[Federal Register Volume 67, Number 171 (Wednesday, September 4, 2002)]
[Notices]
[Pages 56607-56608]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-22531]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 46428]


Order Pursuant to Section 11A of the Securities Exchange Act of 
1934 and Rule 11Aa32(f) Thereunder Granting a De Minimis Exemption for 
Transactions in Certain Exchange-Traded Funds From the Trade-Through 
Provisions of the Intermarket Trading System

August 28, 2002.
    Rule 11Aa32(d),\1\ adopted pursuant to Section 11A of the 
Securities Exchange Act of 1934 (``Act'' or ``Exchange Act''),\2\ 
requires each self-regulatory organization (``SRO'') to comply with, 
and enforce compliance by its members and their associated persons 
with, the terms of any effective national market system plan of which 
it is a sponsor or participant. Rule 11Aa32(f) authorizes the 
Commission to exempt, either unconditionally or on specified terms and 
conditions, any SRO, member thereof, or specified security, from the 
requirement of this rule if the Commission determines that such 
exemption is consistent with the public interest, the protection of 
investors, the maintenance of fair and orderly markets and the removal 
of impediments to, and perfection of the mechanisms of, a national 
market system.\3\
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    \1\ See 17 CFR 240.11Aa32(d).
    \2\ Pursuant to Section 11A of the Act, the Commission may, by 
rule or order, ``authorize or require self-regulatory organizations 
to act jointly with respect to matters as to which they share 
authority under [the Act] in planning, developing, operating, or 
regulating a national market system.'' See Section 11A(a)(3)(B) of 
the Act, 15 U.S.C. 78k1(a)(3)(B).
    \3\ See 17 CFR 240.11Aa32(f).
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    The Intermarket Trading System (``ITS'') is an order routing 
network designed to facilitate intermarket trading in exchange-listed 
equity securities among participating SROs based on current quotation 
information emanating from their markets.\4\ The terms of the linkage 
are governed by the ITS Plan, a national market system plan approved by 
the Commission pursuant to Section 11A of the Act and Rule 11Aa32 
thereunder.\5\
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    \4\ Quotations in exchange-listed securities are collected and 
disseminated by the Consolidated Quote System (``CQS''), which is 
governed by the CQ Plan approved by the Commission under Rule 
11Aa32.
    \5\ See Securities Exchange Act Release No. 19456 (January 27, 
1983), 48 FR 4938 (February 3, 1983). The SROs participating in ITS 
include the American Stock Exchange LLC (``Amex''), the Boston Stock 
Exchange, Inc. (``BSE''), the Chicago Board Options Exchange, Inc. 
(``CBOE''), the Chicago Stock Exchange, Inc. (``CHX''), the 
Cincinnati Stock Exchange, Inc. (``CSE''), the National Association 
of Securities Dealers, Inc. (the ``NASD''), the New York Stock 
Exchange, Inc. (``NYSE''), the Pacific Exchange, Inc. (``PCX''), and 
the Philadelphia Stock Exchange, Inc. (``Phlx'') (``Participants'').
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    Under the ITS Plan, a member of a participating SRO may access the 
best bid or offer displayed in CQS by another Participant by sending an 
order (a ``commitment to trade'') through ITS to that Participant. 
Exchange members participate in ITS through facilities provided by 
their respective exchanges. NASD members participate in ITS through a 
facility of the Nasdaq Stock Market (``Nasdaq'') known as the Computer 
Assisted Execution System (``CAES''). Market makers and electronic 
communications networks (``ECNs'') that are members of the NASD and 
seek to display their quotes in exchange-listed securities through 
Nasdaq must register with the NASD as ITS/CAES Market Makers.\6\
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    \6\ See Securities Exchange Act Release No. 42536 (March 16, 
2000), 65 FR 15401 (March 22, 2000). Market makers and ECNs are 
required to provide their best-priced quotations and customer limit 
orders in certain exchange-listed and Nasdaq securities to an SRO 
for public display under Exchange Act Rule 11Ac11 (the ``Quote 
Rule'') and Regulation ATS. 17 CFR 240.11Ac11(c) and 242.301(b)(3).
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    Section 8(d)(i) of the ITS Plan provides that:
    Absent reasonable justification or excuse, a member located in an 
Exchange Market, or an ITS/CAES Market Maker, should not purchase any 
security that he is permitted to trade through the system at a price 
that is higher than the price at which that security, at the time of 
such purchase, is offered in one or more other Participant's Markets 
that trade the security through ITS as reflected by the offer furnished 
from such other Participant's Market(s) then being displayed on the 
trading floor of, or available in the quotation service used by, such 
member or available in the quotation service used by an ITS/CAES Market 
Maker.\7\
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    \7\ ITS Plan, Section 8(d)(i).
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    A similar provision applies with respect to the sale of any such 
security at a price lower than the price at which the security is bid 
for in one or more other Participant's markets.\8\ If a trade-through 
occurs and a complaint is received through ITS from the party whose bid 
or offer was traded through, the party who initiated the trade-through 
may be required to satisfy the bid or offer traded through or take 
other remedial action.\9\
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    \8\ To implement the intent of Section 8(d)(i), each Participant 
has adopted and obtained Commission approval of a ``trade-through 
rule'' substantially the same as the rule attached as Exhibit B to 
the ITS Plan. See ITS Plan, Section 8(d)(ii). See also NYSE Rule 
15A; NASD Rule 5262.
    \9\ See ITS Plan, Exhibit B.
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    The ITS trade-through provisions were designed both to encourage 
market participants to display their trading interest--which 
contributes liquidity to the market--and to help achieve best execution 
for customer orders in exchange-listed securities. Like ITS itself, 
however, these rules were designed at a time when the order routing and 
execution facilities of markets were much slower, intermarket 
competition less keen, and the minimum quote increment for exchange-
listed securities was 1/8 of a dollar ($0.125).
    With the introduction of decimal pricing and technology changes 
that have enabled vastly reduced execution times, the trade-through 
provisions of the ITS Plan have increasingly limited the ability of a 
Participant or ITS/CAES Market Maker to provide an automated execution 
when a better price is displayed by another Participant that does not 
offer automated execution. For example, certain electronic systems can 
offer internal executions in a fraction of a second, whereas ITS 
participants have, at a minimum, thirty seconds to respond to a 
commitment to trade. Thus, an ITS Participant seeking to execute a 
transaction at a price inferior to the price quoted by another ITS 
Participant must generally either (i)

[[Page 56608]]

attempt to access the other Participant's quote, which could delay the 
customer's transaction by thirty seconds or more, or (ii) become 
potentially liable to the other Participant for the amount by which its 
quote was traded through.
    These provisions are particularly restrictive in the case of 
exchange-traded funds (``ETFs'') tracking the Nasdaq-100 Index 
(``QQQs''), the Dow Jones Industrial Average (``DIAMONDs''), and the 
Standard & Poor's 500 Index (``SPDRs''). These ETFs share certain 
characteristics that may make immediate execution highly desirable to 
certain investors. In particular, because these ETFs are highly liquid 
securities and their value is readily derived from the values of the 
underlying shares, the ability to obtain an immediate execution at a 
displayed price may be more important than the opportunity to obtain a 
better price.
    The Commission is granting a de minimis exemption from the trade-
through provisions of the ITS Plan with respect to transactions in 
these ETFs that are effected at a price no more than three cents away 
from the best bid and offer quoted in CQS. A de minimis exemption will 
allow Participants and ITS/CAES Market Makers to execute transactions, 
through automated execution or otherwise, without attempting to access 
the quotes of other Participants when the expected price improvement 
would not be significant. The Commission believes that exempting 
transactions at this level from the ITS trade-through provisions will, 
on balance, provide investors increased liquidity and increased choice 
of execution venues while limiting the possibility that investors will 
receive significantly inferior prices. In particular, the Commission 
believes that the expected benefit to investors seeking an immediate 
execution in such ETFs, rather than a delayed execution through ITS, is 
not likely to exceed three cents per share.
    The Commission considered other alternatives to the three-cents 
threshold and concluded that on balance it represents a sensible 
compromise between retaining the trade-through provisions in their 
current form (a zero-cent threshold) and permitting all trade-throughs 
(a large threshold). The three-cents threshold was chosen to avoid 
compelling broker-dealers to use ITS unless the expected price 
improvement is greater than the de facto cost of using ITS. The de 
facto cost of using ITS is largely due to the option value of the 
commitments that broker-dealers give to dealers in other markets when 
trying to obtain better execution prices. The Office of Economic 
Analysis estimated the value of these options to be between one cent 
per share and two and one-half cents per share for the securities in 
question. Further, since execution of a commitment is uncertain, there 
is a risk that the expected price improvement will be less than the 
displayed quote would suggest. The staff therefore concluded that a 
three-cents trade-through threshold was more reasonable. Although the 
Commission recognizes the limitations of this analysis, it believes 
that the three-cents threshold represents an appropriate compromise 
between competing interests.
    By granting the exemption on a temporary basis, moreover, the 
Commission will be able to gather the data necessary to study the 
effects of an exemption from the ITS trade-through provisions and the 
desirability of extending the exemption. The Commission therefore 
believes that it is consistent with the public interest, the protection 
of investors, the maintenance of fair and orderly markets and the 
removal of impediments to, and perfection of the mechanisms of, a 
national market system to grant a temporary de minimis exemption from 
the trade-through provisions of the ITS Plan with respect to 
transactions in these ETFs. In this connection, the Commission 
emphasizes that the proposed exemption does not relieve brokers and 
dealers of their best execution obligations under the federal 
securities laws and SRO rules.
    Accordingly, it is ordered, pursuant to Section 11A of the Act and 
Rule 11Aa32(f) thereunder, that Participants of the ITS Plan and their 
members are hereby exempt from Section 8(d) of the ITS Plan during the 
period covered by this Order with respect to transactions in QQQs, 
DIAMONDs, and SPDRs that are executed at a price that is no more than 
three cents lower than the highest bid displayed in CQS and no more 
than three cents higher than the lowest offer displayed in CQS.
    This Order shall be effective commencing on September 4, 2002 
through June 4, 2003.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-22531 Filed 9302; 8:45 am]
BILLING CODE 801001P