[Federal Register Volume 67, Number 232 (Tuesday, December 3, 2002)]
[Notices]
[Pages 72007-72008]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-30537]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46872; File No. SR-CSE-2002-04]


Self-Regulatory Organizations; Cincinnati Stock Exchange, Inc.; 
Order Granting Approval to Proposed Rule Change and Amendment Nos. 1 
and 2 Thereto Relating to the Introduction of Order Delivery and 
Automated Response

November 21, 2002.

I. Introduction

    On April 22, 2002, the Cincinnati Stock Exchange, Inc. (``CSE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a 
proposed rule change related to the introduction of order delivery and 
automated response. The proposed rule change was published for comment 
in the Federal Register on May 10, 2002.\3\ On September 13, 2002, the 
CSE filed Amendment No. 1 to the proposed rule change \4\ and on 
September 17, 2002, filed Amendment No. 2 to the proposed rule 
change.\5\ The proposed rule change, as amended by Amendment Nos. 1 and 
2, was republished in its entirety for comment in the Federal Register 
on October 11, 2002.\6\ No comments were received on the proposal. This 
order approves the proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 45873 (May 3, 2002), 
67 FR 31856.
    \4\ See letter from Jennifer M. Lamie, CSE, to Katherine 
England, Assistant Director, Division of Market Regulation 
(``Division''), Commission (September 12, 2002). In Amendment No. 1, 
the CSE deleted proposed rule language in Paragraph 11.9(i)(2)(a) 
regarding price/time and agency/principal priorities, which was 
inadvertently included in the original proposal.
    \5\ See letter from Jennifer M. Lamie, CSE, to Katherine 
England, Assistant Director, Division, Commission (September 16, 
2002). In Amendment No. 2, the CSE expanded the proposed order 
delivery and automated response alternative to all securities traded 
through the Exchange's National Securities Trading System (``NSTS'' 
or ``System''), rather than simply Nasdaq National Market 
Securities. In addition, Amendment No. 2 made certain non-
substantive grammatical changes.
    \6\ See Securities Exchange Act Release No. 46599 (October 4, 
2002), 67 FR 63484.
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II. Description of the Proposal

    The Exchange proposes to amend its rules to increase the 
flexibility of CSE execution systems to accommodate member needs. 
Specifically, CSE proposes to modify CSE's execution functionality 
within the CSE System from a process of automatically matching and 
executing like-priced displayed orders and quotes to an optional 
process of delivering orders to quoting CSE members and requiring 
automated responses from such members back to the CSE System. CSE is 
proposing this modification to facilitate a diverse membership base 
while promoting a fair and orderly market. CSE members that operate as 
electronic communications networks (``ECNs'')\7\ or alternative trading 
systems (``ATSs'') subject to SEC Regulation ATS,\8\ as well as members 
that act as Designated Dealers or specialists on CSE will have the 
option of selecting the type of centralized execution system that best 
fits their business model.
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    \7\ ECNs are defined in SEC Rule 11Ac1-1(a)(8), 17 CFR 
240.11Ac1-1(a)(8), as any electronic system that widely disseminates 
to third parties orders entered therein by an exchange market maker 
or OTC market maker, and permits such orders to be executed against 
in whole or in part.
    \8\ 17 CFR 242.300-303.
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    Currently, CSE's NSTS functions solely in an automatic execution 
mode. In an automatic execution system like NSTS, a Designated Dealer's 
quotation is held in NSTS, and NSTS executes any like-priced contra-
side order against the dealer's quotation. NSTS then informs the 
Designated Dealer and the contra-side CSE member that the quotation and 
the order have been executed by delivering execution messages to both 
parties.
    With the advent of ECN/ATS trading on CSE, members have expressed 
concern that CSE's automatic execution system exposes them to 
significant multiple execution liability. Given the speed with which 
ECN/ATSs operate, it is likely that displayed quotations will be 
subject to internal matches at the same time as another CSE member 
attempts to execute against the same displayed quotations. When faced 
with a similar dilemma, the Nasdaq Stock

[[Page 72008]]

Market, Inc. permitted ECN/ATSs to remain on SelectNet (an order 
delivery system) for inbound executions against the ECN/ATSs' displayed 
quotations rather than requiring them to migrate to the automatic 
execution methodology of the Nasdaq National Market Execution System 
(``NNMS'').\9\ Nasdaq even amended its Intermarket Trading System 
(``ITS'') / Computer Assisted Execution System (``CAES'') (together, 
``ITS/CAES'') definitions and functionality to permit ECN/ATSs to 
operate in an order delivery format when interacting with inbound 
commitments from ITS. Similarly, CSE now proposes to permit members to 
select order delivery and automated response for order interaction with 
displayed quotations within the CSE System or to continue interacting 
through CSE's automatic execution facility.
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    \9\ See Securities Exchange Act Release No. 42344 (January 14, 
2000), 65 FR 3987 (January 25, 2000) in which Nasdaq designated 
SelectNet as the link to ECNs pursuant to the SEC's Order Handling 
Rules. See Securities Exchange Act Release No. 38156 (January 10, 
1997), 62 FR 2415 (January 16, 1997).
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    In an order delivery and automated response system, a member's 
quotation or displayed order will be held in the CSE System, and when a 
contra-side order is received in the CSE System, CSE will immediately 
forward the order message to the quoting member, who will be obligated 
by rule to respond instantaneously to the order message. Moreover, the 
quoting member must have a demonstrated capability to respond 
instantaneously to the order message. On receipt of the order message 
delivered by CSE, the quoting member will automatically determine 
whether its quote is still active. If so, the member will automatically 
deliver to the CSE System matched orders representing its quote and the 
contra-side for execution. If the member's quote is in the process of 
changing due to a prior internal match at the displayed price, 
consistent with the Firm Quote Rule,\10\ the member will reject the 
inbound order and send it back to the CSE System. The CSE System will 
then automatically send a cancellation message to the member submitting 
the order. The entire duration of the order delivery and automated 
response process likely will be less than one second.
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    \10\ 17 CFR 240.11Ac1-1.
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    CSE will require that members demonstrate the capacity to accept 
inbound orders and to automatically respond to the CSE System before 
they will be permitted use of this functionality. Moreover, CSE Rule 
11.9(i)(2) provides that the CSE System will offer order delivery and 
automated response subject to the requirement that members demonstrate 
the capability to respond in an automated manner. Therefore, by rule 
and through demonstrated capacity verified by CSE examiners before 
operation, the CSE will reduce the risk of multiple execution 
liability, while ensuring that members comply with their obligations 
under the Firm Quote Rule.

III. Discussion

    The Commission finds that the proposed rule change, as amended, is 
consistent with the provisions of section 6(b) of the Act,\11\ in 
general, and section 6(b)(5) of the Act,\12\ in particular, which 
requires, among other things, that the rules of an exchange be designed 
to prevent fraudulent and manipulative acts and practices, 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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    \11\ 15 U.S.C. 78f(b). In approving this proposal, the 
Commission has considered the proposed rule change's impact on 
efficiency, competition and capital formation. 15 U.S.C. 78c(f).
    \12\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that the proposal furthers the purpose of 
this section by reducing the risk of dual liability to CSE members. By 
reducing the risk of dual liability, the proposal may encourage CSE 
members, such as ECNs, to display larger sized quotations thereby 
adding liquidity and transparency to the market. Moreover, the 
Commission approved a similar approach to reducing the risk of dual 
liability in the Nasdaq market and believes that CSE's proposal should 
similarly benefit all market participants in the Nasdaq and listed 
markets. The Commission believes that the proposal's requirement that 
CSE members demonstrate the ability to process inbound orders and 
respond appropriately within one second should facilitate the efficient 
functioning of the order delivery and automated response execution 
option. The Commission believes that encouraging greater participation 
in the national market system by market participants, including ECNs, 
furthers the Congressional goal of developing a comprehensive national 
market system.
    It is important to note that, upon approval of the instant 
proposal, a CSE member (or other market participant routing an order to 
the CSE via ITS) may attempt to execute a trade at a price quoted on 
the CSE by an ECN. In such a case, a CSE member (or ITS user) 
submitting an order to the CSE's NSTS may not receive an execution at 
the price originally quoted by the ECN on the CSE, because the ECN may 
have adjusted its quoted price while the order was in transit from the 
CSE to the ECN. CSE represents that this transit time is less than one 
second, and, for firm quote rule \13\ compliance purposes, the 
Commission believes this time to be de minimis. Moreover, the 
Commission believes it is significant that this one-second transit time 
is generally less than the internal transmission time of order routing 
systems in place in other markets.
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    \13\ SEC Rule 11Ac1-1, 17 CFR 240.11Ac1-1 (``Firm Quote Rule'').
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    CSE has committed to examine regularly for patterns of adjustments 
in ECNs' quoted prices that lead to the rejection of orders. 
Specifically, the CSE will analyze those rejections that occur after an 
order arrives at the CSE and before the order arrives at the ECN. 
Should any such patterns be detected, CSE will scrutinize them for 
violations of the Firm Quote Rule and take appropriate action. The CSE 
has also committed to reporting the results of its examination of ECN 
order rejection patterns to the Commission.

IV. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\14\ that the proposed rule change (SR-CSE-2002-04), as amended, is 
hereby approved.
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    \14\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\15\
Margaret H. McFarland,
Deputy Secretary.
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    \15\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 02-30537 Filed 12-2-02; 8:45 am]
BILLING CODE 8010-01-P