[Federal Register Volume 67, Number 29 (Tuesday, February 12, 2002)]
[Notices]
[Pages 6558-6561]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-3297]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45405; File No. SR-CSE-2001-04]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment No. 1 Thereto by the Cincinnati Stock Exchange, 
Inc. Relating to the Creation of the OTC-UTP System on the Cincinnati 
Stock Exchange, Inc.

February 6, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on October 31, 2001, the Cincinnati Stock Exchange, Inc. (``CSE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the Exchange. The 
Exchange filed an amendment to its proposal on February 5, 2002.\3\ The 
Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Jeffrey T. Brown, Senior Vice President, 
Secretary and General Counsel, CSE, to Katherine England, Assistant 
Director, Division of Market Regulation, Commission (February 5, 
2002) (``Amendment No. 1'').
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange proposes to amend CSE Rule 11.9, National Securities 
Trading System (``NSTS''), to create a parallel trading system within 
the Exchange for Nasdaq/National Market securities (``Nasdaq 
securities''). The Over-the-Counter (``OTC'') Unlisted Trading 
Privileges (``UTP'') System (``OTC-UTP System''), while operating on 
CSE's current hardware and communication lines, will subject CSE users 
to altered Exchange rules that make the CSE's price/time and agency/
principal priorities voluntary for Nasdaq securities. The CSE believes 
that the proposed rule change will enhance the competitive position of 
the Exchange by promoting increased liquidity and greater opportunities 
for members and their customers to obtain best execution on the CSE. 
The text of the proposed rule change is available at the principal 
offices of the Exchange and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
Sections A, B, and C below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The Exchange proposes to change its rules to create the OTC-UTP 
System within the CSE that will provide CSE members with increased 
flexibility to provide best execution to their customers' orders. In 
order to more effectively compete for order flow in Nasdaq securities, 
CSE is proposing to amend its price/time and agency/principal priority 
rules such that CSE users (``Users'') \4\ may voluntarily and on an 
order-by-order basis determine to interact with other bids, offers, and 
orders displayed in CSE's OTC-UTP System. CSE believes that the new 
trading system is consistent with the federal securities laws and 
similar in nature to that currently employed by the Nasdaq Stock 
Market, Inc. (``Nasdaq'') and as proposed in the Nasdaq's exchange 
filing.\5\
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    \4\ CSE Rule 11.9(a)(7) defines the term ``User'' as a Member of 
the Exchange or an Approved Dealer.
    \5\ See Exchange Act Release No. 44396 (June 7, 2001), 66 FR 
31952 (June 13, 2001).
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Description
    The CSE's current trading system, NSTS, is an electronic securities 
communication and execution facility, that combines the display of 
bids, offers, and orders of Users as well as orders on the NSTS central 
limit order book (``CLOB'') with the matching and execution of like-
priced orders, bids, and offers according to programmed price/time and 
agency/principal priorities.\6\ The price/time and agency/principal 
priority rules are set forth in CSE Rules 11.9(i), (l), (m), and (u).
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    \6\ CSE Rule 11.9(a)(1).
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    Rule 11.9(i) states that NSTS shall automatically match and execute 
like-priced orders, bids and offers in accordance with the price/time 
and agency/principal priorities set forth in

[[Page 6559]]

Rules 11.9(l) and (m).\7\ Rule 11.9(l) provides that public agency 
orders to buy or sell at a particular price shall, in all cases except 
execution of such an order pursuant to a limit order guarantee, have 
priority over all other bids and offers on NSTS at the same price. In 
addition, Rule 11.9(l) imposes price/time priority on all bids and 
offers, except those executed pursuant to Rule 11.9(u), such that the 
first in line at the best price shall be executed.\8\
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    \7\ See CSE Rule 11.9(i).
    \8\ See CSE Rule 11.9(l).
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    Rule 11.9(m) requires that each Approved Dealer \9\ or other 
Proprietary Member \10\ when trading on the exchange for its own 
account or as agent for professional agency orders \11\ yield priority 
to (1) All public agency orders in the CLOB at prices equal to, or 
better than, the Dealer's order, bid, or offer; and (2) all orders, 
bids, and offers of an Approved Dealer or other Proprietary Member for 
its own accounts or as agent for professional agency orders entered in 
NSTS (i) at an earlier time than the Dealer's order, bid, or offer, or 
(ii) in the case of Approved Dealers when trading for their own account 
against public agency orders they represent as agent pursuant to Rule 
11.9(u).
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    \9\ CSE Rule 11.9(a)(4) defines ``Approved Dealer'' as a 
Designated Dealer, a Contributing Dealer, or a specialist or market 
maker registered as such with another exchange or national 
securities association with respect to any Designated Issue.
    \10\ Article I, Section 1(k) of CSE By-Laws defines 
``Proprietary Member'' as a person who was a ``regular member'' 
prior to the effective date of these By-Laws or a person who, 
pursuant to the provisions of Article II of these By-Laws, has 
applied for, and been admitted to, membership as a proprietary 
member subsequent to the effective date of these By-Laws.
    \11\ CSE Rule 11.9(a)(10) defines ``professional agency order'' 
as an order entered by a User as agent for the account of a broker-
dealer, a futures commission merchant, or a member of a contract 
market.
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    Rule 11.9(u), ``Preferencing Rule,'' permits orders to be 
preferenced to particular Approved Dealers and executed at the same 
price as current Approved Dealer bids, offers, and professional agency 
displayed orders without regard to the time priority of such bids, 
offers, and displayed orders.\12\
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    \12\ See CSE Rule 11.9(u).
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    To accommodate the introduction of the OTC-UTP System, CSE is 
amending the above rules, where necessary, to clarify that the price/
time and agency/principal priorities are voluntary with respect to 
trading in Nasdaq securities. For example, subparagraph (2) will be 
added to Rule 11.9(i) to provide that ``the OTC-UTP System will match 
and execute like-priced orders, bids, and offers when specifically 
instructed by the CSE Users. Subject to the obligations of Rule 12.10, 
Best Execution, Users may choose to execute like-priced orders without 
regard to the price/time and agency/principal priorities set forth in 
Rules 11.9(l) and (m).'' \13\ Similarly, Rule 11.9(l) will be amended 
to state that ``Public Agency orders, except in Nasdaq/NM securities 
traded through the OTC-UTP System, * * * shall have priority.  * * *'' 
\14\
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    \13\ See Proposed Rule 11.9(i)(2). The CSE notes that with 
regard to matched like-priced orders delivered to CSE by Users, such 
like-priced orders are executed on CSE's OTC-UTP System at the 
moment in time (as captured by the User's system time stamp) that 
the matched like-priced orders are sent to CSE.
    \14\ See Proposed Rule 11.9(l).
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    In addition, the CSE system algorithms that enforce the price/time 
and agency/principal priority rules will be modified to comply with the 
voluntary order interaction of the OTC-UTP System. However, Rule 12.6, 
Customer Priority, which is CSE's ``Manning'' rule will not be amended 
and will continue to be enforced as written on CSE Designated Dealers.
Discussion
    CSE's Preferencing Rule (Rule 11.9(u)) was a step towards creating 
a more competitive environment for exchange-listed securities traded on 
a UTP basis on the CSE. By adopting a rule that permits CSE dealers to 
execute customer orders without regard to the time priority of other 
CSE dealer orders, bids, and offers, the CSE introduced elements of a 
dealer market, such as Nasdaq, into its exchange structure. In 
approving preferencing on CSE, the Commission recognized that, ``the 
CSE combines the features of both exchange and over-the-counter 
markets.'' \15\ Further, the Commission stated that:
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    \15\ See Exchange Act Release No. 37046 (March 29, 1996), 61 FR 
15322 (April 5, 1996).

    [t]hus, the NSTS system provides a central location for CSE 
dealers to interact in a manner similar to a traditional exchange 
trading floor. Preferencing, however, suspends time priority between 
professional trading interest so that the multiple CSE dealers can 
execute their own customer orders without interruption by other 
dealers and is more akin to trading in the over-the-counter 
markets.\16\
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    \16\ Id.

    While the Commission was cautious in supporting preferencing at its 
inception, CSE has proven that the quality of executions pursuant to 
the Preferencing Rule are equal to, and often exceed, the quality of 
executions on the primary markets for exchange-listed securities. As 
the data published pursuant to Rule 11Ac1-5 demonstrates, CSE execution 
quality consistently exceeds that of the New York Stock Exchange, Inc. 
(``NYSE'') and the American Stock Exchange LLC, the two primary listed 
markets. Indeed, CSE numbers are better than those of the NYSE in such 
categories as effective spread, execution speed, and percent of 
executions outside the quoted market. Clearly, eliminating time 
priority among CSE dealers has benefited CSE customers through better 
prices and faster service.
    CSE now seeks to expand on these benefits by introducing the OTC-
UTP System, which makes price/time and agency/principal priorities for 
bids, offers, and orders in Nasdaq securities voluntary among CSE 
market participants. The CSE believes that such an open architecture is 
necessary to attract liquidity from various market participants, 
including dealers, order-entry firms, ECNs, ATSs, and public customers. 
As greater liquidity is introduced into CSE, the competitive 
efficiencies of this open structure will generate greater opportunities 
for order interaction as well as faster and cheaper executions for 
public customers. In summarizing the congressional intent of section 
11A of the Act, the Commission stated in its Concept Release on Issues 
Relating to Market Fragmentation that

    Investor interests are best served by a market structure that, 
to the greatest extent possible, maintains the benefits of both an 
opportunity for interaction of all buying and selling interest in 
individual securities and fair competition among all types of market 
centers seeking to provide a forum for the execution of securities 
transactions.\17\
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    \17\ See Exchange Act Release No. 42450 (February 23, 2000), 65 
FR 10577 (February 28, 2001) (emphasis added).

    The CSE believes that the freely competitive nature of the OTC-UTP 
System will attract new CSE Users and greater liquidity to the 
Exchange. As liquidity begets liquidity, order interaction increases 
and investors are better served. Once the algorithmic controls are 
removed and replaced by the voluntary--to the extent that volition is 
constrained by the duty of best execution--interaction of bids, offers, 
and orders, the CSE believes that its quote driven market will be on a 
level playing field with Nasdaq and an era of true price competition in 
Nasdaq securities may begin. By combining fair competition with 
opportunities for increased order interaction, the CSE believes it has 
proposed a mechanism to achieve the goals of section 11A of the Act.
    As the Commission is aware, Nasdaq members trade without regard to 
price and time priority and intend to do so

[[Page 6560]]

when Nasdaq becomes an exchange. Nasdaq market makers may execute 
customer orders without regard to other Nasdaq bids, offers, displayed 
customer orders, and without being executed through a Nasdaq system. 
Nasdaq believes that its model promotes competition among various 
market participants while balancing the fundamental values necessary 
for the protection of investors. As stated by Nasdaq, ``[i]n the real 
world of investor needs, price is not a simple issue. In most cases, 
size and immediacy are also a consideration, and the most efficient 
execution may not take place at the inside.''\18\
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    \18\ See letter from Richard Ketchum, President, NASD to 
Jonathan G. Katz, Secretary, Commission (May 22, 2000) (``Market 
Fragmentation Letter'').
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    The Commission affirmed this model in its recent approval of 
Nasdaq's SuperMontage system.\19\ SuperMontage is a Nasdaq system that 
provides for the enhanced display of quotes and orders combined with 
certain execution functionalities based upon multiple priority 
algorithms. Nasdaq believes that SuperMontage, ``advances the fairness 
and efficiency of the handling of individual limit orders--without 
inhibiting the creativity of the competitive marketplace which serves 
the interests of all investors.''\20\ Nasdaq preserves its creativity 
by making SuperMontage voluntary. Nasdaq market makers holding customer 
orders do not have to place them into the SuperMontage order facility 
and may execute such orders at any price and at any time without regard 
to the time and price algorithms of SuperMontage (subject, of course, 
to the obligations of providing best execution).
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    \19\ See Exchange Act Release No. 43514 (November 3, 2000), 65 
FR 69084 (November 15, 2000) (``SuperMontage Order'').
    \20\ See Market Fragmentation Letter, supra note 18.
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    In approving SuperMontage, the Commission noted that

    Today most orders in Nasdaq securities are executed directly 
between Nasdaq participants, not using Nasdaq systems. No price/time 
priority rules apply to this trading, other than a market maker's 
duty to protect its customer limit orders before trading as 
principal. While price priority is generally honored as a market 
principle in executing orders outside of Nasdaq's systems, time 
priority is not accorded to quotes in this trading. Even after 
SuperMontage is implemented, many orders probably will be executed 
outside of SuperMontage free from time priorities.\21\

    \21\ See SuperMontage Order, supra note 19.
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    According to the NASD, only 26 percent of share volume and 36 
percent of trades in Nasdaq are executed using SOES and SelectNet.\22\ 
This leaves approximately 70 percent of Nasdaq volume to be executed 
outside any price and time priority rules. The Commission has stated 
that, ``[i]t is unlikely that market makers will enter customer market 
orders into SuperMontage rather than simply internalizing them 
directly.''\23\
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    \22\ Id., at Note 222.
    \23\ Id., at 26.
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    The question then is whether Nasdaq's exchange status, if approved, 
should require Nasdaq to change its general lack of price and time 
priority. Nasdaq certainly believes that no change is necessary. 
Nasdaq's proposed exchange rules do not create any price or time 
priorities separate and apart from the voluntary provisions of 
SuperMontage. The Commission, in publishing notice of Nasdaq's 
application for registration as an exchange, raised certain 
implications related to Nasdaq's separation from the NASD and its 
application to be an exchange.\24\ While this list of implications 
likely was not intended to be exhaustive, the Commission did not raise 
whether Nasdaq should be required to impose price and time priority in 
order to become an exchange.
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    \24\ Supra note 5 at 31953.
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    The CSE, however, brought this matter before the Commission in its 
comment letter on Nasdaq's exchange application.\25\ The CSE emphasized 
that a competitive response to Nasdaq would be necessary. In filing its 
exchange rules without providing for general price/time priority and 
mandatory centralization of order interaction, Nasdaq apparently 
believes that the Commission will approve Nasdaq's decentralized market 
model. Similarly, the CSE is proposing its OTC-UTP System because CSE 
believes that its proposed market structure is both consistent with the 
federal securities laws and promotes competition and efficient 
execution practices for the ultimate benefit of public investors.
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    \25\ See letter from Jeffrey T. Brown, General Counsel, CSE, to 
Jonathan G. Katz, Secretary, Commission (August 28, 2001).
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Regulatory Oversight
    The Exchange will oversee the OTC-UTP System in the same manner and 
using the same techniques as used for trading through NSTS. Given the 
significance of Rule 12.10, Best Execution, in the operation of the 
OTC-UTP System, however, the Exchange is designing new automated 
exception reports to track unusual trading activity that may indicate a 
failure to provide best execution. The unusual trading activity review 
will include, but not be limited to, a review of trades at prices 
inferior to preexisting bids, offers, and orders, particularly, trades 
inferior to public agency orders on the CLOB. The surveillance 
procedures should reduce the possibility of inadvertent mishandling of 
orders and should detect trading abuses that may be related to a denial 
of best execution. In addition, these regulatory measures should induce 
Users to generally honor price priority across all bids, offers, and 
orders, on the CSE, and thereby increase the likelihood of order 
interaction on the CSE.
    The Regulatory Staff also will include in its annual examination of 
members a review of order handling and execution practices in light of 
the daily exception reports generated by the Exchange. The Exchange 
believes that its proposed regulatory measures exceed those applied by 
NASD Regulation to trading on Nasdaq and should assure the Commission 
that trading activity related to the OTC-UTP System will be performed 
in accordance with the just and equitable principles of trade as 
required by the Act.
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with the provisions of section 6(b) of the Act,\26\ in general, and 
section 6(b)(5) of the Act,\27\ in particular, which requires, among 
other things, that the rules of an exchange be designed to promote just 
and equitable principles of trade, to remove impediments to and perfect 
the mechanism of a free and open market and a national market system, 
and, in general, to protect investors and the public interest.
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    \26\ 15 U.S.C. 78f(b).
    \27\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is not necessary or appropriate 
in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    The Exchange has neither solicited nor received written comments on 
the proposed rule change.\28\
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    \28\ The Commission received a comment letter from the Nasdaq 
and a response to the letter from the CSE. Both letters are 
available in the Commission's Public Reference Room. See letter from 
Richard G. Ketchum, President, Nasdaq, to Jonathan G. Katz, 
Secretary, Commission (January 9, 2002) and letter from Jeffrey T. 
Brown, Senior Vice President, Secretary and General Counsel, CSE, to 
Jonathan G. Katz, Secretary, Commission (January 24, 2002).

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[[Page 6561]]

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the Exchange consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is 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 
Exchange. All submissions should refer to File No. SR-CSE-2001-04 and 
should be submitted by March 5, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\29\
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    \29\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-3297 Filed 2-11-02; 8:45 am]
BILLING CODE 8010-01-P