[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]]
-----------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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'').
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
[[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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.)
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\28\ See proposed PCXE Rule 7.31(h) (definition of ``working
order'').
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\29\ See proposed PCXE Rule 7.31(k) (definition of ``Q order'').
A Q order may not be a working order.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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).
---------------------------------------------------------------------------
\31\ See proposed PCXE Rule 7.34 (description of ``trading
sessions'').
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\32\ See proposed PCXE Rule 7.31(u) (description of ``cleanup
orders'').
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\36\ See D.A. Davison Letter, supra note 4.
\37\ See LASA Letter and SFSA Letter, supra note 4.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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'').
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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