Dissemination of quotations.

    (a) Definitions. * * *
    (5) The term consolidated system means the consolidated transaction 
reporting system, including a transaction reporting system operating 
pursuant to an effective national market system plan.
* * * * *
    (20) The term reported security means any security or class of 
securities for which transaction reports are collected, processed and 
made available pursuant to an effective transaction reporting plan, or 
an effective national market system plan for reporting transactions in 
listed options.
* * * * *
    (26) The term customer means any person that is not a registered 
broker-dealer.
    (27) The term listed option means any option traded on a registered 
national securities exchange or automated facility of a national 
securities association.
    (28) The term options class means all of the put option or call 
option series overlying a security, as defined in Section 3(a)(10) of 
the Act (15 U.S.C. 78c(a)(10)).
    (29) The term options series means the contracts in an options 
class that have the same unit of trade, expiration date, and exercise 
price, and other terms or conditions.
    (30) The term trading rotation means, with respect to an options 
class, the time period on an exchange during which:
    (i) Opening, re-opening, or closing transactions in options series 
in such options class are not yet completed; and
    (ii) Continuous trading has not yet commenced or has not yet ended 
for the day in options series in such options class.
* * * * *
    (d) Transactions in listed options.
    (1) An exchange or association:
    (i) Shall not be required, under paragraph (b) of this section, to 
collect from responsible brokers or dealers who are members of such 
exchange or association, or to make available to quotation vendors, the 
quotation sizes and aggregate quotation sizes for listed options, if 
such exchange or association establishes by rule and periodically 
publishes the quotation size for which such responsible brokers or 
dealers are obligated to execute an order to buy or sell an options 
series that is a subject security at its published bid or offer under 
paragraph (c)(2) of this section;
    (ii) May establish by rule and periodically publish a quotation 
size, which shall not be for less than one contract, for which 
responsible brokers or dealers who are members of such exchange or 
association are obligated under paragraph (c)(2) of this section to 
execute an order to buy or sell a listed option for the account of a 
broker or dealer that is in an amount different from the quotation size 
for which it is obligated to execute an order for the account of a 
customer; and
    (iii) May establish and maintain procedures and mechanisms for 
collecting from responsible brokers and dealers who are members of such 
exchange or association, and making available to quotation vendors, the 
quotation sizes and aggregate quotation sizes in listed options for 
which such responsible broker or dealer will be obligated under 
paragraph (c)(2) of this section to execute an order from a customer to 
buy or sell a listed option and establish by rule and periodically 
publish the size, which shall not be less than one contract, for which 
such responsible brokers or dealers are obligated to execute an order 
for the account of a broker or dealer.
    (2) If, pursuant to paragraph (d)(1) of this section, the rules of 
an exchange or association do not require its members to communicate to 
it their quotation sizes for listed options, a responsible broker or 
dealer that is a member of such exchange or association shall:
    (i) Be relieved of its obligations under paragraph (c)(1) of this 
section to communicate to such exchange or association its quotation 
sizes for any listed option; and
    (ii) Comply with its obligations under paragraph (c)(2) of this 
section by executing any order to buy or sell a listed option, in an 
amount up to the size established by such exchange's or association's 
rules under paragraph (d)(1) of this section.
    (3) Thirty second response. Each responsible broker or dealer, 
within thirty seconds of receiving an order to buy or sell a listed 
option in an amount greater than the quotation size established by an 
exchange's or association's rules pursuant to paragraph (d)(1) of this 
section, or its published quotation size must:
    (i) Execute the entire order; or
    (ii)(A) Execute that portion of the order equal to at least:
    (1) The quotation size established by an exchange's or 
association's rules, pursuant to paragraph (d)(1) of this section, to 
the extent that such exchange or association does not collect and make 
available to quotation vendors quotation size and aggregate quotation 
size under paragraph (b) of this section; or
    (2) Its published quotation size; and
    (B) Revise its bid or offer.
    (4) Notwithstanding paragraph (d)(3) of this section, no 
responsible broker or dealer shall be obligated to execute a 
transaction for any listed option as provided in paragraph (c)(2) of 
this section if:
    (i) Any of the circumstances in paragraph (c)(3) of this section 
exist; or
    (ii) The order for the purchase or sale of a listed option is 
presented during a trading rotation in that listed option.
    (e) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any responsible broker or dealer, electronic communications 
network, exchange, or association if the Commission

[[Page 75462]]

determines that such exemption is consistent with the public interest, 
the protection of investors and the removal of impediments to and 
perfection of the mechanism of a national market system.
    3. Section 240.11Ac1-4 is amended by revising paragraph (a)(10) to 
read as follows:


Sec. 240.11Ac1-4  Display of customer limit orders.

    (a) Definitions. * * *
    (10) The term reported security means any security or class of 
securities for which transaction reports are collected, processed, and 
made available pursuant to an effective transaction reporting plan.
* * * * *

    4. Section 240. 11Ac1-7 is added to read as follows:


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

    (a) Definitions. For purposes of this section:
    (1) The term block trade means a transaction in an option series 
that is for 500 or more contracts and has a premium value of at least 
$150,000.
    (2) The term customer means any person that is not a registered 
broker-dealer.
    (3) The term effective national market system plan shall have the 
meaning provided in Sec. 240.11Aa3-2.
    (4) The term listed option means any option traded on a registered 
national securities exchange or automated facility of a national 
securities association.
    (5) The term options class means all of the put option or call 
option series overlying a security, as defined in Section 3(a)(10) of 
the Act (15 U.S.C. 78c(a)(10)).
    (6) The term options series means the contracts in an options class 
that have the same unit of trade, expiration date, and exercise price, 
and other terms or conditions.
    (7) The term receipt means, with respect to an order sent to an 
away market displaying a superior price, the time at which the order is 
either represented in the trading crowd or received by the specialist.
    (b) Broker-dealer disclosure requirements. (1) Any broker or dealer 
that effects a transaction in a listed option for the account of its 
customer must disclose in writing to such customer, at or before 
completion of such transaction, as defined in Sec. 240.15c1-1:
    (i) When such transaction is effected at a price that trades 
through a better price published at the time of execution; and
    (ii) That better published price.
    (2) A broker-dealer shall not be required to provide the disclosure 
set forth in paragraph (b)(1) of this section if:
    (i) It effects such transaction on a market that is a sponsor or 
participant in an effective national market system options linkage plan 
that includes provisions reasonably designed to limit the incidence of 
customer orders being executed at prices that trade through a better 
published price, including prices published other than by a linkage 
plan sponsor or participant, or
    (ii) The customer order is executed as part of a block trade.
    (3) A customer order is executed at a price that trades through a 
better published price if:
    (i) The price at which an order to purchase a listed option is 
executed is higher than the lowest offer, at the time the order was 
executed, published pursuant to a national market system plan for 
reporting quotations in listed options; or
    (ii) The price at which an order to sell a listed option is 
executed is lower than the highest bid, at the time the order was 
executed, published pursuant to a national market system plan for 
reporting quotations in listed options.
    (4) Notwithstanding paragraph (b)(3) of this section, a customer 
order is not considered to be executed at a price that trades through a 
better published price if:
    (i) The market on which the order is executed has verified that the 
market publishing such better price is experiencing a failure, material 
delay, or malfunction of its systems;
    (ii) The quotations disseminated pursuant to the national market 
system plan for reporting quotations indicates that it is experiencing 
delays in transmitting such quotations;
    (iii) Such better published price was published by an exchange 
whose members are relieved of their obligations under paragraph (c)(2) 
of Sec. 240.11Ac1-1 because, pursuant to paragraphs (b)(3) or (d)(4) of 
Sec. 240.11Ac1-1, such exchange is not required to meet its obligations 
under paragraph (b)(1) of Sec. 240.11Ac1-1; or
    (iv) The customer order is executed only after the market 
publishing the better price fails to respond to an order routed to it 
within 30 seconds of the order's receipt by that market.
    (c) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any broker or dealer if the Commission determines that such 
exemption is consistent with the public interest, the protection of 
investors, the maintenance of fair and orderly markets, or the removal 
of impediments to and perfection of the mechanism of a national market 
system.

    Dated: November 17, 2000.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 00-30132 Filed 11-30-00; 8:45 am]
BILLING CODE 8010-01-P