[Federal Register Volume 66, Number 142 (Tuesday, July 24, 2001)]
[Proposed Rules]
[Pages 38390-38396]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-18357]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-44568; File No. S7-14-01]
RIN 3235-AI23


Request for Comment on the Effects of Decimal Trading in 
Subpennies

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comments.

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SUMMARY: The Securities and Exchange Commission (``Commission'') seeks 
comment on the impact on fair and orderly markets and investor 
protection of trading and potentially quoting securities in an 
increment of less than a penny. As of April 9, 2001, all U.S. equity 
markets have been quoting stocks in pennies. In the past, some Nasdaq 
market makers and electronic communication networks (``ECNs'') traded 
stocks in smaller price increments than the public quote. This practice 
has continued in the new decimal environment, with some trades 
occurring in Nasdaq securities priced in subpennies. The Commission 
seeks comment on the effects of subpenny prices on market transparency 
and the operation and effectiveness of Commission and self-regulatory 
organization (``SRO'') rules that are dependent on trading or quoting 
price differentials. The Commission also seeks comment on the effects 
of subpenny trading on automated systems.

DATES: Comments must be received on or before September 24, 2001.

ADDRESSES: Persons wishing to submit written comments should send three 
copies to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments 
also may be submitted electronically at the following E-mail address: 
[email protected]. All comment letters should refer to File No. S7-
14-01. Comments submitted by E-mail should include this file number in 
the subject line. Comment letters received will be available for public 
inspection and copying in the Commission's Public Reference Room, 450 
Fifth Street, NW., Washington, DC 20549. Electronically submitted 
comment letters will be posted on the Commission's Internet web site 
(http://www.sec.gov).\1\
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    \1\ Personal identifying information, such as names or e-mail 
addresses, will not be edited from electronic submission. Submit 
only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Any of the following attorneys in the 
Division of Market Regulation, Securities and Exchange Commission, 450 
Fifth Street, NW., Washington, DC 20549: James Brigagliano, Jo Anne 
Swindler, Gregory Dumark, or Kevin Campion at (202) 942-0772; Alton 
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Harvey, Patrick Joyce, or John Roeser at (202) 942-0154.

SUPPLEMENTARY INFORMATION:

I. Introduction and Summary

    The conversion from fractional to decimal pricing for consolidated 
quotations in all equity securities and options was successfully 
completed on April 9, 2001. As a result, the minimum price variation 
(``MPV'') for consolidated quotations in equity securities has been 
narrowed from \1/16\ of a dollar to a penny. The decimal conversion was 
effected with no significant operational problems on the markets, 
clearing organizations, and key market participants.\2\ Preliminary 
estimates indicate that decimal pricing has reduced quotation spreads 
(the difference between the highest bid quotation and the lowest offer 
quotation) in both exchange-traded and Nasdaq securities with 
manageable increases in quotation volumes.\3\
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    \2\ See, e.g., Nasdaq Decimalization Impact Study (June 11, 
2001) (``Nasdaq Study'') at 55. This study can be accessed at 
www.nasdaqnews.com.
    \3\ The Nasdaq Study found that, on average, quoted and 
effective spreads both have fallen by about 50%, with greater 
declines in stocks with greater trading volume and lower prices. For 
the most actively traded stocks, quoted spreads fell from 6.6 cents 
to 1.9 cents when penny increments were introduced. Id. at pp. 2, 
15-16.
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    While the move from fractions to decimals was designed to simplify 
pricing for investors and to make our markets more competitive 
internationally,\4\ a number of market structure and investor 
protection issues have been raised by this fundamental change. In 
particular, difficult issues have been raised in connection with the 
limited practice of pricing orders and trades in increments that are 
smaller than the MPV for quotations.
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    \4\ See Securities Exchange Act Release No. 42360 (January 28, 
2000), 65 FR 5004 (February 2, 2000).
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    For years, some ECNs and Nasdaq market makers have permitted 
trading in increments smaller than the public quote. This practice has 
continued in the decimal environment, with approximately 4% to 6% of 
trades in Nasdaq securities priced in subpenny increments even though 
the quotations for these securities are at a penny MPV. Trading in 
subpennies raises difficult questions under rules based on the MPV, 
which markets allowing subpenny trading have attempted to address.\5\ 
The Commission approved these measures on a pilot basis.
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    \5\ On April 6, 2001, the Commission approved, on a pilot basis, 
a rule filed by the NASD specifying the protections Nasdaq market 
makers must provide to customer limit orders in subpennies. See 
Securities Exchange Act Release No. 44165 (April 6, 2001), 66 FR 
19268 (April 13, 2001). On April 6, 2001, the Commission also 
granted the Chicago Stock Exchange (``CHX''), on a pilot basis, the 
flexibility to compete with ECNs and Nasdaq market makers by 
accepting orders in Nasdaq/NM securities priced in subpenny 
increments while maintaining the uniform penny MPV for quotations. 
See Letter to Paul O'Kelley, Chief Operations Officer, CHX, from 
Annette L. Nazareth, Director, Division of Market Regulation, 
Commission (April 6, 2001). This letter provided CHX specialists and 
market makers with the same flexibility in handling subpenny orders 
that had been granted to ECNs and Nasdaq market makers in a no-
action letter to the Nasdaq Stock Market from the Division of Market 
Regulation, dated July 30, 1997. See infra n.30. The Commission also 
approved on April 6 a pilot program setting forth protections that 
must be provided by CHX specialists and market makers for customer 
subpenny orders in Nasdaq/NM securities. Securities Exchange Act 
Release No. 44164 (April 6, 2001), 66 FR 19263 (April 13, 2000) 
(order approving a proposed rule change by the CHX relating to the 
precedence of customer limit orders on the book).
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    Before considering whether to permanently approve these measures, 
however, the Commission is seeking comment on their impact on market 
transparency, as well as the impact of subpenny trading on customer 
protection rules, and alternative approaches, if any.\6\
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    \6\ The Nasdaq and CHX proposals were originally approved as 
pilot programs until July 9, 2001, and were recently extended until 
November 5, 2001. See Securities Exchange Act Release No. 44529 
(July 9, 2001), 66 FR 37082 (July 16, 2001) (order extending the 
Nasdaq pilot); Securities Exchange Act Release No. 44535 (July 10, 
2001), 66 FR 37251 (July 17, 2001) (order extending the CHX pilot). 
During this time the markets will supply the Commission staff with 
monthly reports on their activity in subpenny increments.
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    In ordering the conversion to decimals, the Commission noted that 
this effort might require further analyses of the impact of a small MPV 
on trading rules and the markets.\7\ There may be a point at which the 
incremental costs of

[[Page 38391]]

reducing the MPV exceed the incremental benefits. With the conversion 
to decimal pricing complete, the Commission believes it is an 
appropriate time to seek comment on the effect of subpenny trading on 
Commission and SRO rules that are dependent on trading or quoting price 
differentials. In particular, the Commission seeks comment on the 
effect of subpenny trading on market transparency, customer limit 
orders, various price dependent rules, and automated systems.
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    \7\ See Securities Exchange Act Release No. 42914 (June 8, 
2000), 65 FR 38010 (June 19, 2000). See also Securities Exchange Act 
Release No. 42360 (January 28, 2000), 65 FR 5004 (February 2, 2000).
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II. Background

A. Subpenny Trading

    Even before the decimal conversion, a small amount of trading in 
Nasdaq stocks was being effected in increments smaller than the quoting 
increment. For example, the Commission's Office of Economic Analysis 
(``OEA'') found that, in a sample of five active Nasdaq stocks on 
January 12, 2001, approximately 4.4% of transactions were reported in 
the equivalent of subpenny prices.\8\ A broader review by OEA of post-
conversion trading in all Nasdaq securities found little change in the 
level of subpenny trading. For April 9-12, 2001 (the first week in 
which all Nasdaq securities were priced in decimals), subpenny prices 
accounted for approximately 5.7% of the trades and 4.2% of the dollar 
volume in these stocks.\9\
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    \8\ OEA reviewed trading in shares of Intel Corp. (INTC), Cisco 
Systems, Inc. (CSCO), Dell Computer Corp. (DELL), Microsoft Corp. 
(MSFT) and Apple Computer, Inc. (AAPL).
    \9\ In exchange-listed stocks, however, the current level of 
subpenny trading appears to be minimal. For example, OEA reviewed 
trading in 148 New York Stock Exchange (``NYSE'') listed stocks over 
15 trade dates from February 26 to March 16 and found that only 0.2% 
of the reported trades had price increments of less than a penny. 
All of the subpenny transactions were effected in over-the-counter 
(``OTC'') trading in these NYSE-listed stocks. While the overall 
level of subpenny trading was light for these NYSE-listed stocks, 
OEA found that this activity represented a relatively larger 
proportion (8.4% of the share volume) of OTC trading in these 
securities.
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    The decimals study submitted by Nasdaq \10\ found that with a penny 
increment after decimals, the incentive to submit limit orders within 
the quotation increment has decreased.\11\ But despite the finer 
increment, sub-quotation level limit orders have not disappeared and 
continue to play an active role, especially on ECNs.\12\ The study also 
found that the importance of limit orders at finer than the minimum 
tick size has decreased in a decimals environment.\13\ It was also 
determined that the number of subpenny executions has decreased from 
12.8% to 5.4% under decimals.\14\ Additional statistics on subpenny 
trading will be available in the near future.\15\
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    \10\ See Nasdaq Study, supra n.2. Nasdaq explains that the bulk 
of its report is based on an empirical analysis of various 
characteristics of Nasdaq. Nasdaq explains that its general 
methodology is to measure and compare these characteristics two 
weeks before (3/26/01-4/6/01) and two weeks (4/9/01-4/20/01) after 
the April 9th conversion date. The subject of Nasdaq's analysis is, 
then, the set of stocks that converted to decimal quoting on April 
9th. Nasdaq includes in its report a caveat that it attempts to 
measure the initial impact of decimals only, and that in light of 
the major changes it has induced, it is possible, if not likely, 
that the ultimate impact of decimals may take a number of months to 
reveal itself. Many market participants, investors as well as market 
intermediaries, are in the process of adapting to the new trading 
environment. It is also possible that some of the observed effects 
are due to a novelty effect. Nasdaq thus notes that what was 
measured in the first two weeks may be substantially different a 
year from now. Id. at 6.
    \11\ The study found that the percentage of limit orders entered 
within the minimum quotation increment has decreased from 35.1% to 
14.6% under decimals. See Nasdaq Study at 31.
    \12\ The study found that only 0.5% of subpenny limit orders are 
routed to and kept by market makers. Nasdaq found that market makers 
either do not generally accept subpenny limit orders or route the 
orders to ECNs, with the vast majority of subpenny limit orders 
handled by a single ECN (95%). Id.
    \13\ Nasdaq broke down the usage of sub-increments by the price 
aggressiveness of limit orders relative to the prevailing NBBO. The 
percentages of sub-increment orders were much higher both during the 
pre- and post-decimal periods. In a fraction world 81% of inside-
setting limit orders were quoted at finer increments, compared to 
just 47% under decimals. For near-the-inside limit orders, the 
percentage dropped from 47% to 17%. Overall, Nasdaq found that the 
percentages do not vary much from one day to the other. Id.
    \14\ The study found that the majority (84%) of subpenny 
executions involve ECNs at least one side of trades, though the 
percentage is lower than that for subpenny limit orders (99.5%). Id. 
at 32.
    \15\ Nasdaq and CHX have agreed to provide monthly data 
submissions to the Commission staff that should provide more 
information concerning subpenny order flow and trading.
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B. The Transition to Decimal Pricing

    On June 8, 2000, the Commission ordered the exchanges and the NASD 
to submit a plan that would phase in decimal pricing for stocks and 
options beginning no later than September 5, 2000, and ending by April 
9, 2001.\16\ In its June 8 Order, the Commission acknowledged that 
there was little agreement among commenters regarding the appropriate 
minimum quoting increment for stocks during the phase-in process, with 
suggestions ranging from $0.10 to $0.01. Accordingly, the Order 
permitted the exchanges and the NASD to select a uniform increment for 
stock quotations during the phase-in period of no greater than $0.05 
and no less than $0.01.\17\ The Decimals Implementation Plan that was 
submitted to the Commission by the exchanges and Nasdaq on July 24, 
2000 set the MPV for equity securities quotations at a penny.\18\
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    \16\ See Securities Exchange Act Release No. 42914 (June 8, 
2000), 65 FR 38010 (June 19, 2000).
    \17\ Id.
    \18\ The minimum quotation increment for option issues quoted 
under $3 a contract was set at $.05 and for options issues quoted at 
$3 and greater it was set at a $.10.
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    The June 8 Order also directed the SROs to submit a study (jointly 
or separately) to the Commission sixty days after full implementation 
on April 9, 2001, regarding the impact of decimal pricing on systems 
capacity, liquidity, and trading behavior, including an analysis of 
whether there should be a uniform price increment for securities. In 
particular, the Commission stated that, if an exchange or Nasdaq wished 
to move to quoting stocks in an increment of less than a penny, the 
study should include a full analysis of the potential impact on the 
market requesting the change and the markets as a whole. Within thirty 
days after submitting the study, the exchanges and Nasdaq must 
individually submit for notice, comment, and Commission consideration, 
proposed rule changes under Section 19(b) of the Securities Exchange 
Act of 1934 (``Exchange Act'') to establish their individual choice of 
minimum increments by which equities and options are quoted on their 
markets.\19\
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    \19\ Id.
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    In view of the complexities of some of the issues that have been 
raised concerning decimal pricing, the Commission extended the deadline 
for the markets' studies to September 10, 2001.\20\ In the interim, the 
Commission is soliciting the views of a wider range of commenters 
concerning the appropriate price increments for quotations, orders, and 
trading for stocks in a decimal environment. To assist commenters, we 
have identified and requested comments on a number of specific issues. 
Commenters should provide data supporting their views, including costs 
and benefits, whenever possible.
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    \20\ See Securities Exchange Act Release No. 44336 (May 22, 
2001), 66 FR 29368 (May 30, 2001) (order extending the deadline for 
the exchanges and SROs to submit studies and rule filings concerning 
the implementation of decimal pricing in equity securities and 
options). Nasdaq submitted a study on June 11, 2001. See supra n.2.
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III. Specific Topics To Be Addressed

A. Impact of Subpenny Trading on Transparency

    Market transparency--the dissemination of meaningful quote and 
trade information--assists investors to make informed order entry 
decisions

[[Page 38392]]

and enables broker-dealers to meet their best execution duties for 
their customer orders. Moreover, market transparency plays an essential 
role in linking dispersed markets and improving the price discovery, 
fairness, competitiveness, and attractiveness of U.S markets.
1. Price Clarity, Order Entry Decisions, and Quotation Management
    Decimal pricing presumably has enhanced the ability of investors to 
understand the consolidated quotations of competing market centers. 
Investors can now compare prices to buy and sell stocks in dollars and 
cents without having to deal with prices in fractions.
    Subpenny pricing, however, has the potential to undercut this price 
clarity in at least two ways. If the consolidated quotations used by 
investors do not fully reflect the subpenny orders available for 
execution at various price levels, the accuracy of the quotations could 
be compromised. In particular, the quoted spreads may not accurately 
reflect the true trading interest in the market.
    On the other hand, if quotes were in subpennies, investors and 
market participants might have to deal with confusing and rapidly 
changing quote montages--e.g., an investor might have to choose quickly 
between one market bidding at $10.0101 for a stock and a competing 
market with a bid at $10.0110.\21\ In addition, as this could result in 
``flickering'' quotes in miniscule price increments, issues would be 
raised about how broker-dealers could comply with their best execution 
duties for customer orders.\22\ Moreover, the potential for rapidly 
changing consolidated quotes in miniscule increments could have 
implications for market rules pertaining to ``locked'' and ``crossed'' 
markets \23\ and the Intermarket Trading System (``ITS'') Plan's 
``trade-through'' provisions.\24\
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    \21\ It could also raise order handling and systems issues, 
particularly because displays have physical limits. See discussion 
at Part 3, infra.
    \22\ The Nasdaq Study found that the number of inside quote 
price-only updates (a.k.a. ``quote flickering'') went up 90% for the 
final-phase stocks, similar to what was found before with the pilot 
stocks. The results confirmed Nasdaq's prior expectation that as 
tick-size goes down, the inside quote would flicker more often as 
market participants compete at less cost for the inside positions. 
See Nasdaq Study, supra n.2 at 12.
    \23\ In a locked market, the best bid price equals the best ask 
price; in a crossed market, the best bid price exceeds the best ask 
price. The Nasdaq Study found that there are more instances of 
locked or crossed markets under decimals. The study notes that due 
to the more frequent changes of inside quotes, many quote updates 
may have locked or crossed the other side inadvertently. See Nasdaq 
Study, supra n.2 at 2.
    \24\ 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).
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2. Effects on Market Depth
    Another aspect of transparency that has been affected by the 
decimals conversion is quotation depth. In order for investors and 
other market participants to make use of the price information provided 
by the consolidated quotation systems, there needs to be meaningful 
information available concerning the amount of buy or sell interest 
that is available at the quotations. As the minimum quoting increment 
has narrowed to a penny, the market depth at any particular price level 
(that is, the number of shares reflected at the published bid or offer) 
has decreased as well. For example, OEA has estimated that quote sizes 
in NYSE-listed securities have been reduced an average of 60% since the 
conversion to decimals, and preliminary analyses of Nasdaq securities 
show a 68% reduction in quote sizes.\25\ Some firms and institutional 
investors have also expressed concerns that the reduction in quoted 
market depth may be adversely affecting their ability to execute large 
orders.\26\ In particular, market participants have indicated that 
smaller trading and quoting increments have increased the risk of 
displaying limit orders, particularly larger limit orders, leading to a 
reduction in the amount of liquidity provided by such orders. In an 
effort to provide more information about available liquidity, the NYSE 
recently began disseminating ``depth indications'' and ``depth 
conditions'' to reflect market interest in a security below the 
published bid and above the published offer.\27\ Market participants, 
however, have asserted that these measures alone are unlikely to 
address all of their liquidity concerns in a decimal environment, 
particularly where liquidity may be spread over more numerous price 
points if bids and offers are quoted in prices of less than a penny.
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    \25\ The Nasdaq Study found that displayed depth has decreased 
by two-thirds under decimals. The total amount of cumulative 
displayed depth near the inside has likewise fallen, though by a 
much smaller percentage. See Nasdaq Study, supra n.2 at 2.
    \26\ See letter to Richard A. Grasso, Chairman, NYSE, from Craig 
S. Tyle, General Counsel, Investment Company Institute, dated March 
1, 2001.
    \27\ See Securities Exchange Act Release No. 44084 (March 16, 
2001), 66 FR 16307 (March 23, 2001) (NYSE Rule 60).
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3. Order Handling Rules
    In recent years, the Commission has sought to ensure the 
transparency benefits of the national market system through inclusion 
of limit orders and ECN prices in the quote.\28\ One area in which ECNs 
have offered their customers added flexibility has been in the price 
increments accepted for their orders. As discussed above, even before 
the decimal conversion, some ECNs permitted their customers to enter 
orders in penny and subpenny increments or their equivalents (e.g., in 
increments as small as \1/256\ of a dollar). When the Commission's 
Order Handling Rules brought ECNs into the national market system 
framework, some accommodation was necessary for ECN price increments. 
Accordingly, the Commission staff permitted orders in small increments 
held by ECNs and OTC market makers to be rounded to the nearest price 
increment accepted by the Nasdaq system.\29\ While the Commission 
originally believed that rounding indicators should be provided in the 
public quotes under these circumstances, market participants claimed 
that this was not feasible due to the then-current limitations in 
quotation systems and vendor displays. Accordingly, the Commission 
staff provided a no action letter in 1997 to Nasdaq for ECNs and market 
makers to handle orders priced in increments

[[Page 38393]]

smaller than \1/16\ in Nasdaq securities without having consolidated 
quotations reflect that bids or offers had been rounded.\30\ Following 
the complete conversion to decimal pricing with a penny minimum 
increment for consolidated quotations on April 9, 2001, the flexibility 
to handle subpenny orders in Nasdaq/NM securities, including continued 
quote displays without rounding indicators, was temporarily extended to 
CHX specialists and market makers.\31\
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    \28\ On August 28, 1997, the Commission adopted Rule 11Ac1-4 
(``Limit Order Display Rule'') and amendments to Rule 11Ac1-1 
(``Quote Rule'') under the Exchange Act. See Securities Exchange Act 
Release No. 37619A (September 6, 1996), 61 FR 48290 (September 12, 
1996) (17 CFR 240.11Ac1-4; 17 CFR 240.11Ac1-1) The Limit Order 
Display Rule requires the display of certain customer limit orders 
priced better than an OTC market maker's or specialist's quote, or 
when the limit order adds to the size associated with such quote if 
that quote is at the national best bid or offer (``NBBO''). The 
Quote Rule generally requires the collection and public 
dissemination of the best bid, best offer, and size for each market 
quoting a security covered by the rule, as well as the consolidation 
and public dissemination of those markets' quotations. The Quote 
Rule also requires an OTC market maker or specialist to make 
publicly available any superior prices that the market maker or 
specialist privately quotes through an ECN. Alternatively, an OTC 
market maker or specialist can deliver better priced orders to an 
ECN without changing its public quote if that ECN: (1) Ensures that 
the best prices market markers and specialists have entered in the 
ECN are communicated to the public quotation system; and (2) 
provides brokers and dealers with equivalent access to those orders 
entered by market makers and specialists into the ECN. In addition, 
the ``ECN Display Alternative'' allows an ECN to act as a voluntary 
intermediary in communicating to the public quotation system the 
best price and size of orders that specialists and market makers 
enter into the ECN. See also Rule 301(b)(3), 17 CFR 240.301(b)(3) 
(order display and access to certain alternative trading systems).
    \29\ Securities Exchange Act Release No. 37619A (September 6, 
1996), 61 FR 48290 (September 12, 1996).
    \30\ See Letter to Robert Aber, Vice President and General 
Counsel, Nasdaq, from Richard R. Lindsey, Director, Division of 
Market Regulation (July 31, 1997). While the orders were rounded for 
quotation purposes, the trades were reported and printed in the 
actual price increments.
    \31\ See discussion in Part I, supra.
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    Now that the decimal conversion has been completed, the Commission 
believes that it would be appropriate to reevaluate the interim 
measures that were implemented to preserve the benefits of the Order 
Handling Rules.
4. Scenarios To Be Addressed
    As discussed above, if subpenny bids and offers are not reflected 
in the public quote, this may reduce the accuracy of the quotation for 
investors. On the other hand, the possible incorporation of subpenny 
prices into the consolidated quotes could potentially undercut some of 
the gains from decimal pricing in terms of pricing clarity, and could 
significantly complicate order entry decisions and the markets' quoting 
and trading rules based on meaningful quoting increments. Subpenny 
pricing could also potentially exacerbate difficulties faced by 
investors in determining the market depth at or near the NBBO. 
Moreover, the routine use of subpenny increments for trading and 
quoting could reduce the value of displaying limit orders, perhaps 
leading to a reduction in market liquidity. The Commission, therefore, 
seeks comment on the impact of subpenny trading and possible subpenny 
quoting on market transparency and liquidity. Commenters should address 
their comments to two mutually independent scenarios under which 
subpenny trading might be accommodated, as described below.
    Rounding Scenario. If the exchanges and Nasdaq accept orders in 
subpenny increments, should they round the quotations to display the 
orders in whole penny increments? If so:
    1. What effect would this practice have on price discovery, price 
competition, liquidity, transparency, trading costs, and execution 
quality?
    2. How would investors monitor executions and execution quality?
    3. How would this practice affect different market participants? 
Would this practice promote or hinder institutional participation?
    4. Would this practice encourage or impede competition among 
multiple markets?
    5. If rounding is maintained, have the quotation systems, vendors, 
and others developed sufficient capability to accommodate rounding 
indicators to reflect subpenny orders? If so, would rounding indicators 
be beneficial for investors and the markets?
    6. What other alternatives should the Commission consider? 
Inclusion Scenario. Alternatively, if the exchanges and Nasdaq accept 
orders in subpenny increments, should they display consolidated quotes 
in subpenny increments? If so:
    7. How small should the allowable quotation increment be?
    8. At what point would the quoting increment be so small as to be 
economically insignificant for order entry decisions (including best 
execution duties owed by broker-dealers to customer orders)?
    9. What impact would this practice have on the displayed quote size 
and the overall depth of the markets, and how should this be addressed? 
Would increased display of the limit order book help to alleviate 
concerns about transparency?
    10. What effect would this practice have on price discovery, price 
competition, liquidity, transparency, trading costs, and execution 
quality?
    11. Would this practice affect the ability of investors to monitor 
executions and execution quality?
    12. How would it affect the exchanges' and Nasdaq's ability to 
maintain fair and orderly markets? Consider the impact on quoting and 
trading rules, such as rules addressing locked and crossed markets and 
intermarket trade-throughs.
    13. How would this practice affect institutional participation in 
the markets?
    14. How would this practice affect competition among multiple 
markets?
    Finally, the Commission invites public comment on any other market 
transparency and liquidity issues raised by subpenny trading.

B. Order Priority

    Markets use priority rules to determine which orders are filled 
first.\32\ The highest bids and the lowest offers are filled before 
orders with inferior prices. Historically, traders were required to 
make an economically significant contribution to the price of a 
security to gain priority over other traders.\33\
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    \32\ For example, the NYSE Rule 71 gives precedence to the 
highest bid and the lowest offer.
    \33\ See Lawrence Harris, Decimalization: A Review of the 
Arguments and Evidence (April 1997).
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    Subpenny orders may significantly affect priority rules and order 
submission strategy. For example, a trader may post a best bid of 
$10.00 in a security, while another trader may gain priority by bidding 
$10.001 in the same security. By offering price improvement of $0.001, 
the other trader gains priority over the trader who bid $10.00.\34\
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    \34\ Arguably, if the price of the security declines, the trader 
who offered price improvement of $0.001 will suffer a loss. However, 
it is possible that this trader could sell the security to the 
trader who bid $10.00 and limit his loss to $0.001 per share.
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    There are many potential behavioral effects of such activity on the 
markets. Investors may use floor brokers to shield their orders from 
being publicly displayed or they may increasingly use market orders. 
Investors may seek to trade more in automated systems that offer 
greater confidentiality by not displaying their orders.
    15. Should there be a minimum trading increment that requires a 
trader to make an economically significant change to the quoted price 
of a security in order to obtain priority over another order? If so, 
what should that increment be? Should all market participants be 
subject to the same trading increment?
    16. Should the minimum increment used to establish priority over 
other orders be dependent upon the security price or quotation spread?

C. Effects of Subpenny Trading on Other Price Dependent Rules

1. Customer Limit Order Protection
    Commission and SRO rules provide customer limit orders with 
priority over specialist and market maker orders at the same price on 
the exchanges and on Nasdaq. Rule 11a1-1(T) \35\ under the Exchange Act 
requires exchange members to grant priority to any bid or offer at the 
same price for the account of a person who is not a member. Exchanges 
have generally applied the basic requirements of Rule 11a1-1(T) to 
specialists as well as all other members of the exchange.\36\
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    \35\ 17 CFR 240.11a1-1(T).
    \36\ For example, NYSE Rule 92(b) prohibits NYSE members from 
trading for their own account at the same price as an unexecuted 
customer limit order. Rule 92(b) states that no member shall ``(1) 
personally buy or initiate the purchase of any security on the 
Exchange for any such account, at or below the price at which he 
personally holds or has knowledge that his member organization holds 
an unexecuted limited price order to buy such security in the unit 
of trading for a customer, or (2) personally sell or initiate the 
sale of any security on the Exchange for any such account at or 
above the price at which he personally holds or has knowledge that 
his member organization, holds an unexecuted limited price order to 
sell such security in the unit trading for a customer.'' Pursuant to 
Section 11(b) and Rule 11b-1 under the Act, the NYSE applies the 
provisions of Rule 92(b) to specialists since they are allowed to 
trade for their own accounts.

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[[Page 38394]]

    The rules under Section 11(a) do not address ``stepping ahead'', 
i.e., transactions by market professionals trading for their own 
account at prices better than customer limit orders. However, exchange 
rules, in effect, establish a de facto ``stepping-ahead'' increment 
because exchanges generally set the exchange minimum quoting and 
trading increments. Therefore, for a member to trade ahead of a 
customer limit order, the member must improve the price by the minimum 
increment. In the current decimals environment, that increment has been 
a penny. As discussed above, CHX recently amended its rules to accept 
orders in Nasdaq/NM securities in subpenny increments while maintaining 
a uniform penny MPV for quotations. Allowing CHX to take orders and 
trade in subpenny increments in Nasdaq/NM securities has, in effect, 
altered the de facto ``stepping ahead'' increment to a subpenny for 
some CHX orders outside the NBBO.
    NASD's Manning Interpretation requires the execution of a customer 
limit order upon the execution of a proprietary trade at a price that 
would satisfy the customer limit order.\37\ For example, the 
Interpretation requires market makers who want to trade ahead of 
customer limit orders to trade at a price $0.01 better than the 
customer limit order priced at or better than (inside) the best 
displayed inside market. For customer limit orders priced outside the 
best displayed inside market, a market maker must trade at a price at 
least equal to the next superior minimum quotation increment.\38\
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    \37\ NASD IM-3220-2--Trading Ahead of Customer Limit Order.
    \38\ See supra n.5. Nasdaq does not specify a minimum trading 
increment.
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    The Interpretation previously had required a market maker to 
protect all limit orders within $0.01 of the price at which it sought 
to trade for its proprietary account.\39\ Nasdaq modified its rule 
because of certain anomalies that occurred under the earlier 
Interpretation when market makers elected to accept customer limit 
orders in price increments smaller than a penny. For example, the 
operation of the Interpretation was problematic where the market was 
$10.00 to $10.01 and the market maker accepted a customer limit order 
to buy 100 shares at $9.994. If the market maker then sought to buy 
1,000 shares at $10.00 on a proprietary basis, it would be obligated to 
execute the customer limit order at $9.994 as well as all other 
customer limit orders to buy it accepted and priced above $9.990 and up 
to $10.00, up to a total of 1,000 shares.\40\ Customers may have been 
submitting subpenny orders within a penny of a market maker's bid, 
i.e., ``stepping-behind'' the bid by less than a penny, in order to 
obtain execution of their limit buy orders at a price less than the 
best bid.\41\
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    \39\ See Securities Exchange Act Release No. 44030 (March 2, 
2001), 66 FR 14235 (March 9, 2001) (order approving Nasdaq proposed 
rule change to the Manning Interpretation adopting a $0.01 price 
improvement standard for securities quoting in decimals).
    \40\ A firm that executes in front of customer limit orders that 
are owed Manning protection is obligated to fill such limit orders 
for a total amount of shares equal to the number of shares traded on 
a proprietary basis by the firm. NASD's Notice to Members 95-43 
(June 1995).
    \41\ Further, these anomalies may occur in situations in which 
the market maker is not affirmatively trading in front of customer 
orders but may instead have its displayed quotes accessed by other 
market participants.
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    Subpenny trading may have an adverse effect on the operation of 
``customer first'' rules and the use of limit orders.\42\ Further, to 
the extent that ``stepping-behind'' activity is facilitated by subpenny 
orders, it may discourage market making. Therefore, the Commission 
solicits comment on how subpenny orders and trades should be treated 
under the limit order protection rules. In particular, the Commission 
seeks commenters' views in response to the following questions:
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    \42\ Limit orders are a very important source of price 
information and market liquidity. A customer uses a limit order to 
obtain an execution at the limit price or better. By submitting a 
limit order, the customer competes for a better price than the 
market is offering, or limits the price that the investor will 
accept. As a result, limit orders provide liquidity to those who 
demand immediate execution. See Kenneth A. Kravajecz, A Specialist's 
Quoted Depth and the Limit Order Book, 54 J. Fin. 747, 749 (1999).
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    17. Is price improvement by less than $0.01 an economically 
sufficient amount for specialists or market makers to be able to 
``step-ahead'' of customer limit orders? \43\ If not, what amount of 
price improvement would be considered economically sufficient in order 
to ``step-ahead'' of a customer limit order?
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    \43\ While the Commission seeks comments on the effects of 
subpenny trading, it is nonetheless aware that decimal trading in a 
penny increment presents many of the same questions. See Norris, Big 
Board Will Study Effects of Decimal Trading, The New York Times, 
Feb. 17, 2001, at C1. However, our request is generally limited to 
subpenny trading activity as a means to complement the Decimals 
Study.
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    18. Should the minimum price improvement increment for ``stepping-
ahead'' be dependent upon the minimum trading or quoting increment in a 
market? If so, how should this minimum increment be determined? 
Alternatively, should the ``stepping-ahead'' increment be dependent 
upon the security price or quotation spread?
    19. Who should the ``stepping-ahead'' minimum increment apply to, 
e.g., specialists, market makers, floor brokers, or other market 
participants? Would imposing a minimum ``stepping-ahead'' increment on 
these individuals benefit non-professional customers?
    20. If ``customer first'' provisions continue to incorporate the 
minimum pricing increment in each market, will customers seek 
alternative means of displaying their orders to avoid ``stepping-
ahead'' activity or will they use automated systems which do not 
display orders? Will these reactions cause or result in greater market 
fragmentation, i.e., the trading of orders in multiple locations 
without interaction among those orders? \44\ Will customer responses 
differ between market structures?
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    \44\ See Securities Exchange Act Release No. 42450 (February 23, 
2000), 65 FR 10577 (February 28, 2000).
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2. Effect of Trading in Subpennies on Short Sale Regulation
    Rule 10a-1 was adopted in 1938 under the Exchange Act and was 
designed to prevent short selling in a declining market. A short sale 
is the sale of a security that the seller does not own or that the 
seller owns but does not deliver.\45\ In order to deliver the security 
to the purchaser, the short seller will borrow the security, typically 
from a broker-dealer or an institutional investor. The short seller 
later closes out the position by returning the security to the lender, 
typically by purchasing equivalent securities on the open market. In 
general, short selling is utilized to profit from an expected downward 
price movement, or to hedge the risk of a long position in the same 
security or in a related security.
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    \45\ See Rule 3b-3 under the Exchange Act, 17 CFR 240.3b-3.
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    Rule 10a-1 generally applies to short sales in any security 
registered on a national securities exchange (``listed securities'') if 
trades of the security are reported pursuant to an ``effective 
transaction reporting plan'' and if information as to such trades is 
made available in accordance with such plan on a real-time basis to 
vendors of market transaction information.\46\ Rule 10a-

[[Page 38395]]

1(a)(1) provides that, subject to certain exceptions, a listed security 
may be sold short: (i) At a price above the price at which the 
immediately preceding sale was effected (plus tick), or (ii) at the 
last sale price if it is higher than the last different price (zero-
plus tick). Conversely, short sales are not permitted on minus ticks or 
zero-minus ticks, subject to narrow exceptions. The operation of these 
provisions is commonly described as the ``tick test.''
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    \46\ Rule 10a-1 uses the term ``effective transaction reporting 
plan'' as defined in Rule 11Aa3-1 (17 CFR 240.11Aa3-1) under the 
Exchange Act. See 17 CFR 240.10a-1(a)(1)(i).
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    The Commission adopted the ``tick test'' to achieve three 
objectives: (i) Allowing relatively unrestricted short selling in an 
advancing market; (ii) preventing short selling at successively lower 
prices, thus eliminating short selling as a tool for driving the market 
down; and (iii) preventing short sellers from accelerating a declining 
market by exhausting all remaining bids at one price level, causing 
successively lower prices to be established by long sellers.
    The NASD's short sale rule, Rule 3350, prohibits short sales by 
NASD members in Nasdaq/NM securities at or below the current best 
(inside) bid as shown on the Nasdaq screen when that bid is lower than 
the previous best (inside) bid (this is commonly referred to as the 
``bid test''). Stated differently, this rule requires a short sale to 
be effected at a price above the current bid in a declining market. 
Until recently, the rule did not specify how much above the current bid 
a ``legal'' short sale must be. On March 2, 2001, the Commission 
approved a Nasdaq rule change, on a pilot basis, that amended Rule 3350 
in light of decimalization.\47\ Specifically, Rule 3350 presently 
requires that when the current best bid in an NMS security is lower 
than the preceding best bid in that security, a ``legal'' short sale 
must be executed at a price at least $0.01 above the current best bid.
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    \47\ See Securities Exchange Act Release No. 44030 (March 2, 
2001), 66 FR 14235 (March 9, 2001).
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    In approving an amendment to Rule 3350, we noted that transactions 
based on very small price changes could undermine the operation of 
short sale regulation.\48\ While the Commission stated that a $0.01 
increment standard for short sales was a reasonable approach during the 
initial stages of the conversion to decimal pricing, we required Nasdaq 
to submit a study analyzing the operation of the short sale rule as 
amended.
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    \48\ Id. at n.16.
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    In this Release, we ask commenters to focus specifically on the 
actual or potential impact of subpenny trading on short sale 
regulations in answering the following questions:
    21. Would short sale rules that operate off a minimum price 
increment, such as Rule 10a-1 and NASD Rule 3350, be less effective if 
the minimum up ``tick'' or up ``bid'' required were less than a penny? 
If so, would these rules be sufficient to protect investors?
    22. Should the minimum price increment used for short sale 
regulation be dependent upon the minimum trading or quoting increment? 
If so, how should this minimum increment be determined? Alternatively, 
should the increment used for short sale regulation be dependent upon 
security price or quotation spread?
    23. Would subpenny trading increase the frequency of price changes, 
i.e., rapid trade and quote changes, and make it more difficult to 
effect a short sale on the proper ``tick'' or ``bid''? If so, what 
steps should be taken to address the problem? \49\
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    \49\ The Commission is considering possible rule changes to 
address short selling in a decimals environment as a part of its 
overall review of Rule 10a-1. See Securities Exchange Act Release 
No. 42037 (October 20, 1999), 64 FR 57996 (October 28, 1999) 
(concept release soliciting public comment on the regulation of 
short sales).
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D. Automated Systems Issues

    At each stage of the decimal phase-in of stocks and options, no 
significant problems were reported with regard to systems operations or 
capacity at the markets, clearing organizations, or major broker-
dealers. The Commission is nevertheless concerned that a widespread 
transition to quoting, trading, or reporting of stocks in increments of 
less than a penny could result in system issues that could compromise 
essential market and broker-dealer operations or disrupt the successful 
transition to decimals. The Commission seeks information related to the 
readiness of the industry's automated systems to handle potential 
quoting, trading, and reporting securities in increments of less than a 
penny and options on those stocks.\50\
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    \50\ As discussed, supra, options priced above $3 trade in 10-
cent increments, and options priced at $3 or less trade in 5-cent 
increments. In the Decimals Study, the Commission anticipates that 
the industry will address whether the minimum increment on options 
should be less than the current nickel and dime increments. See 
supra n.20.
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    24. Are the automated systems at the exchanges, Nasdaq, the 
clearing organizations, broker-dealers, and vendors currently capable 
of handling trading, reporting, or quoting stocks and options in 
subpennies? If not, how long would it take to prepare these systems for 
subpennies?
    25. If system changes need to be made to accommodate subpenny 
trading, reporting, or quoting, what types and scope of changes would 
need to be made (e.g., hardware and software) and how much time would 
be required? What are the associated costs and benefits?
    26. What is the anticipated impact on industry systems capacity 
associated with trading, reporting, or quoting of stocks and options in 
subpennies?

IV. General Issues for Comment

    We have identified a number of specific issues for comment 
regarding the effect of subpenny trading on the operation and 
effectiveness of Commission and SRO rules. In discussing these issues, 
commenters should consider the possibility and advisability of allowing 
trading in subpennies, but limiting the operation of price dependent 
rules (such as ``stepping-ahead,'' short sales, and order priority 
rules) to increments in whole pennies.
    We recognize that given the complexity and diversity of today's 
markets there may be other subpenny-related issues not identified 
above. Accordingly, we solicit comments on the following general 
questions regarding subpenny trading behavior:
    27. Are there any other market issues associated with subpenny 
trading that have not been addressed in this Release? If so, please 
provide a description of the issues and, where possible, provide 
specific examples of the trading behavior that gives rise to the issue.
    28. If the minimum trading increment is less than a penny, should 
there be a limit on this increment? Is there a practical or logical 
limit to the number of decimal places in our trading market?
    29. One of the perceived benefits of decimal trading was that 
decimal prices would be easier for investors to understand than 
fractional prices. Would allowing trading and possibly quoting in very 
fine increments increase investor confusion?
    30. Would vendors and reporting services, i.e., news-wires and 
newspapers, have the capability to handle such quotes or trades?

    Dated: July 18, 2001.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-18357 Filed 7-23-01; 8:45 am]
BILLING CODE 8010-01-P