[Federal Register Volume 66, Number 212 (Thursday, November 1, 2001)]
[Notices]
[Pages 55225-55236]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-27417]



[[Page 55225]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44983; File No. SR-PCX-00-25]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the Pacific Exchange, Inc., as Amended, and Notice of Filing 
and Order Granting Accelerated Approval to Amendment Nos. 4 and 5 
Concerning the Establishment of the Archipelago Exchange as the 
Equities Trading Facility of PCX Equities, Inc.

October 25, 2001.

I. Introduction

    On July 31, 2000, pursuant to section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ the 
Pacific Exchange, Inc. (``PCX'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') a proposed rule change to create 
a new electronic trading facility called the Archipelago Exchange 
(``ArcaEx''). The PCX filed Amendment No. 1 to the proposal on November 
9, 2000. The proposed rule change, as amended by Amendment No. 1, was 
published for comment and appeared in the Federal Register on December 
15, 2000.\3\ The Commission received 10 comment letters.\4\ The PCX 
filed Amendment No. 2 to the proposal on February 27, 2001. On April 
20, 2001, the PCX filed Amendment No. 3 to the proposal, which replaced 
Amendment No. 2 in its entirety. Notice of the proposed rule change, as 
amended by Amendment No. 3, was published in the Federal Register on 
May 8, 2001.\5\ The Commission received two comment letters on 
Amendment No. 3.\6\ On July 19, 2001, the PCX filed Amendment No. 4 to 
the proposed rule change.\7\ On October 9, 2001, the PCX filed 
Amendment No. 5 to the proposed rule change. This order approves the 
PCX's proposed rule change, as amended, publishes notice of Amendment 
Nos. 4 and 5 to the proposed rule change, and grants accelerated 
approval of Amendment Nos. 4 and 5.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 43608 (November 21, 
2000), 65 FR 78822 (December 15, 2000).
    \4\ Letter from Lanny A. Schwartz, Executive Vice President and 
General Counsel, Philadelphia Stock Exchange, to Jonathan G. Katz, 
Secretary, SEC, dated Dec. 21, 2000 (``Phlx Letter''); letter from 
John F. Malitzis, Associate General Counsel, Nasdaq Stock Market 
Inc., to Jonathan G. Katz, Secretary, SEC, dated Dec. 28, 2000 
(``Nasdaq Letter 1''); letter from San Francisco Specialists 
Association to Jonathan G. Katz, Secretary, SEC, dated Jan. 3, 2001 
(``SFSA Letter''); letter from Los Angeles Specialists Association, 
to Jonathan G. Katz, Secretary, SEC, dated Jan. 4, 2001 (``LASA 
Letter''); letter from David Hultman, D.A. Davidson & Co., to 
Jonathan G. Katz, Secretary, SEC, dated Jan. 5, 2001 (``D.A. 
Davidson Letter''); letter from Jeffrey T. Brown, Cincinnati Stock 
Exchange, to Jonathan G. Katz, Secretary, SEC, dated Jan. 8, 2001 
(``CSE Letter''); letter from Richard G. Ketchum, President, Nasdaq 
Stock Market Inc., to Jonathan G. Katz, Secretary, SEC, dated Jan. 
22, 2001 (``Nasdaq Letter 2''); letter from Robert R. Glauber, Chief 
Executive Officer and President, NASD Regulation, Inc., to Jonathan 
G. Katz, Secretary, SEC, dated Jan. 26, 2001 (``NASD Regulation 
Letter''); letter from Steve Wunsch, President, Arizona Stock 
Exchange, to Jonathan G. Katz, Secretary, SEC, dated Feb. 1, 2001 
(``AZX Letter''); and letter from Michael T. Dorsey, Senior Vice 
President, General Counsel and Secretary, Knight Trading Group, 
Inc., to Jonathan G. Katz, Secretary, SEC, dated Feb. 9, 2001 
(``Knight Letter 1'').
    \5\ Securities Exchange Act Release No. 44233 (April 30, 2001), 
66 FR 23291 (May 8, 2001).
    \6\ See letter from Michael T. Dorsey, Senior Vice President, 
General Counsel and Secretary, Knight Trading Group, Inc., to 
Jonathan G. Katz, Secretary, SEC, dated June 22, 2001 (``Knight 
Letter 2'') and letter from Richard G. Ketchum, President, Nasdaq 
Stock Market Inc., to Jonathan G. Katz, Secretary, SEC, dated June 
4, 2001 (``Nasdaq Letter 3'').
    \7\ In Amendment No. 4 to the proposed rule change, the PCX 
added new subsection (d) to proposed PCXE Rule 14.3, which would 
require that Archipelago Exchange LLC and Archipelago Holdings LLC 
maintain all books and records related to the ArcaEx within the 
United States. In addition, the PCX made technical changes to 
various proposed rules. By letter dated October 24, 2001, 
Archipelago Holdings LLC withdrew its Form 1 application to register 
as an exchange.
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II. Description of the Proposal

A. Introduction

    The PCX proposes to establish ArcaEx as the new electronic 
communications and trading facility \8\ of its subsidiary, PCX 
Equities, Inc. (``PCXE''). Operating in place of PCXE's traditional 
trading floor, the ArcaEx facility would automatically execute orders 
in equity securities listed or traded on the PCXE.\9\ As described 
further below, ArcaEx market makers would replace the PCX's traditional 
floor specialists.\10\
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    \8\ See 15 U.S.C. 78c(a)(2) (definition of ``facility'').
    \9\ The PCX has delegated its self-regulatory authority to the 
PCXE. See Securities Exchange Act Release No. 42759 (May 5, 2000), 
65 FR 30654 (May 12, 2000).
    \10\ The proposal does not require that a market maker be 
assigned to every PCXE security. See proposed PCXE Rule 1.1(u) 
(definition of ``market maker'').
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    As a facility of the PCX, ArcaEx would be subject to the 
Commission's oversight and examination. Consequently, the Commission 
would have the same authority to oversee the premises, personnel, and 
records of ArcaEx as it currently has with respect to the PCX. In 
addition, the PCX would be fully responsible for all activity that 
takes place through ArcaEx, and persons using ArcaEx would be subject 
to PCXE rules. For example, under the proposal, the PCX would conduct 
all necessary surveillance of the operation of ArcaEx and would 
maintain an audit trail of trading through ArcaEx. The PCX would rely 
on its own regulatory staff, and not on the employees of ArcaEx or its 
parent companies, to perform its regulatory functions concerning 
ArcaEx.
    The Archipelago Exchange LLC, a subsidiary of Archipelago Holdings 
LLC, would operate the ArcaEx facility, and would be responsible for 
ArcaEx's business activities to the extent that those activities are 
not inconsistent with the regulatory and oversight functions of the PCX 
and PCXE.\11\ This means that Archipelago Exchange LLC will not 
interfere with the PCX's self-regulatory responsibilities. The PCX 
currently has a 10% ownership interest in Archipelago Holdings LLC.\12\ 
Pursuant to contractual agreement, the PCX has the right to appoint a 
representative to the board of Archipelago Holdings LLC. The current 
rules of PCXE allow an officer or director of a PCX trading facility to 
have a single seat on the PCXE's board.\13\ By operation of PCX rules, 
the books, records, premises, officers, directors, agents, and 
employees of Archipelago Exchange LLC, which owns and operates the 
ArcaEx, would be deemed to be those of the PCX and PCXE for purposes of 
the Act. Moreover, all officers and directors of ArcaEx's parent 
company, Archipelago Holdings LLC, would be deemed officers and 
directors of PCX and PCXE for purposes of the Act.\14\
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    \11\ See proposed PCXE Rule 14.3. See also Amendment No. 3 to 
the proposed rule change, Securities Exchange Act Release No. 44233 
(April 30, 2001), 66 FR 23291 (May 8, 2001).
    \12\ See PCX Annual Report at http://www.pacificex.com/about/2001AnnualReport/ EQUITIES/equities.html, visited on August 21, 
2001.
    \13\ See Securities Exchange Act Release No. 44442 (June 18, 
2001), 66 FR 33733 (June 25, 2001).
    \14\ The relationship between the PCX, PCXE, and the Archipelago 
entities is explained in proposed PCXE Rule 14.3. Under proposed 
PCXE Rule 14.3(a), the books, records, premises, officers, 
directors, agents, and employees of Archipelago Exchange LLC would 
be deemed to be the books, records, premises, officers, directors, 
agents, and employees of the PCX and PCXE for purposes of and 
subject to oversight under the Act. The books and records of 
Archipelago Exchange LLC would be subject at all times to inspection 
and copying by the PCX, PCXE, and the Commission. Under proposed 
PCXE Rule 14.3(b), all officers and directors of Archipelago 
Holdings LLC would be deemed to be officers and directors of the PCX 
and PCXE for purposes of and subject to oversight under the Act. 
Under proposed PCXE Rule 14.3(d), Archipelago Exchange LLC and 
Archipelago Holdings LLC would be required to maintain all books and 
records related to the Archipelago Exchange within the United 
States. See Amendment No. 4 to the proposed rule change.

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[[Page 55226]]

B. Trading on ArcaEx

    Equity Trading Permit (``ETP'') Holders \15\ and other users \16\ 
of ArcaEx would be able to submit orders to an electronic file of 
orders, called the ``Arca Book,'' \17\ where trades would be executed 
at prices equal to or better than the national best bid or offer 
(``NBBO''). ArcaEx users could choose to have their unexecuted orders 
left on the Arca Book, returned to them, or routed to other 
markets.\18\ A broker-dealer subsidiary of Archipelago Holdings LLC, 
Wave Securities LLC (``Wave''), would serve as an optional mechanism 
for routing the orders of ArcaEx users to other market centers.\19\ 
ArcaEx users who do not choose to use Wave could establish routing 
arrangements with other providers of order-routing services or use 
their own proprietary routing mechanisms.
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    \15\ See proposed PCXE Rule 1.1(n) (definition of ``ETP 
Holder'').
    \16\ A user is any ETP Holder or sponsored participant who is 
authorized to obtain access to ArcaEx. See proposed PCXE Rule 
1.1(oo).
    \17\ See proposed PCXE Rule 1.1(a) (the Arca Book contains all 
the user's orders in each of the directed order, display order, 
working order and tracking order processes).
    \18\ See proposed PCXE Rule 7.37 (describing ArcaEx's order 
execution processes).
    \19\ As discussed more fully in part IV, infra, Wave would also 
act as an introducing broker and would function as an electronic 
communications network for the limited number of securities that 
would not be eligible to trade on ArcaEx.
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    The Arca Book would feature four trading processes dealing with 
directed orders,\20\ display orders,\21\ working orders,\22\ and 
tracking orders,\23\ respectively. In the directed order process, a 
user could direct an order to a particular market maker, including 
itself.\24\ In the display order and working order processes, orders 
would be ranked and maintained in the Arca Book according to price-time 
priority with displayed orders and prices having priority over 
undisplayed orders, sizes, and prices. In the tracking order process, 
orders that were not filled through the first three processes could be 
matched with tracking orders in accordance with the users' stated 
instructions. Finally, at the customer's option, orders not matched on 
the Arca Book may be routed to a different market center for execution.
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    \20\ See proposed PCXE Rule 7.37(a) (description of ``directed 
order process'').
    \21\ See proposed PCXE Rule 7.37(b)(1) (description of ``display 
order process'').
    \22\ See proposed PCXE Rule 7.37(b)(2) (description of ``working 
order process'').
    \23\ See proposed PCXE Rule 7.37(c) (description of ``tracking 
order process'').
    \24\ But see PCXE Rule 7.43, submitted in Amendment No. 3 to the 
proposed rule change. (A market maker's ability to direct 
proprietary orders to itself would be limited because the practice 
could violate just and equitable principles of trade.)
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1. The Directed Order Process
    Any market or limit order to buy or sell that has been directed to 
a particular market maker is referred to as a ``directed order.'' \25\ 
A market maker would be allowed to submit standing ``directed fill'' 
instructions, including such parameters as the size of the order, the 
price improvement algorithm, the period of time that the instruction is 
effective, and the identity of the users that may send the market maker 
a directed order.\26\ A directed order transaction would not take place 
unless a corresponding directed fill would execute the trade at a 
better price than any displayed order held in the Arca Book and in any 
case at the NBBO or better. Directed orders and directed fills are not 
displayed. Any directed order that is unexecuted or partially executed 
against a directed fill would enter the display order process.
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    \25\ See proposed PCXE Rule 7.31(i). A directed order is defined 
as ``any market or limit order to buy or sell which has been 
directed to a particular market maker by the user.''
    \26\ See proposed PCXE Rule 7.31(j). A directed fill is a limit 
order with (1) a size that is equal to or less than the size of the 
directed order and (2) a price that improves the best bid or offer 
by an automatically preset amount, which must be equal to or greater 
than the minimum price improvement interval, pursuant to a price 
improvement algorithm; provided, however, that the directed fill 
will not be generated if the price is not equal to or better than 
the national best bid or offer.
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2. The Display and Working Order Processes
    All limited price orders \27\ submitted to ArcaEx would be ranked 
and maintained in the display order process or the working order 
process of the Arca Book. Orders in those processes would be ranked 
according to price-time priority such that within each price level all 
orders would be assigned priority according to the time of entry.
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    \27\ A ``limited price order'' is any order with a specified 
price or prices (e.g., limit orders and working orders) other than 
stop orders. See proposed PCXE Rule 1.1(s). Directed orders and 
tracking orders are limited price orders that are not displayed and 
are not handled within the display order process. See proposed PCXE 
Rule 7.31.
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    Users of ArcaEx would be able to submit discretionary orders, 
reserve orders, and all-or-none orders--collectively referred to as 
``working orders''--that have conditional or undisplayed prices and/or 
sizes.\28\ A discretionary order is an order to buy or sell a stated 
amount of a security at a specified, undisplayed price (the 
``discretionary price''), in addition to at a specified, displayed 
price. For example, a user could submit an order to buy 5000 shares of 
XYZ at 20, with discretion to buy at a price up to 20.25. In that case, 
the order is represented at a displayed price of 20, but under 
prescribed conditions the order may be filled partially or completely, 
at any allowable price up to the maximum discretionary price of 20.25.
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    \28\ See proposed PCXE Rule 7.31(h) (definition of ``working 
order'').
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    A reserve order is a limit order with a portion of the size 
displayed and with a reserve portion of the size (the ``reserve size'') 
not displayed on the Arca Book. For example, a user could submit an 
order to buy 5000 shares of XYZ at 20 with a request that 1000 shares 
be displayed. Therefore, the 1000 shares would be displayed and the 
4000 share reserve size would not be displayed until the displayed size 
is exhausted. An all-or-none order is a limit order that is to be 
executed in its entirety or not at all. All-or-none orders would not be 
displayed.
    The display order process would include market orders, limit 
orders, and limit orders entered by market makers, known as ``Q 
orders.'' \29\ In addition, the display order process includes the 
displayed portions of discretionary orders and reserve orders. 
Discretionary orders would be ranked in the display order process based 
on the displayed price and the time of order entry. If a discretionary 
order were decremented, it would remain ranked based on the displayed 
price and the time of original order entry. The displayed portion of 
reserve orders would be ranked in the display order process at the 
specified limit price and the time of order entry.
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    \29\ See proposed PCXE Rule 7.31(k) (definition of ``Q order''). 
A Q order may not be a working order.
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    All-or-none orders and the undisplayed portion of discretionary 
orders and reserve orders would be ranked in the working order process. 
Discretionary orders would be ranked in the working order process based 
on the displayed price and the time of original order entry. If a 
discretionary order were decremented, it would retain its standing in 
order priority. The reserve portion of reserve orders would be ranked 
in the working order process based on the specified limit price and the 
time of original order entry. If the displayed portion of the reserve 
order were exhausted, the displayed portion of the reserve order would 
be refreshed from the reserve portion at the original displayed amount, 
and would be submitted and ranked at the specified limit price and at 
the new time that the displayed portion of the order was refreshed. 
After the displayed portion of a reserve order is refreshed from the 
reserve portion, the reserve portion

[[Page 55227]]

would remain ranked based on the original time of order entry, while 
the displayed portion would be sent to the display order process with a 
new time stamp. All-or-none orders would be ranked in the working order 
process based on the specified limit price and the time of order entry.
3. Examples
    The PCX offers the following example to clarify how orders would be 
ranked in the display and working order processes. Suppose that users 
submit the following orders to ArcaEx:

10:00 a.m.--Order A--Limit order to buy 1000 XYZ at 20
10:01 a.m.--Order B--Reserve order to buy 5000 XYZ at 20 (show 1000)
10:02 a.m.--Order C--Limit order to buy 500 XYZ at 20
10:03 a.m.--Order D--Discretionary order to buy 5000 XYZ at 20 
(discretion to 20.25)
10:04 a.m.--Order E--All-or-none to buy 1500 XYZ at 20
10:05 a.m.--Order F--Q order to buy 1000 XYZ at 20
10:06 a.m.--Order G--Limit order to buy 700 XYZ at 20
10:07 a.m.--Order H-Q order to buy 500 XYZ at 20
10:08 a.m.--Order I--Discretionary order to buy 10,000 XYZ at 20 
(discretion to 20.25)

    In the display order process, Orders A-H would be ranked in the 
Arca Book in the following order:
    (1) Order A;
    (2) Order B1 (the displayed 1000 shares of Order B);
    (3) Order C;
    (4) Order D1 (the displayed price of 20 for Order D);
    (5) Order F;
    (6) Order G;
    (7) Order H; and
    (8) Order I1 (the displayed price of 20 for Order I).
    In the working order process, the orders would be ranked in the 
Arca book in the following order:
    (1) Order B2 (4000 shares of the reserve portion of Order B);
    (2) Order D2 (the discretionary price up to 20.25 for Order D);
    (3) Order E; and
    (4) Order I2 (the discretionary price up to 20.25 for Order I).
4. The Tracking Order Process
    If an order has not been executed in its entirety after progressing 
through the directed order, display order, and working order processes, 
the order (or the remaining portion of the order) would enter the 
tracking order process. An incoming order may be matched to tracking 
orders held in the tracking order process in accordance with a user's 
set parameters, such as maximum aggregate size, maximum tradeable size, 
and the price in relation to the NBBO. Once a user has entered the 
parameters of a tracking order, the parameters may not be changed.\30\ 
Like a directed fill, a tracking order would be executed only at the 
NBBO or better. Tracking orders are not displayed.
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    \30\ The instructions would remain in effect until the user's 
aggregate size limit were achieved or the day's trading session 
ended. See proposed PCXE Rule 7.31(f) (description of tracking 
orders).
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C. Early, Core, and Late Trading Sessions

    ArcaEx would maintain three sessions each trading day: the opening 
session, the core trading session, and the late trading session.\31\ 
The opening session would begin at 5:00 a.m. (Pacific Time) with an 
opening auction in which only limited price orders would be eligible. 
The opening session would conclude with a market order auction in which 
both market and limited price orders would be eligible. The market 
order auction would begin at 6:30 a.m. (Pacific Time). The core trading 
session would begin for each security at 6:30 a.m. (Pacific Time) or at 
the conclusion of the market order auction for such security, whichever 
comes later, and conclude at 1:00 p.m. (Pacific Time). The late trading 
session would begin after the conclusion of the core trading session 
and conclude at 5:00 p.m. (Pacific Time).
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    \31\ See proposed PCXE Rule 7.34 (description of ``trading 
sessions'').
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    Market makers have certain obligations in the market order auction 
and core trading session. A market maker would be required to enter at 
least one ``cleanup order'' for each security in which it is registered 
for each market order auction.\32\ When trading in the core session 
begins, market makers would be obligated to enter and maintain 
continuous, two-sided limit orders (i.e., Q orders) in the securities 
in which they are registered. The directed order process and the 
tracking order process would not be available during the opening and 
late sessions. Market orders would be available during the core trading 
session, would not be available during the late trading session, and 
would be available only for the market order auction during the opening 
trading session.
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    \32\ See proposed PCXE Rule 7.31(u) (description of ``cleanup 
orders'').
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    For each day order entered into ArcaEx, the entering user would 
have to designate the trading sessions for which the order would be in 
effect. Any good-til-cancelled order entered into ArcaEx would be in 
effect only during core trading sessions unless the entering user 
specifically instructs otherwise.

III. Comments Received

    The Commission received twelve comment letters from nine 
commenters.\33\ A majority of the commenters supported the 
proposal.\34\ Two commenters that operate electronic markets, the 
Arizona Stock Exchange (``AZX'') and the Cincinnati Stock Exchange, 
stated that the proposal would benefit market participants, including 
retail investors, by bringing innovation and increased competition to 
the securities markets.\35\ In particular, the AZX stated its support 
for the proposed auction method and sophisticated electronic 
surveillance capabilities.
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    \33\ See note 4, supra.
    \34\ NASD Regulation Inc. submitted a letter that neither 
supported nor opposed the proposal but urged the Commission to 
consider the regulatory relationship between any new exchange and 
existing self-regulatory organizations. See NASD Regulation Letter, 
supra note 4.
    \35\ See AZX Letter and CSE Letter, supra note 4.
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    Several PCXE members expressed strong support for the proposal and 
encouraged the Commission to expedite the approval process. D.A. 
Davidson & Co. stated its intention to participate on ArcaEx as both a 
market maker and a retail order flow provider, and noted that the 
proposal will ``create a new national marketplace which will level the 
playing field for all participants.'' \36\ Two commenters, the Los 
Angeles Specialists Association (``LASA'') and the San Francisco 
Specialists Association (``SFSA''), strongly supported replacing the 
PCX's physical trading floor with the fully electronic order execution 
facility. LASA and SFSA believe that all investors would have equal 
access to information and would benefit from immediate electronic 
executions, possible price improvement, and anonymity on ArcaEx.\37\ 
Further, in offering their strong support for the proposal, LASA and 
SFSA cited the proposed regulatory structure and ArcaEx's unique order 
execution algorithm, sophisticated order routing mechanism, and ability 
to attract corporate issuers.
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    \36\ See D.A. Davison Letter, supra note 4.
    \37\ See LASA Letter and SFSA Letter, supra note 4.
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    In contrast, three commenters submitted a total of five letters 
opposing the proposal.\38\ The Philadelphia Stock Exchange, Inc. 
(``Phlx'') stated that the

[[Page 55228]]

proposal was inconsistent with section 11(a) of the Act because public 
customer agency orders would not have priority over broker-dealer 
proprietary orders.\39\ In support of this position, the Phlx argued 
that broker-dealers would have an informational advantage over public 
customers even though transactions would take place on a fully 
electronic system as opposed to a physical trading floor. The Phlx 
argued that the Commission should condition approval of the proposal on 
the requirement that customer orders be given priority.
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    \38\ See Phlx Letter, Knight Letter 1, and Nasdaq Letter 2, 
supra note 4; Knight Letter 2, and Nasdaq Letter 3, supra note 6.
    \39\ See Phlx Letter, supra note 4; see also discussion in Part 
IV.D., infra. The Commission notes that proposed PCXE Rule 6.16(a) 
would prohibit ETP Holders from trading ahead of their customer 
limit orders.
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    The Nasdaq Stock Market, Inc. (``Nasdaq'') submitted two letters 
opposing the proposal.\40\ Nasdaq argued that, by seeking approval for 
ArcaEx as a facility of PCXE through the rule filing process under 
section 19 of the Act, the PCX and ArcaEx have improperly circumvented 
the exchange registration process. In Nasdaq's view, the PCX should 
obtain a controlling ownership interest in Archipelago Holdings LLC or 
ArcaEx should seek registration as a national securities exchange under 
section 6 of the Act. Taking note that the PCX previously regulated a 
competing specialist system, Nasdaq asserted that the PCX's regulatory 
structure was insufficient for regulating a competing dealer market. 
Nasdaq also questioned whether the proposal would ensure an adequate 
audit trail with respect to trading in Nasdaq securities.
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    \40\ See Nasdaq Letter 2, supra note 4; Nasdaq Letter 3, supra 
note 6. In Nasdaq Letter 1, Nasdaq requested that the Commission 
extend the period for comment on the proposal as amended by 
Amendment No. 1. See Nasdaq Letter 1, supra note 4.
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    Nasdaq also believes that an exchange is statutorily obligated to 
guarantee liquidity in its marketplace. Noting that there is no 
requirement under the proposal that a market maker be assigned to every 
ArcaEx security, Nasdaq asserted that the PCX would be unable to 
guarantee liquidity in its marketplace. Nasdaq also raised concerns 
with respect to ArcaEx's integration into the national market system, 
and contended that the requirement that users enter into a routing 
agreement raised best execution issues and could amount to a denial of 
access.
    Knight Trading Group, Inc. (``Knight'') questioned whether the PCX 
plans to impose fees on market participants that trade Nasdaq/NM 
securities admitted to unlisted trading privileges on ArcaEx, and 
asserted that expanding trading in the over-the-counter market 
potentially could place Nasdaq market makers that are not ETP Holders 
at a competitive disadvantage and disrupt the Nasdaq market.\41\ In 
Knight's view, the proposal would provide an opportunity for Nasdaq 
securities to trade on ArcaEx through the OTC-UTP Plan \42\ to the 
detriment of Nasdaq market makers.\43\
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    \41\ See Knight Letter 1, supra note 4; Knight Letter 2, supra 
note 6. The Commission notes that the PCX intends to submit a 
separate filing pursuant to Section 19(b) of the Act to establish 
its fees.
    \42\ See Joint Self-Regulatory Organization Plan Governing the 
Collection, Consolidation and Dissemination of Quotation and 
Transaction Information for Exchange-listed Nasdaq/National Market 
System Securities and for Nasdaq/National Market System Securities 
Traded on Exchanges on an Unlisted Trading Privilege Basis (``OTC-
UTP Plan''). Securities Exchange Act Release No. 24407 (April 29, 
1987), 52 FR 17349 (May 7, 1987). See also Securities Exchange Act 
Release No. 36985 (March 18, 1996), 61 FR 12122 (March 25, 1996).
    \43\ To the extent that Knight's concerns relate to the 
potential expansion of the OTC/UTP Plan, those issues are more 
appropriately addressed in the context of the pending proposal to 
expand the OTC/UTP Plan, which has been noticed for public comment. 
See Securities Exchange Act Release No. 44822 (September 20, 2001), 
66 FR 50226 (October 2, 2001).
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    The PCX submitted three letters in response to the comments.\44\ 
The PCX reiterated its belief that ArcaEx should properly be regulated 
as a facility of an exchange, and asserted that regulating ArcaEx as a 
facility is consistent with the Commission's regulation of facilities 
operated by other exchanges. Furthermore, the PCX stated that the 
relationship between the PCX and ArcaEx satisfies the regulatory 
requirements of the Act.
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    \44\ See letters from Cherie L. Macauley, Wilmer, Cutler & 
Pickering, to John Polise, Senior Special Counsel, Division, 
Commission dated February 26, 2001 (``PCX Response 1''), April 19, 
2001 (``PCX Response 2''), and August 3, 2001 (``PCX Response 3'').
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    In response to Nasdaq concerns about ArcaEx's integration into the 
national market system, particularly the Intermarket Trading System 
(``ITS''), the PCX stated that it intends to comply with the national 
market system plans in connection with the operation of ArcaEx. 
Consistent with the terms of the ITS Plan, the PCX will not charge fees 
to non-members using ITS to access ArcaEx.\45\ With regard to the 
concerns that commenters raised about the PCX's ability to conduct 
adequate surveillance of ArcaEx, the PCX argued that it has ``not only 
the technological capability to establish and maintain an audit trail, 
but also the staff expertise and capital resources to satisfactorily 
oversee a new electronic market trading an increased number of 
securities.''\46\ The PCX represents that it will implement a state-of-
the-art electronic audit trail system.\47\
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    \45\ The ITS Plan was designed to facilitate intermarket trading 
in exchange-listed equity securities based on current quotation 
information emanating from the linked markets. See Securities 
Exchange Act Release No. 19456 (January 27, 1983), 48 FR 4938 
(February 3, 1983).
    \46\ See PCX Response 1 and PCX Response 2.
    \47\ See PCX Response 2.
---------------------------------------------------------------------------

    In response to Nasdaq's concerns with respect to liquidity, the PCX 
stated that the Act does not specifically require that a market maker 
be assigned to each security traded on an exchange. Moreover, the PCX 
asserted that under the Commission's new regulatory framework for 
exchanges, liquidity provided by a market maker is not an essential 
element of an exchange.
    Comments also questioned the proposed use of discretionary orders 
and the role of Wave on the ArcaEx. In particular, Nasdaq expressed the 
view that the use of discretionary orders would violate Rule 11Ac1-1 
\48\ and that Wave, the broker-dealer subsidiary of Archipelago 
Holdings LLC, should be regulated as a facility of the PCX. More 
detailed summaries of those comments and the PCX's responses to them 
are included in part IV, infra.
---------------------------------------------------------------------------

    \48\ 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------

IV. Discussion

    After careful review and consideration of the comments, the 
Commission finds, for the reasons discussed below, that the ArcaEx 
proposal is consistent with the requirements of the Act and the rules 
and regulations thereunder applicable to the PCX.
    The Commission historically has encouraged exchanges to integrate 
new data communications and trade execution mechanisms into their 
marketplaces in order to further these goals of the national market 
system. In recent years, for example, the Commission's Order Handling 
Rules \49\ and Regulation ATS \50\ sought to bring alternative trading 
systems (``ATSs''), including electronic communications networks 
(``ECNs''), into the framework of the national market system. In 
addition, the Commission approved the Nasdaq SuperMontage,\51\ NYSE 
Direct+,\52\ the application of the

[[Page 55229]]

International Securities Exchange to become an all-electronic national 
securities exchange,\53\ and the proposals of the PCX and the NASD to 
implement trading facilities using applications of the OptiMark 
System.\54\
---------------------------------------------------------------------------

    \49\ See Securities Exchange Act Release No. 37619A (September 
6, 1996), 61 FR 48290 (September 12, 1996) (``Order Handling 
Rules'').
    \50\ See Securities Exchange Act Release No. 40760 (December 8, 
1998), 63 FR 70844 (December 22, 1998) (``ATS Release''). Generally, 
the ATS Release established a new regulatory framework that gives 
securities markets the choice to register as exchanges or as broker 
dealers, and also provided guidance to those markets that wished to 
register as national securities exchanges.
    \51\ See Securities Exchange Act Release No. 43863, (January 19, 
2001), 66 FR 8020 (January 26, 2001) (Order approving the Nasdaq 
SuperMontage).
    \52\ Securities Exchange Act Release No. 43767 (December 22, 
2000), 66 FR 834 (January 4, 2001) (Order approving NYSE Direct+).
    \53\ See Securities Exchange Act Release No. 42455 (February 24, 
2000), 65 FR 11388 (March 2, 2000) (File No. 10-127).
    \54\ See Securities Exchange Act Release No. 39086 (September 
17, 1997), 62 FR 50036 (September 24, 1997) (SR-PCX-97-18); 
Securities Exchange Act Release No. 41967 (September 30, 1999), 64 
FR 54704 (October 7, 1999) (SR-NASD-98-85).
---------------------------------------------------------------------------

    In proposing to establish ArcaEx as the equities trading facility 
of the PCXE, the PCX has sought to replace its floor trading model with 
a sophisticated electronic trading system. In the Commission's view, 
the proposed ArcaEx facility would provide a new and technologically 
advanced way for trading interest to be matched and orders to be 
executed on the PCX. The Commission believes that, if the ArcaEx 
facility is able to attract new market participants and to increase 
order flow to the PCX, the facility could promote greater competition 
among market centers. In particular, the novel features of the ArcaEx 
facility may enable retail customers and institutional investors to 
come together in a new marketplace. For example, institutional 
investors may be able to use working orders in the ArcaEx facility to 
represent their trading interest more completely than is currently 
feasible in other electronic auction facilities.\55\ If the ArcaEx 
facility succeeds in attracting more order flow to the PCX, the PCX may 
begin to serve as a greater source of liquidity for investors.
---------------------------------------------------------------------------

    \55\ The PCX has represented that the ArcaEx displayed portion 
of the Arca Book will be available to the public in real time via 
the Archipelago internet web site.
---------------------------------------------------------------------------

    In publishing notice of the PCX's proposal, the Commission invited 
public comment on several important issues and received a number of 
well-reasoned comment letters that broadly criticized both the form and 
the function of the proposed ArcaEx facility. The major comments are 
discussed below.

A. ArcaEx Is an Equities Trading Facility of the PCX

    The Commission believes that the PCX's proposal for ArcaEx to 
become its facility is properly filed under section 19(b)(1) of the 
Act,\56\ and that it is not necessary for ArcaEx to register as a 
national securities exchange independent of the PCX under section 6(a) 
of the Act.\57\ Section 19(b)(1) of the Act \58\ requires that every 
self-regulatory organization (``SRO'') file with the Commission copies 
of any proposed rule or any proposed change to its rules, accompanied 
by a concise general statement of the basis and purpose of the proposed 
rule change. The Commission is required to publish notice of the filing 
of a proposed rule change and to give interested persons an opportunity 
to submit written data, views, and arguments. Section 19(b)(2) of the 
Act \59\ provides that the Commission shall approve an SRO's proposed 
rule change if it is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to the SRO, or 
disapprove the proposed rule change if the Commission does not make 
such a finding. In the Commission's view, the PCX's proposal to 
establish ArcaEx as an exchange facility is consistent with the Act, as 
well as with previous proposals of national securities exchanges filed 
under section 19(b) of the Act \60\ to use the personnel and equipment 
of third parties to operate trading platforms.\61\
---------------------------------------------------------------------------

    \56\ 15 U.S.C. 78s(b)(1).
    \57\ 15 U.S.C. 78f(a).
    \58\ 15 U.S.C. 78s(b)(1).
    \59\ 15 U.S.C. 78s(b)(2).
    \60\ 15 U.S.C. 78s(b).
    \61\ See, e.g., Securities Exchange Act Release No. 41210 
(March. 24, 1999), 64 FR 15857 (April 1, 1999) (approval of Phlx's 
VWAP Trading System); Securities Exchange Act Release No. 39086 
(September 17, 1997), 62 FR 50036 (September 24, 1997) (approval of 
PCX's Application of the OptiMark System). See also Securities 
Exchange Act Release No. 41967 (September 30, 1999), 64 FR 54704 
(October 7, 1999) (approval of Nasdaq Application of OptiMark 
System); Securities Exchange Act Release No. 35030 (November 30, 
1994), 59 FR 63141 (December 7, 1999) (approval of Chicago Match 
System).
---------------------------------------------------------------------------

    The Commission notes that PCXE rules will govern the operation of 
the ArcaEx facility. PCXE is a wholly-owned subsidiary of the PCX, 
which is a national securities exchange registered under section 6 of 
the Act.\62\ The PCX, as the SRO, retains ultimate responsibility for 
its members' compliance with the provisions of the Act and the rules 
and regulations thereunder. In particular, the PCX must approve any 
changes to the rules and governing documents of PCXE. Moreover, the PCX 
must file changes to PCXE's bylaws and rules with the Commission 
pursuant to section 19(b) of the Act \63\ and Rule 19b-4,\64\ including 
any rules relating to its facilities.
---------------------------------------------------------------------------

    \62\ 15 U.S.C. 78f.
    \63\ 15 U.S.C. 78s(b).
    \64\ 17 CFR 240.19b-4.
---------------------------------------------------------------------------

    In short, as a facility of the PCX, ArcaEx falls under the PCX's 
self-regulatory authority. In this regard, ``the PCX will be fully 
responsible for all activity that takes place through ArcaEx, including 
its regulation and oversight, because ArcaEx is a part of the 
Exchange.'' \65\ Although the PCX has delegated to PCXE the authority 
to administer and manage the PCX's equities trading function, the PCX 
retains the ultimate responsibility for the operation, administration, 
rules, and regulation of PCXE.\66\ The PCX must review rulemaking and 
disciplinary decisions of PCXE and direct PCXE to take action that may 
be necessary to effectuate the purposes and functions of the Act.
---------------------------------------------------------------------------

    \65\ PCX Response 2 at p. 5.
    \66\ See PCXE Rule 14.
---------------------------------------------------------------------------

    ArcaEx would also be subject to Commission oversight and 
examination as a facility of the PCX. The Commission would oversee the 
premises, personnel, and records of ArcaEx to the same extent that it 
currently oversees the premises, personnel, and records of the PCX. 
Proposed PCXE Rule 14.3(a) states:

    The books, records, premises, officers, directors, agents, and 
employees of Archipelago Exchange LLC shall be deemed to be the 
books, records, premises, officers, directors, agents, and employees 
of PCX and PCX Equities for purposes of and subject to oversight 
pursuant to the Securities Exchange Act. The books and records of 
Archipelago Exchange LLC shall be subject at all times to inspection 
and copying by the PCX, PCX Equities and the SEC.

    Similarly, proposed PCXE Rule 14.3(b) states that ``[a]ll officers 
and directors of Archipelago Holdings LLC shall be deemed to be 
officers and directors of PCX and PCX Equities for purposes of and 
subject to oversight pursuant to the Securities Exchange Act.'' \67\ 
Under proposed PCXE Rule 14.3(d), Archipelago Exchange LLC and 
Archipelago Holdings LLC must maintain all books and records related to 
ArcaEx within the United States.\68\ The Commission believes that these 
provisions would adequately enable its oversight of the ArcaEx 
facility.
---------------------------------------------------------------------------

    \67\ The PCX has represented, and the staff has confirmed, that 
the provisions of proposed PCXE Rule 14.3 are included in the 
contractual agreements between PCX and Archipelago Holdings LLC. See 
PCX Response 2 at p. 6.
    \68\ See Amendment No. 4 to the proposed rule change.
---------------------------------------------------------------------------

    The Commission also believes that the PCX's proposal is designed to 
provide for the rigorous regulatory oversight that the Act requires. 
Under the proposal, the PCX would use its own regulatory staff, and not 
the employees of Archipelago Holdings LLC or Archipelago Exchange LLC, 
to perform its regulatory oversight duties. In addition, the PCX would 
maintain a full audit trail and would conduct all necessary 
surveillance of the trading

[[Page 55230]]

effected through the ArcaEx facility. The PCX would also be required to 
comply with the Commission's Automation Review Policy, which requires, 
among other things, that the PCX ensure that ArcaEx has ``the capacity 
to accommodate current and reasonably anticipated future trading volume 
levels adequately and to respond to localized emergency conditions.'' 
\69\
---------------------------------------------------------------------------

    \69\ See Securities Exchange Act Release No. 27445 (November 16, 
1989), 54 FR 48703, 48705-06 (November 24, 1989); see also 
Securities Exchange Act Release No. 29185 (May 9, 1991), 56 FR 22490 
(May 15, 1991).
---------------------------------------------------------------------------

    The Commission believes that the PCX possesses the technological 
capability to develop and maintain a proper audit trail with respect to 
ArcaEx and the staff expertise and capital resources properly to 
oversee the new ArcaEx electronic marketplace.\70\ In addition, the PCX 
has agreed that: \71\
---------------------------------------------------------------------------

    \70\ The Commission notes that the PCX has regulated both a 
traditional trading floor as well as the OptiMark electronic trading 
facility.
    \71\ Letter from Katherine Beck, Senior Vice President and 
Special Counsel, PCX, to Jonathan G. Katz, Secretary, Commission, 
dated October 24, 2001.

     The PCX will demonstrate to the satisfaction of the 
Commission's staff that it has adequate surveillance programs and 
procedures in place to monitor trading on the ArcaEx facility;\72\ 
and
---------------------------------------------------------------------------

    \72\ The Commission notes that, as matter of Commission policy, 
surveillance programs and procedures are generally kept 
confidential. The Commission believes that disclosure of specific 
surveillance procedures could provide information that market 
participants could use to circumvent regulatory oversight.
---------------------------------------------------------------------------

     Prior to the start of trading on the ArcaEx facility, 
the PCX will demonstrate that the development and capabilities of 
its systems satisfy the Commission's Automation Review Policy 
(``ARP''); i.e., that it has adequate computer system capacity, 
integrity and security to support its operation. In particular, PCX 
should continue to provide to Commission staff the results of 
testing ArcaEx trading system functionality, external market 
interfaces, and capacity, fail-over testing to the alternate data 
center, and mock trade testing with member firms.

    Based on the foregoing, including the PCX's agreement with respect 
to surveillance and compliance with ARP, the Commission believes that 
the relevant regulatory objectives of the Act have been satisfied, and 
that the PCX's submission of the proposal under section 19(b) of the 
Act \73\ is appropriate.
---------------------------------------------------------------------------

    \73\ 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

    Nasdaq suggests that, because the PCX has filed a proposed rule 
change to establish ArcaEx as its facility, the proposal will receive 
less rigorous scrutiny than if Archipelago Holdings LLC had filed a 
Form 1 \74\ to establish ArcaEx as a national securities exchange. The 
Commission notes that its publication of notice and solicitation of 
comments on the ArcaEx proposal would have been no different in the 
Form 1 process than it was in the rule filing process. Indeed, 
recognizing that the ArcaEx proposal is unique, the Commission has 
given the public ample opportunity to comment on a market structure 
initiative of this magnitude. The proposal was formally filed on July 
31, 2000, and has been amended five times. The proposal has twice been 
the subject of notices in the Federal Register. In the many months that 
the proposal has been in the public domain, interested persons, 
including other SROs, broker-dealers, investors, and other market 
participants, have submitted substantial, meaningful comments on the 
proposal.\75\ The Commission believes that the public has had an 
adequate opportunity, pursuant to section 19(b) of the Act, to 
scrutinize the proposal and submit comments.
---------------------------------------------------------------------------

    \74\ See 17 CFR 249.1.
    \75\ A complete description of the rule filing, as well as such 
documents as the Equity Trading Permit Application, the Wave Routing 
Agreement, and other contracts for ArcaEx users, have also been 
available to the public via the internet. See http//
www.tradearca.com/exchange, visited on August 21, 2001.
---------------------------------------------------------------------------

    Finally, the Commission notes that, as a national registered 
exchange, the PCX is required to file an amendment to its Form 1 to 
reflect the agreement relating to the operation of ArcaEx, including a 
description of its affiliations with other parties, information 
describing the reporting, clearance, or settlement of transactions in 
connection with the operations of the facility, and a copy of existing 
by-laws or corresponding rules and instruments.\76\
---------------------------------------------------------------------------

    \76\ See Rule 6a-2, 17 CFR 240.6a-2; see also Form 1, 17 CFR 
249.1.
---------------------------------------------------------------------------

B. A Market Maker Is Not Required for Every Security Traded on ArcaEx

    Broker-dealers that register as market makers on ArcaEx would be 
required to maintain two-sided quotes, and would thereby provide a 
source of liquidity to the ArcaEx marketplace. Although the PCX 
believes that broker-dealers will make markets in many securities 
traded on ArcaEx, the proposed PCXE rules allow securities to be traded 
on ArcaEx without a registered market maker.
    Nasdaq argues that PCX's failure to require a market maker in every 
security is a ``clear statutory deficiency.'' In Nasdaq's view, the 
``most fundamental requirement'' of an exchange is to provide a ``ready 
source of liquidity,'' and therefore a market maker or specialist must 
be assigned to each security listed on an exchange.\77\
---------------------------------------------------------------------------

    \77\ Nasdaq Letter 2 at p.10.
---------------------------------------------------------------------------

    In the ATS Release,\78\ the Commission specifically addressed the 
question whether the Act requires an exchange to guarantee liquidity in 
its marketplace. The Commission stated that, although traditional 
exchanges provide liquidity through two-sided quotations and therefore 
raise an expectation of execution at the quoted price, modern 
technology now enables market participants and investors to tap 
simultaneous and multiple sources of liquidity from remote locations. 
Significantly, the Commission rejected the suggestion that a guaranteed 
source of liquidity was a necessary component of an exchange.\79\ The 
Commission notes that, although market makers could be important 
sources of liquidity on the ArcaEx, they would not be the sole source. 
In particular, the Arca Book is specifically designed to match the 
buying and selling interest of all users of ArcaEx. ArcaEx is not 
required to ensure that a market maker is registered in every PCXE 
security in order to be the core exchange facility of PCXE.\80\
---------------------------------------------------------------------------

    \78\ Securities Exchange Act Release No. 40760 (December 8, 
1998), 63 FR 70844 (December 22, 1998).
    \79\ ATS Release, 63 FR at 70898; see also Section 3(a)(1) of 
the Act, 15 U.S.C. 78c(a)(1), and Rule 3b-16, 17 CFR 240.3b-16 
(definition of ``exchange'').
    \80\ The Commission notes that, under the previous PCX equities 
trading rules, securities that were not traded with sufficient 
frequency to warrant the attention of a specialist were nonetheless 
traded on the PCX pursuant to ``cabinet trading programs.'' See PCX 
Rule 7.20. With cabinet trading, buy and sell limit orders are 
booked for execution on the exchange and executed outside the 
regular specialist or market maker system. See also Section 
11A(a)(1)(C) of the Act, 15 U.S.C. 78k-1(a)(1)(C) (opportunity for 
investors' orders to be executed without the participation of a 
dealer).
---------------------------------------------------------------------------

C. Discretionary Orders Under the Quote Rule

1. The Discretionary Order Type
    As discussed in part II, above, a user of ArcaEx would be able to 
submit a type of order called a discretionary order, which is an order 
to buy or sell a stated amount of a security at a specified, 
undisplayed price as well as at a specified, displayed price.\81\ A 
non-marketable discretionary order would be displayed to all users at 
the displayed price, but the discretionary prices of the order would 
not be displayed. The undisplayed prices of a discretionary order would 
be represented in the working order process and could be matched with 
orders on the other side of the market under prescribed conditions.\82\ 
The PCX believes that, because the discretionary order type

[[Page 55231]]

allows a user to represent a single order at multiple price points, 
investors would be able to express their trading interest more 
accurately than is possible with traditional order types. In this way, 
according to the PCX, ArcaEx would replicate the dynamics of a floor 
trading model in an electronic environment.
---------------------------------------------------------------------------

    \81\ See proposed PCXE Rule 7.31(h)(2) (definition of 
``discretionary order'').
    \82\ See proposed PCXE Rule 7.37 (description of ArcaEx order 
execution process).
---------------------------------------------------------------------------

2. The Quote Rule
    In its comment letters, Nasdaq questioned whether ArcaEx's 
discretionary orders comply with the Commission's ``Quote Rule,'' Rule 
11Ac1-1 under the Act.\83\ The Quote Rule requires exchanges to collect 
bids, offers, quotation sizes, and aggregate quotation sizes from 
``responsible brokers or dealers'' and to make the best prices and 
aggregate quotation sizes available to quotation vendors.\84\ In 
addition, responsible brokers and dealers must promptly communicate 
their best bids, offers, and quotation sizes to their exchange and be 
firm for their published bids and offers in any amount up to their 
published quotation sizes.\85\
---------------------------------------------------------------------------

    \83\ Nasdaq Letter 2 at p.11.
    \84\ Subsection (a)(21)(i) of the Quote Rule defines the term 
``responsible broker or dealer'' to mean: ``When used with respect 
to bids or offers communicated on an exchange, any member of such 
exchange who communicates to another member on such exchange, at the 
location (or locations) designated by such exchange for trading in a 
covered security, a bid or offer for such covered security, as 
either principal or agent * * *'' Rule 11Ac1-1(a)(21)(i).
    \85\ Rule 11Ac1-1(c).
---------------------------------------------------------------------------

    The Quote Rule applies only to trading interest among brokers and 
dealers that falls within the definition of a bid or an offer. 
Specifically, the Quote Rule defines ``bid'' and ``offer'' as the ``bid 
price and the offer price communicated by an exchange member or OTC 
market maker to any broker or dealer, or to any customer, at which it 
is willing to buy or sell one or more round lots of a covered security, 
as either principal or agent, but shall not include indications of 
interest.''\86\ Therefore, a responsible broker or dealer must do more 
than simply indicate its interest in trading; it must affirmatively 
communicate its intentions to at least one other potential counter-
party in the form of a cognizable bid or an offer in order to come 
under the Quote Rule.
---------------------------------------------------------------------------

    \86\ Rule 11Ac1-1(a)(4) (emphasis added).
---------------------------------------------------------------------------

    In response to these concerns, the PCX argues that discretionary 
orders comply with both the letter and the spirit of the Quote Rule. 
First, the PCX argues that discretionary orders are consistent with the 
Quote Rule because the discretionary prices are communicated only to 
the exchange and not to another counter-party.\87\ The essence of this 
argument is that the discretionary price of the discretionary order is 
not displayed, it is not communicated to another member or customer, 
and therefore that price does not qualify as a ``bid'' or an ``offer.'' 
Second, the PCX argues that undisplayed, discretionary prices represent 
``inchoate trading interest,'' and are therefore excluded from the 
Quote Rule's definition of bid and offer as ``indications of 
interest.'' In this regard, the PCX contends that discretionary orders 
are analogous to OptiMark Profiles, a feature of the PCX's former 
OptiMark equities trading facility.\88\
---------------------------------------------------------------------------

    \87\ The Commission solicited comments as to whether 
discretionary orders on ArcaEx are consistent with the Quote Rule. 
Nasdaq opposed discretionary orders but provided no analysis to 
support the position.
    \88\ See Securities Exchange Act Release No. 39086 (September 
17, 1997), 62 FR 50036 (September 23, 1997). The Commission does not 
believe that the undisplayed prices of discretionary orders can 
properly be characterized as ``indications of interest.'' Unlike 
OptiMark Profiles, the undisplayed portion of a discretionary order 
would depend upon a publicly displayed price to establish its 
priority and standing within the ArcaEx system. Moreover, as the 
rules of the ArcaEx facility require both the displayed and the 
undisplayed portions of discretionary orders to be firm, a 
compatible incoming limit order would be automatically executed 
against the discretionary price imbedded in a discretionary order.
---------------------------------------------------------------------------

3. Analysis of Discretionary Orders
    The Commission is not persuaded by Nasdaq's assertion that 
discretionary orders would violate the Quote Rule. Although the 
Commission recognizes that discretionary orders raise novel issues 
under the Quote Rule, the Commission does not believe that it would be 
in the best interests of the national market system or the protection 
of investors to prohibit the use of discretionary orders on ArcaEx. In 
the Commission's view, discretionary orders may represent a positive 
development for equities trading in an electronic exchange environment. 
The Commission believes that the discretionary order type, for example, 
might enable an institution to express its trading interest more fully 
than otherwise would be the case, in a single order covering multiple 
prices. This in turn could give other investors, both individual and 
institutional, an opportunity to interact more easily with such orders. 
In this regard, discretionary orders may give retail investors access 
to price improvement that previously has not been available in 
automated trading systems.\89\
---------------------------------------------------------------------------

    \89\ The Commission notes that the ATS Release recognized the 
value of conditional orders, and expressly allowed ATSs to continue 
using reserve size orders, negotiation features, and other similar 
conditional orders. See Securities Exchange Act Release No. 40760 
(December 8, 1998), 63 FR 70844, 70866 (December 22, 1998).
---------------------------------------------------------------------------

    In addition, one of the Commission's goals is to encourage ``the 
deepest, most liquid markets possible.''\90\ In the Commission's view, 
by providing investors with greater flexibility in the expression of 
their trading interest, discretionary orders may encourage greater 
investor participation on the PCX, which, in turn, may increase the 
depth and liquidity of the securities markets.\91\
---------------------------------------------------------------------------

    \90\ Securities Exchange Act Release No. 43084 (July 28, 2000), 
65 FR 48406, 48407 (August 8, 2000) (``Disclosure of Order Routing 
and Execution Practices'').
    \91\ Cf. Securities Exchange Act Release No. 42344 (January 14, 
2000), 65 FR 3987, 3995 (January 25, 2000) (stating that increased 
participation in the Nasdaq National Market Execution System, as a 
result of the attractiveness of reserve orders for large investors, 
should enhance the depth and liquidity of the market for Nasdaq 
National Market securities to the benefit of all market 
participants).
---------------------------------------------------------------------------

    The Commission notes, moreover, that near equivalents to 
discretionary orders already exist on our national exchanges. For 
example, specialists at the New York Stock Exchange (``NYSE'') 
routinely accept ``percentage orders,'' in which the specialist follows 
instructions to match bids and offers up to a described limit but 
ordinarily does not display that limit, and floor brokers on the NYSE 
work orders with varying degrees of discretion that may be partially 
converted to displayed bids or offers within an allowed range.\92\ In 
short, the functional equivalents of discretionary orders are being 
employed at other national securities exchanges today.
---------------------------------------------------------------------------

    \92\ Discretionary orders may also resemble certain trading 
practices on regional exchanges, where regional specialists display 
one set of quotes while guaranteeing their customers more favorable 
order executions at the NBBO or better, which they do not display. 
See, e.g., CHX Rule 37(a). The Commission historically has not 
determined that the order guarantees of regional specialists violate 
the Quote Rule.
---------------------------------------------------------------------------

    After carefully considering the advantages and disadvantages of 
discretionary orders, the Commission has concluded that discretionary 
orders are consistent with the Quote Rule. Because discretionary orders 
as applied on ArcaEx would represent a novel order type, however, the 
Commission believes that it would be useful to monitor their 
application in a live trading environment. The PCX has agreed to 
provide specific information to the Commission's staff with respect to 
the use of discretionary orders, including their impact on the 
execution of market orders in the Arca Book. Specifically, the PCX has 
agreed to

[[Page 55232]]

submit data with respect to the following:
     The manner and frequency with which PCX market makers and 
other users are employing discretionary orders on ArcaEx;
     The extent to which market makers are using discretionary 
orders when trading for their own accounts;
     The quality of execution of discretionary orders (e.g., 
inside the quote); and
     The volume of trading attributed to discretionary orders.
    This information will enable the Commission's Division of Market 
Regulation, Office of Economic Analysis, and Office of Compliance 
Inspections and Examinations to evaluate the practical effects of 
discretionary orders as applied on ArcaEx.

D. Section 11(a) of the Act

    Section 11(a) prohibits a member of a national securities exchange 
from effecting transactions on that exchange for its own account, the 
account of an associated person, or an account over which it or its 
associated person exercises discretion (collectively, covered accounts) 
unless an exemption applies.\93\ The purpose of this section was to 
encourage fair dealing and fair access in the exchange markets by 
reducing the conflicts arising from an exchange member trading for its 
own account in the public exchange markets.\94\
---------------------------------------------------------------------------

    \93\ 15 U.S.C. 78k(a). In addition to the exemptions contained 
in Section 11(a) of the Act, the Commission has adopted rules under 
this Section to provide additional exemptions. See 17 CFR 240.11a-1 
(regulation of floor trading); 17 CFR 240.11a1-1(T) (transactions 
yielding priority, parity, and precedence); 17 CFR 240.11a1-2 
(transactions for certain accounts of associated persons of 
members); 17 CFR 240.11a1-3(T) (bona fide hedge transactions in 
certain securities), 17 CFR 240.11a1-4(T) (bond transactions on 
national securities exchanges), 17 CFR 240.11a1-5 (transactions by 
registered competitive market makers and registered equity market 
makers); 17 CFR 240.11a1-6 (transactions for certain accounts of OTC 
derivatives); and 17 CFR 240.11a2-2(T) (transactions effected by 
exchange members through other members).
    \94\ See 78 Cong. Rec. 2270-71 (1934).
---------------------------------------------------------------------------

    To supplement the exemptions in the statute, the Commission has 
adopted several rules that provide specific exemptions for transactions 
that would otherwise be prohibited by section 11(a). For example, Rule 
11a1-1(T) provides that a member's proprietary order may be executed on 
the exchange to which the member belongs, as long as (1) the member 
discloses to the broker employed and to the trading floor that the 
order is proprietary,\95\ and (2) any member presenting a proprietary 
order on the exchange floor yields priority to any bid or offer at the 
same price that is not also a proprietary order, notwithstanding any 
otherwise applicable rules of priority, parity, and precedence.\96\ In 
addition, Rule 11a2-2(T) permits an exchange member to effect 
transactions for covered accounts if, among other things, the member 
uses an independent floor broker to execute the transactions on the 
exchange floor.\97\ In particular, a member relying on Rule 11a2-2(T): 
(1) Must transmit the order from off the exchange floor; (2) may not 
participate in the execution of the transaction once it has been 
transmitted to the member performing the execution; \98\ (3) may not be 
affiliated with the executing member; and (4) with respect to an 
account over which the member or an associated person has investment 
discretion, neither the member nor the associated person may retain any 
compensation in connection with effecting the transaction without 
express written consent from the person authorized to transact business 
for the account in accordance with the rule. The purpose of these 
requirements is ``to put members and non-members on the same footing, 
to the extent practicable, in light of the purposes of section 11(a).'' 
\99\
---------------------------------------------------------------------------

    \95\ Specifically, Rule 11a1-1(T)(a)(1) provides that the member 
must disclose that the order is proprietary to any member with whom 
the order is placed or to whom the order is communicated, and 
members with whom such an order is placed or communicated must 
disclose the proprietary status of the order to others participating 
in effecting the order. Rule 11a1-1(T)(a)(2) provides that 
immediately before executing a proprietary order, a member (other 
than the specialist in the security being traded) presenting such an 
order must ``clearly announce or otherwise indicate'' to the 
specialist and to any other members then present for trading in that 
security, that the order is proprietary.
    \96\ Proprietary orders must yield to non-proprietary orders at 
the same price, regardless of the size of the orders or the time at 
which they are entered. See Rule 11a1-1(T)(a)(3), 17 CFR 240.11a1-
1(T)(a)(3).
    \97\ See Rule 11a2-2(T)(a)(2), 17 CFR 240.11a2-2(T)(a)(2). See 
also Securities Exchange Act Release No. 14563 (March 14, 1978), 43 
FR 11542 (March 17, 1978) (orders that are cancelled or changed 
under this rule are treated as new orders; such instructions must 
also be transmitted to the executing broker from off the floor); 
Securities Exchange Act Release No. 14713 (April 28, 1978), 43 FR 
18557 (May 1, 1978) (orders must be transmitted directly to the 
executing broker from off the floor; they can not be sent through 
the initiating member's floor employees).
    \98\ The member may participate, however, in clearing and 
settling the transaction.
    \99\ Securities Exchange Act Release No. 14713 (April 28, 1978), 
43 FR 18557 (May 1, 1978).
---------------------------------------------------------------------------

    As noted above, the Phlx asserted that the operation of ArcaEx 
would be inconsistent with the requirements of section 11(a) because 
members' proprietary orders would not yield priority to public customer 
orders. In response to this comment, the PCX explained that ArcaEx is 
not relying on the exemption provide by Rule 11a1-1(T), but rather is 
relying on Rule 11a2-2(T). As the PCX explained, ``the order execution 
algorithm of ArcaEx complies with the formal requirements of, and 
satisfies the policy concerns underlying, section 11(a) without 
requiring public customer priority.'' \100\
---------------------------------------------------------------------------

    \100\ See PCX Response 1 at p. 12.
---------------------------------------------------------------------------

    In particular, the PCX explained that all users, including exchange 
members, would transmit their orders electronically directly to ArcaEx 
from remote terminals. Once an order has been transmitted, a user could 
not further control or influence the order's execution. The orders 
enter a line of other orders to be executed against each other in the 
Arca Book based on an established matching algorithm. Execution depends 
on what orders are entered into ArcaEx at the same time, what orders 
are already in the Arca Book, and how the orders are ranked based on 
the time-price ranking algorithm.\101\
---------------------------------------------------------------------------

    \101\ The Commission notes that proposed PCXE Rule 6.16 would 
prohibit ETP Holders from trading ahead of customer limit orders.
---------------------------------------------------------------------------

    This electronic order and execution process of ArcaEx satisfies the 
four criteria of Rule 11a2-2(T). First, all orders are electronically 
submitted through remote terminals from off the exchange floor. Second, 
because a member relinquishes control of its order after transmission 
to ArcaEx, it receives no special or unique trading advantages. Third, 
although the rule contemplates having an order executed by an exchange 
member who is unaffiliated with the member initiating the order, the 
Commission recognizes that this requirement is not applicable when 
automated exchange facilities are used.\102\ Fourth, ArcaEx members 
trading for covered accounts will disclose discretionary account 
compensation, as required by the rule. The Commission and its staff 
have, on numerous occasions, considered the application of Rule 11a2-
2(T) to electronic trading and order routing

[[Page 55233]]

systems.\103\ The PCX requested guidance from the staff regarding PCX's 
interpretation of how ArcaEx meets the requirements of Rule11a2-2(T), 
and the staff concurred with PCX's interpretation.\104\ The Commission 
finds that the proposed operation of ArcaEx is consistent with section 
11(a) of the Act.
---------------------------------------------------------------------------

    \102\ For example, in considering the operation of automated 
execution systems operated by an exchange, the Commission noted that 
while there is no independent executing exchange member, the 
execution of an order is automatic once it has been transmitted into 
the systems. Because the design of these systems ensures that 
members do not possess any special or unique trading advantages in 
handling their orders after transmitting them to the exchange 
floors, the Commission has stated that executions obtained through 
these systems satisfy the independent execution requirement of Rule 
11a2-2(T). See Securities Exchange Act Release No. 15533 (January 
29, 1979).
    \103\ See, e.g., Securities Exchange Act Release No. 29237 (May 
31, 1991) (regarding NYSE's Off-Hours Trading Facility); Securities 
Exchange Act Release No. 15533 (January 29, 1979) (regarding the 
Amex Post Execution Reporting System, the Amex Switching System, the 
Intermarket Trading System, the Multiple Dealer Trading Facility of 
the Cincinnati Stock Exchange, the PCX's Communications and 
Execution System, and the Phlx's Automated Communications and 
Execution System); Securities Exchange Act Release No. 14563 (March 
14, 1978) (regarding the NYSE's Designated Order Turnaround System). 
See also Letter from Larry E. Bergmann, Senior Associate Director, 
Division of Market Regulation, SEC, to Edith Hallahan, Associate 
General Counsel, Phlx (March 24, 1999) (regarding Phlx's VWAP 
Trading System); Letter from Catherine McGuire, Chief Counsel, 
Division of Market Regulation, SEC, to David E. Rosedahl, PCX 
(November 30, 1998) (regarding OptiMark); and Letter from Brandon 
Becker, Director, Division of Market Regulation, SEC, to George T. 
Simon, Foley & Lardner (November 30, 1994) (regarding Chicago 
Match).
    \104\ Letter from Catherine McGuire, Chief Counsel, Division of 
Market Regulation, SEC, to Kathryn Beck, Senior Vice President and 
Special Counsel, PCX, dated October 25, 2001.
---------------------------------------------------------------------------

E. The Wave Broker-Dealer

1. The Proposed Functions of Wave
    Wave, a wholly owned subsidiary of Archipelago Holdings LLC, is a 
registered broker-dealer and a member of the NASD. The PCX described 
Wave's three functions with respect to ArcaEx in Amendment No. 3 to the 
proposed rule change.
    First, Wave would register as an ETP Holder and act as an 
introducing broker for customers that are non-ETP Holders. In that 
capacity, Wave would provide sponsored access to ArcaEx pursuant to 
contractual relationships with entities that are not ETP Holders.
    Second, Wave would provide an optional routing service for ArcaEx, 
and, as necessary, would route orders to other market centers from 
ArcaEx.\105\ Those who choose to use this service would sign a Wave 
Routing Agreement that reads, in pertinent part:
---------------------------------------------------------------------------

    \105\ See, e.g., proposed PCXE Rules 1.1(gg), 7.32 and 7.37(d).

    User agrees that all orders on its behalf must be transmitted to 
WAVE through the Archipelago Exchange. User agrees that the 
Archipelago Exchange is its exclusive mechanism for purposes of 
transmitting orders on its behalf to WAVE and for receiving notice 
regarding such orders. WAVE shall be entitled to rely upon and act 
in accordance with any order instructions received from the 
Archipelago Exchange on behalf of User. User agrees that all order 
executions effected on behalf of User pursuant to this agreement 
shall be reported by WAVE to the Archipelago Exchange. The User 
shall be notified of such executions through the Archipelago 
Exchange.\106\
---------------------------------------------------------------------------

    \106\ See Wave Routing Agreement, http://www.tradearca.com/exchange, visited on October 14, 2001.

    In addition, the Wave routing agreement provides that orders routed 
through Wave will remain subject to the rules of PCXE.\107\
---------------------------------------------------------------------------

    \107\ Id. (``User understands and agrees that orders executed on 
its behalf shall at all times be subject to the terms and conditions 
of the PCXE Rules.'')
---------------------------------------------------------------------------

    Third, Wave would continue to operate an ECN. Wave's ECN would 
trade only those securities that are ineligible for unlisted trading 
privileges on ArcaEx. As proposed, Wave's ECN would continue to trade 
the securities that are ineligible for unlisted trading on ArcaEx, but 
it would cease trading those securities if they became eligible.\108\
---------------------------------------------------------------------------

    \108\ Unlisted trading privileges of Nasdaq securities on 
national securities exchanges are subject to the OTC-UTP Plan and 
Section 12(f) of the Act. Currently, 1,000 Nasdaq National Market 
issues may be admitted to unlisted trading privileges on national 
securities exchanges.
---------------------------------------------------------------------------

2. ArcaEx's Affiliation with Wave
    As noted above, Archipelago Holdings LLC would own both ArcaEx, a 
facility of the PCX, and Wave, a broker-dealer. Nasdaq and Knight 
expressed concerns regarding ArcaEx's affiliation with the Wave broker-
dealer operating in the capacities described above. Specifically, in 
their comment letters, Nasdaq and Knight contended that the proposed 
market structure of ArcaEx, particularly the relationship between 
ArcaEx and Wave, would be anti-competitive.\109\ Nasdaq believes that 
Wave's order routing mechanism, combined with its role as an 
introducing broker and its maintenance of an ECN for trading Nasdaq 
securities, would create a troubling conflict of interest and would 
result in a competitive imbalance between Wave and other ETP Holders. 
Similarly, Knight believes that the proposal does not adequately 
address Wave's potential conflict as a broker-dealer and an order-
routing mechanism for ArcaEx.
---------------------------------------------------------------------------

    \109\ See Nasdaq Letters 2 and 3; Knight Letters 1 and 2.
---------------------------------------------------------------------------

    Under section 6 of the Act, the rules of a national securities 
exchange must not be designed to permit unfair discrimination between 
customers, issuers, brokers, or dealers.\110\ The Commission recognizes 
that the potential for unfair discrimination may be heightened if a 
national securities exchange or its affiliate owns or operates a broker 
dealer. This is because the financial interests of the national 
securities exchange may conflict with its responsibilities as an SRO 
regarding the affiliated broker-dealer. For this reason, the national 
securities exchange must not serve as the self-regulatory organization 
that is primarily responsible for examining its affiliated broker-
dealer.\111\ Moreover, a conflict of interest would arise if the 
national securities exchange (or an affiliate) provided advantages to 
its broker-dealer that are not available to other members, or provided 
a feature to all members that was designed to give its broker-dealer a 
special advantage. These advantages, such as greater access to 
information, improved speed of execution, or enhanced operational 
capabilities in dealing with the exchange, might constitute unfair 
discrimination under the Act. The Commission has considered these 
potentially unfair advantages in the light of Wave's proposed 
functions.
---------------------------------------------------------------------------

    \110\ See Section 6(b)(5) of the Act, 15 U.S.C. 78f(b)(5).
    \111\ See ATS Release, 63 FR at 70892. Indeed, as the Commission 
noted in the ATS Release, a national securities exchange that 
operates a broker-dealer/alternative trading system must arrange for 
another SRO to act as the regulator for that entity. Here, the NASD 
will be the designated examining authority for those functions of 
Wave that are not facilities of the PCX.
---------------------------------------------------------------------------

a. The PCX Application of the Wave Order-Routing Function
    Both Nasdaq and Knight believe that users who do not choose to 
enter into a routing agreement, and therefore do not use the order 
routing services of Wave, would be placed at a competitive disadvantage 
vis a vis users who opt to enter into a routing agreement. Moreover, 
Knight suggested that Wave would violate the fair access provisions of 
the Act because certain order types would not be available to those who 
have chosen not to use Wave. Finally, Nasdaq suggested that, because 
ArcaEx would have to return the partially executed or unexecuted orders 
to non-users of Wave, who would then route the orders by alternative 
means, the price and speed of execution for such orders could be 
significantly compromised.
    The PCX addressed Wave's role as an optional order routing 
mechanism of the PCX in considerable detail. First, the PCX asserted 
its view that no denial of access issues arise with respect to any 
order type, regardless of their routing mechanism, because every user 
must satisfy identical, objective requirements for submitting each 
order type.\112\ In the PCX's view, as the requirements do not vary 
based on the identity of the user, the routing procedures and 
mechanisms

[[Page 55234]]

do not unfairly discriminate against any particular class of user.\113\
---------------------------------------------------------------------------

    \112\ See PCX Response 2 and 3.
    \113\ See, e.g., Section 6(b)(5) of the Act (the rules of an 
exchange may not be designed to permit ``unfair discrimination'').
---------------------------------------------------------------------------

    Second, the PCX noted that, although users could opt to route 
orders from ArcaEx to other market centers through the Wave order 
routing function, no ArcaEx user would be required to use Wave for this 
purpose.\114\ Members could also select other broker-dealers to provide 
order-routing functions. Under the PCX's proposal, if a user has not 
chosen to use Wave's routing services, the user's unexecuted or 
partially unexecuted order would be returned to the user or its 
designated agent after a sweep of the ArcaEx market.\115\ Once the 
order is returned, the user would then be able to route it to another 
market center by an alternative means. As an example, the PCX pointed 
out that a user could opt to bypass Wave entirely and instead rely on 
its own routing abilities or those of another broker-dealer by using a 
``fill or return'' or a ``fill or return plus'' order.\116\ By using 
those orders, a user could route its order to another market in a 
manner of its own choosing if the order is not fully executed on the 
ArcaEx.
---------------------------------------------------------------------------

    \114\ See, e.g., proposed PCXE Rules 1.1(gg), 7.32 and 7.37(d). 
The PCX explained the PCX and Archipelago opted to employ the 
services of a routing broker (rather than to rely on routing orders 
to other markets directly from PCX itself) simply because of various 
technical issues associated with market center-to-market center 
routing.
    \115\ See proposed PCXE Rule 7.37(d) (describing ``Routing 
Away,'' Step 5 of the trading algorithm, after the directed order, 
display order, working order and tracking order processes).
    \116\ See proposed PCXE Rules 7.31(p) and 7.31(r) (definitions 
of ``fill or return'' and ``fill or return plus'' orders, 
respectively).
---------------------------------------------------------------------------

    Third, the PCX emphasized that users who opt out of the Wave 
routing services would be precluded from entering only a very limited 
subset of orders that specifically incorporate a Wave routing 
requirement within the definition of the order. In particular, non-
users of Wave would be unable to enter only a primary-only order (an 
order that is automatically routed to the primary market as a market-
on-open order) and a NOW order (an order that is automatically routed 
to a different market center for immediate execution).\117\ In handling 
these particular orders, which are executed solely on another market, 
WAVE does not have advantages from its ArcaEx function. The PCX also 
represented that information barriers would be maintained to ensure 
that Wave does not unfairly take advantage of knowledge gained as the 
PCX's order routing mechanism.
---------------------------------------------------------------------------

    \117\ See proposed PCXE Rule 7.31(v) and (x) (definitions of 
``NOW'' and ``primary only'' orders, respectively).
---------------------------------------------------------------------------

    The Commission believes that, although Wave's routing services are 
optional, Wave's order-routing function occupies a special position 
with respect to ArcaEx. In the Commission's view, Wave is uniquely 
linked to and endorsed by ArcaEx to provide its outbound routing 
functionality. Therefore, the Commission believes, and the PCX agrees, 
that the PCX application of the Wave order-routing function falls 
within the definition of a facility under the Act. Section 3(a)(2) of 
the Act provides:

    The term ``facility'' when used with respect to an exchange 
includes its premises, tangible or intangible property whether on 
the premises or not, any right to use of such premises or property 
or any service thereof for the purpose of effecting or reporting a 
transaction on the exchange (including, among other things, any 
system of communication to or from the exchange, by ticket or 
otherwise maintained by or with the consent of the exchange), and 
any right of the exchange to the use of any property or service. 
(Emphasis added.)

    In the Commission's view, by functioning as an order routing 
mechanism for ArcaEx, Wave would operate as a ``system of 
communication'' to or from the PCX for the purpose of effecting a 
transaction on the exchange. Specifically, pursuant to contract, Wave 
would receive instructions from ArcaEx, would route orders away in 
accordance with those instructions, and would be responsible for 
reporting resulting executions back to ArcaEx.\118\ In addition, as 
discussed above, all orders routed through Wave would remain subject to 
the terms and conditions of the PCX's rules.\119\
---------------------------------------------------------------------------

    \118\ These trades would be reported by the executing market.
    \119\ See Wave Routing Agreement, http://www.tradearca.com/exchange, visited on October 14, 2001.
---------------------------------------------------------------------------

    Because the application of the Wave order routing function is a 
facility of the PCX, the PCX would be responsible for regulating the 
Wave order routing function as an exchange facility subject to section 
6 of the Act. As such, Wave's order routing function would be subject 
to the Commission's continuing oversight. In particular, under the Act, 
the PCX must file rule changes and fees relating to the Wave order-
routing function, and Wave would be subject to exchange non-
discrimination requirements.\120\ These requirements are intended to 
address the potential misuse of advantages that might arise from Wave's 
order-routing function.\121\
---------------------------------------------------------------------------

    \120\ See, e.g., Section 6(b)(5) of the Act, 15 U.S.C. 
78f(b)(5).
    \121\ The Commission also believes that, because Wave's order-
routing function is optional and because those who decline to use it 
would continue to have full access to the rest of the ArcaEx 
facility, the Wave order-routing function would not be per se 
unfairly discriminatory.
---------------------------------------------------------------------------

b. Wave's Function as Introducing Broker for ArcaEx
    The PCX's indirect ownership of Wave, combined with Wave's role as 
an introducing broker to ArcaEx, raises the question whether Wave in 
this role should be considered a facility of the PCX. Despite Wave's 
affiliation with the PCX, the Commission does not believe that Wave's 
introducing broker function should necessarily be viewed as 
constituting a facility of the PCX.\122\ In its introducing broker 
role, Wave would be acting as a user/member of the ArcaEx on precisely 
the same terms as any other member. Wave would not be the sole source 
of sponsored access to ArcaEx; all other ETP Holders could readily 
provide similar services on behalf of their customers. In addition, the 
PCX is subject to existing statutory standards that prohibit denials of 
access and other unfair discrimination against any member regarding 
access to the PCX's services. Those standards would preclude the PCX 
from providing Wave with unfair, preferential access to its facilities.
---------------------------------------------------------------------------

    \122\ Cf. Securities Exchange Act Release No. 44201 (April 18, 
2001), 66 FR 21025 (April 26, 2001) (Certain aspects of OTC Tools 
software application providing enhanced access to Nasdaq 
functionality, which was owned and exclusively available through the 
NASD was considered a facility of the NASD).
---------------------------------------------------------------------------

    Furthermore, the PCX has provided additional protections to limit 
the risk that Wave would receive an unfair advantage over other ETP 
Holders in operating as an introducing broker. The PCX has instituted 
safeguards to ensure that Wave's introducing broker function would be 
segregated from the operation of the PCX and its facilities, so that 
Wave would not receive any informational advantages from its 
affiliation with ArcaEx and the PCX. Specifically, proposed PCXE Rule 
14 requires the PCX to maintain strong information barriers between its 
facilities and other functions of the Wave broker-dealer.\123\
---------------------------------------------------------------------------

    \123\ See Amendment No. 5 to the proposed rule change.
---------------------------------------------------------------------------

    The Commission believes that the availability of sponsored access 
to ArcaEx from multiple sources, coupled with the segregation of 
functions described above, would adequately protect investors and the 
public interest from potential concerns arising from the

[[Page 55235]]

PCX's affiliation with Wave. This analysis would change, however, 
should Wave become the sole or predominant source of sponsored access 
to ArcaEx, or should the PCX's information barriers prove to be 
ineffective. In that case, the potential advantages provided to Wave in 
its operation as an introducing broker from its affiliation with the 
PCX may cause Wave to be considered a facility of the PCX and therefore 
subject to the requirements of section 6 of the Act.
c. Wave's Operation of an ECN
    As noted above, Nasdaq expressed the view that Wave's ECN should be 
regulated as a facility of the PCX. The PCX submitted a response in 
which it argued that Wave's ECN does not meet the definition of a 
facility under section 3(a)(2) of the Act. The PCX noted that Wave's 
ECN would perform a very limited trading function, serving as an ECN 
for only those Nasdaq securities that are not eligible for trading on 
ArcaEx.
    In the ATS Release, the Commission stated that exchanges may ``form 
subsidiaries or affiliates that operate alternative trading systems 
registered as broker-dealers.''\124\ Such subsidiaries or affiliates 
are required to become members of a national securities association or 
national securities exchange. Furthermore, the alternative trading 
system would be considered a facility of its affiliated exchange if it 
were integrated or otherwise linked to that exchange.
---------------------------------------------------------------------------

    \124\ See ATS Release, 63 FR at 70891.
---------------------------------------------------------------------------

    Here, Wave's ECN will continue to be regulated by the NASD rather 
than the PCX,\125\ will trade only those Nasdaq securities that are not 
eligible for trading on the PCX, and will not be integrated or 
otherwise linked to the PCX. In addition, the PCX has represented that 
once all Nasdaq securities are eligible for trading on the PCX, the 
Wave ECN will cease operation completely. In view of the foregoing, the 
Commission believes that the Wave ECN is not a facility of the PCX, and 
that it is properly regulated within the framework that Regulation ATS 
establishes.
---------------------------------------------------------------------------

    \125\ See PCX Response 2 and 3.
---------------------------------------------------------------------------

V. Commission's Findings

    On the basis of the facts and conclusions discussed in Sections I 
through IV above, the Commission makes the following findings with 
respect to the PCX's proposal.

A. Competition, Efficiency, and Capital Formation

    In reviewing the PCX's proposal, the Commission is required under 
section 3(f) of the Act \126\ to consider whether the proposal will 
promote competition, efficiency, and capital formation. In addition, 
section 6(b)(8) requires that the rules of an exchange not impose any 
burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.\127\
---------------------------------------------------------------------------

    \126\ 15 U.S.C. 78c(f).
    \127\ 15 U.S.C. 78f(b)(8).
---------------------------------------------------------------------------

    As noted above, in the Commission's view, the proposed ArcaEx 
facility would provide a new and technologically advanced way for 
trading interest to be matched and orders to be executed on the PCX. If 
the ArcaEx facility is able to attract new market participants and to 
increase order flow to the PCX, the facility could promote greater 
competition among market centers. In particular, ArcaEx's trading rules 
are designed to encourage the use of various tools, such as 
discretionary orders and reserve size, that will allow investors 
greater flexibility in displaying and managing their orders, thereby 
allowing them to more fully represent their trading interest in a 
public marketplace. Thus, the Commission believes that the PCX's 
proposal does not impose any burden on competition that is not 
necessary or appropriate in furtherance of the purposes of the Act.
    Moreover, if the ArcaEx facility succeeds in attracting more order 
flow to the PCX, the PCX may begin to serve as a greater source of 
liquidity for investors, and this in turn could promote greater 
efficiency of executions. Similarly, the availability of novel features 
will provide investors and issuers with new opportunities to interact, 
thereby encouraging capital formation.

B. Section 6(b)(5) of the Act

    The Commission finds that the PCX's proposed rules establishing the 
ArcaEx as its facility are consistent with section 6(b)(5) of the 
Act,\128\ in that the rules have been designed to remove impediments to 
and to perfect the mechanism of a free and open market and a national 
market system, while also protecting investors and the public interest. 
Specifically, the PCX's rule proposal would create a new electronic 
platform for matching and executing orders. Significant features of the 
ArcaEx facility (as reflected in the PCXE rules), such as the 
availability, in real time, of the entire displayed book via the 
internet, would provide investors with more timely and accurate 
information regarding trading interest on the facility. In addition, 
the use of discretionary orders on ArcaEx may provide investors with 
greater flexibility to represent their trading interest accurately and 
completely. Further, the order routing function and the ITS connection 
would also provide investors entering orders into ArcaEx with the 
ability to access the best prices in different markets should their 
order not be executable on the Arca Book.
---------------------------------------------------------------------------

    \128\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    In addition, the Commission finds that the PCX's proposal is 
consistent with the requirements of section 6(b)(5) that the rules of 
an exchange be designed to prevent fraudulent and manipulative acts and 
to promote just and equitable principles of trade, and that they not be 
designed to permit unfair discrimination among customers, issuers, or 
broker-dealers. Specifically, the PCX has, when necessary and 
appropriate, adapted its customer protection rules to reflect its 
adoption of the all-electronic ArcaEx trading facility.\129\ The PCX 
has also committed to develop and maintain an appropriate system of 
surveillance and an audit trail. Finally, by rule, the PCX has proposed 
to segregate the functions of the ArcaEx facility and the functions of 
Wave that are not regulated as facilities of the PCX. Accordingly, the 
Commission does not believe that the PCX's rules permit unfair 
discrimination among users of ArcaEx.
---------------------------------------------------------------------------

    \129\ See, e.g., proposed PCXE Rule 6.16 (prohibiting members 
from trading ahead of customer limit orders).
---------------------------------------------------------------------------

C. Section 11A of the Act

    In section 11A(a)(1)(C),\130\ Congress found that it is in the 
public interest and appropriate for the protection of investors and the 
maintenance of fair and orderly markets to assure: (1) The economically 
efficient execution of securities transactions; (2) fair competition 
among brokers and dealers; (3) the availability to brokers, dealers, 
and investors of information with respect to quotations and 
transactions in securities; (4) the practicability of brokers executing 
investors' orders in the best market; and (5) an opportunity for 
investors' orders to be executed without the participation of a dealer. 
Congress also recognized that technology would drive competition among 
the securities markets, stating, ``[n]ew data processing and 
communications techniques create the opportunity for more efficient and

[[Page 55236]]

effective market operations.''\131\ Congress instructed the Commission 
to seek to ``enhance competition and to allow economic forces, 
interacting with a fair regulatory field, to arrive at appropriate 
variation in practices and services.''\132\
---------------------------------------------------------------------------

    \130\ 15 U.S.C. 78k-1(a)(1)(C).
    \131\ Id.
    \132\ See S. Rep. No. 94-75, 94th Cong., 1st Sess. 7 (1975) at 
p. 8.
---------------------------------------------------------------------------

    The Commission believes that the proposal incorporates features 
that will provide investors with the opportunity to receive 
economically efficient execution of their securities transactions and 
to promote fair and orderly markets.\133\ In addition to the features 
noted above, the Commission notes that a significant feature of the 
Arca Book is that it potentially provides an opportunity for investors' 
orders to be executed without the participation of a market maker. The 
Commission also believes that the real-time dissemination of the Arca 
Book to the public via the internet will provide valuable information 
to all market participants and is reasonably designed to promote price 
discovery. Finally, the Commission believes that ArcaEx's routing 
technology and link to ITS will allow investor orders efficiently to 
reach other markets with better prices. Therefore, Commission finds 
that the PCX's proposal is consistent with section 11A of the Act.
---------------------------------------------------------------------------

    \133\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

VI. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 4 and 5, including whether 
Amendment Nos. 4 and 5 are consistent with the Act. Persons making 
written submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW, Washington, 
DC 20549-0609. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the PCX. All submissions should refer to Amendment 
Nos. 4 and 5 of File No. SR-PCX-2000-25 and should be submitted by 
November 23, 2001.

VII. Order Granting Approval

    The original rule proposal was noticed for public comment in 
November 2000. Amendment No. 4 makes technical corrections to the rules 
and adds a provision with respect to the status of the books and 
records of Archipelago Holdings LLC. Amendment No. 5 is directly 
responsive to questions raised by commenters regarding the status of 
Wave. The Commission believes that it has received and fully considered 
substantial, meaningful comments with respect to the PCX's proposal, as 
amended, and that Amendment Nos. 4 and 5 do not raise issues that 
warrant further delay.\134\ Accordingly, pursuant to section 19(b)(2) 
of the Act,\135\ the Commission finds good cause to approve Amendment 
Nos. 4 and 5 prior to the thirtieth day after notice of the Amendments 
is published in the Federal Register.
---------------------------------------------------------------------------

    \134\ See also discussion at text accompanying note 76, supra.
    \135\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\136\ that Amendment Nos. 4 and 5 to the PCX's proposed rule change 
are hereby granted accelerated approval; and
---------------------------------------------------------------------------

    \136\ Id.
---------------------------------------------------------------------------

    It is also ordered, pursuant to section 19(b)(2) of the Act,\137\ 
that the proposed rule change (File No. SR-PCX-00-25), as amended, is 
hereby approved.
---------------------------------------------------------------------------

    \137\ Id.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-27417 Filed 10-31-01; 8:45 am]
BILLING CODE 8010-01-P