[Federal Register Volume 70, Number 124 (Wednesday, June 29, 2005)]
[Rules and Regulations]
[Pages 37496-37644]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-11802]



[[Page 37495]]

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Part II





Securities and Exchange Commission





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17 CFR Parts 200, 201, et al.



Regulation NMS; Final Rule

  Federal Register / Vol. 70, No. 124 / Wednesday, June 29, 2005 / 
Rules and Regulations  

[[Page 37496]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200, 201, 230, 240, 242, 249, and 270

[Release No. 34-51808; File No. S7-10-04]
RIN 3235-AJ18


Regulation NMS

AGENCY: Securities and Exchange Commission.

ACTION: Final rules and amendments to joint industry plans.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting rules under Regulation NMS and two amendments to the joint 
industry plans for disseminating market information. In addition to 
redesignating the national market system rules previously adopted under 
Section 11A of the Securities Exchange Act of 1934 (``Exchange Act''), 
Regulation NMS includes new substantive rules that are designed to 
modernize and strengthen the regulatory structure of the U.S. equity 
markets. First, the ``Order Protection Rule'' requires trading centers 
to establish, maintain, and enforce written policies and procedures 
reasonably designed to prevent the execution of trades at prices 
inferior to protected quotations displayed by other trading centers, 
subject to an applicable exception. To be protected, a quotation must 
be immediately and automatically accessible. Second, the ``Access 
Rule'' requires fair and non-discriminatory access to quotations, 
establishes a limit on access fees to harmonize the pricing of 
quotations across different trading centers, and requires each national 
securities exchange and national securities association to adopt, 
maintain, and enforce written rules that prohibit their members from 
engaging in a pattern or practice of displaying quotations that lock or 
cross automated quotations. Third, the ``Sub-Penny Rule'' prohibits 
market participants from accepting, ranking, or displaying orders, 
quotations, or indications of interest in a pricing increment smaller 
than a penny, except for orders, quotations, or indications of interest 
that are priced at less than $1.00 per share. Finally, the Commission 
is adopting amendments to the ``Market Data Rules'' that update the 
requirements for consolidating, distributing, and displaying market 
information, as well as amendments to the joint industry plans for 
disseminating market information that modify the formulas for 
allocating plan revenues (``Allocation Amendment'') and broaden 
participation in plan governance (``Governance Amendment'').

DATES: Effective Date: August 29, 2005. Compliance Dates: For specific 
phase-in dates for compliance with the final rules and amendments, see 
section VII of this release.

FOR FURTHER INFORMATION CONTACT: Order Protection Rule: Heather Seidel, 
Senior Special Counsel, at (202) 551-5608, Marc F. McKayle, Special 
Counsel, at (202) 551-5633, David Hsu, Special Counsel, at (202) 551-
5664, or Raymond Lombardo, Attorney, at (202) 551-5615; Access Rule: 
Heather Seidel, Senior Special Counsel, at (202) 551-5608, or David 
Liu, Attorney, at (202) 551-5645; Sub-Penny Rule: Michael Gaw, Senior 
Special Counsel, at (202) 551-5602; Market Data Rules, Allocation 
Amendment, and Governance Amendment: David Hsu, Special Counsel, at 
(202) 551-5664; Regulation NMS: Yvonne Fraticelli, Special Counsel, at 
(202) 551-5654; all of whom are in the Division of Market Regulation, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-6628.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. Summary of Rulemaking Process and Record
    B. NMS Principles and Objectives
    1. Competition Among Markets and Competition Among Orders
    2. Serving the Interests of Long-Term Investors and Listed 
Companies
    C. Overview of Adopted Rules
    1. Order Protection Rule
    2. Access Rule
    3. Sub-Penny Rule
    4. Market Data Rules and Plans
II. Order Protection Rule
    A. Response to Comments and Basis for Adopted Rule
    1. Need for Intermarket Order Protection Rule
    2. Limiting Protection to Automated and Accessible Quotations
    3. Workable Implementation of Intermarket Trade-Through 
Protection
    4. Elimination of Proposed Opt-Out Exception
    5. Scope of Protected Quotations
    6. Benefits and Implementation Costs of the Order Protection 
Rule
    B. Description of Adopted Rule
    1. Scope of Rule
    2. Requirement of Reasonable Policies and Procedures
    3. Exceptions
    4. Duty of Best Execution
III. Access Rule
    A. Response to Comments and Basis for Adopted Rule
    1. Means of Access to Quotations
    2. Limitation on Access Fees
    3. Locking or Crossing Quotations
    B. Description of Adopted Rule
    1. Access to Quotations
    2. Limitation on Access Fees
    3. Locking or Crossing Quotations
    4. Regulation ATS Fair Access
IV. Sub-Penny Rule
    A. Background
    B. Commission Proposal and Reproposal on Sub-Penny Quoting
    C. Comments Received
    1. Restriction Based on Price of the Quotation Not Price of the 
Stock
    2. Quotations Below $1.00
    3. Revisiting the Penny Increment
    4. Sub-Penny Trading
    5. Acceptance of Sub-Penny Quotations
    6. Application to Options Markets
    7. One-to-One Negotiating Systems
    8. Implementation of Rule 612
V. Market Data Rules and Plan Amendments
    A. Response to Comments and Basis for Adopted Rules
    1. Alternative Data Dissemination Models
    2. Level of Fees and Plan Governance
    3. Revenue Allocation Formula
    4. Distribution and Display of Data
    B. Description of Adopted Rules and Amendments
    1. Allocation Amendment
    2. Governance Amendment
    3. Consolidation, Distribution, and Display of Data
VI. Regulation NMS
    A. Description of Regulation NMS
    B. Rule 600--NMS Security Designation and Definitions
    1. NMS Security Designation--Transaction Reporting Requirements 
for Equities and Listed Options
    2. NMS Security and NMS Stock
    3. Changes to Existing Definitions in the NMS Rules
    4. Definitions in the Regulation NMS Rules Adopted Today
    C. Changes to Other Rules
VII. Effective Date and Phased-In Compliance Dates
VIII. Paperwork Reduction Act
IX. Consideration of Costs and Benefits
X. Consideration of Burden on Competition, and Promotion of 
Efficiency, Competition and Capital Formation
XI. Regulatory Flexibility Act
XII. Response to Dissent
XIII. Statutory Authority
XIV. Text of Adopted Amendments to the CTA Plan, the CQ Plan, and 
the Nasdaq UTP Plan
XV. Text of Adopted Rules

I. Introduction

    The Commission is adopting Regulation NMS, a series of initiatives 
designed to modernize and strengthen the national market system 
(``NMS'') for equity securities.\1\ These initiatives include:
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    \1\ The Commission originally proposed Regulation NMS in 
February 2004. Securities Exchange Act Release No. 49325 (Feb. 26, 
2004), 69 FR 11126 (Mar. 9, 2004) (``Proposing Release''). It issued 
a supplemental request for comment in May 2004. Securities Exchange 
Act Release No. 49749 (May 20, 2004), 69 FR 30142 (May 26, 2004) 
(``Supplemental Release''). On December 16, 2004, the Commission 
reproposed Regulation NMS in its entirety for public comment. 
Securities Exchange Act Release No. 50870 (Dec. 16, 2004), 69 FR 
77424 (Dec. 27, 2004) (``Reproposing Release'').

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    (1) A new Order Protection Rule,\2\ which reinforces the 
fundamental principle of obtaining the best price for investors when 
such price is represented by automated quotations that are immediately 
accessible;
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    \2\ Although the Reproposing Release referred to Rule 611 as the 
``Trade-Through Rule,'' the reproposed Rule itself was named ``Order 
Protection Rule.'' The term ``Trade-Through Rule'' was used in the 
Reproposing Release to avoid confusion, given that the term had been 
widely used in public debate. The term ``Order Protection Rule,'' 
however, better captures the nature of the adopted Rule. For 
example, the term helps distinguish the existing trade-through 
provisions for exchange-listed stocks, which do not really protect 
orders. Limit order users want a fast, efficient execution of their 
orders, not a slow, costly ``satisfaction'' process that is provided 
by the existing trade-through provisions. See infra, note 30 and 
accompanying text.
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    (2) a new Access Rule, which promotes fair and non-discriminatory 
access to quotations displayed by NMS trading centers through a private 
linkage approach;
    (3) a new Sub-Penny Rule, which establishes a uniform quoting 
increment of no less than one penny for quotations in NMS stocks equal 
to or greater than $1.00 per share to promote greater price 
transparency and consistency;
    (4) amendments to the Market Data Rules and joint industry plans 
that allocate plan revenues to self-regulatory organizations (``SROs'') 
for their contributions to public price discovery and promote wider and 
more efficient distribution of market data; and
    (5) a reorganization of existing Exchange Act rules governing the 
NMS to promote greater clarity and understanding of the rules.
    The Commission is adopting Regulation NMS in furtherance of its 
statutory responsibilities. In 1975, Congress directed the Commission, 
through enactment of Section 11A of the Exchange Act, to facilitate the 
establishment of a national market system to link together the multiple 
individual markets that trade securities. Congress intended the 
Commission to take advantage of opportunities created by new data 
processing and communications technologies to preserve and strengthen 
the securities markets. By incorporating such technologies, the NMS is 
designed to achieve the objectives of efficient, competitive, fair, and 
orderly markets that are in the public interest and protect investors. 
For three decades, the Commission has adhered to these guiding 
objectives in its regulation of the NMS, which are essential to meeting 
the investment needs of the public and reducing the cost of capital for 
listed companies. Over this period, the Commission has continued to 
revise and refine its NMS rules in light of changing market conditions.
    Today, the NMS encompasses the stocks of more than 5000 listed 
companies, which collectively represent more than $14 trillion in U.S. 
market capitalization. Consistent with Congressional intent, these 
stocks are traded simultaneously at a variety of different venues that 
participate in the NMS, including national securities exchanges, 
alternative trading systems (``ATSs''), and market-making securities 
dealers. The Commission believes that the NMS approach adopted by 
Congress is a primary reason that the U.S. equity markets are widely 
recognized as being the fairest, most efficient, and most competitive 
in the world. The rules that the Commission is now adopting represent 
an important and needed step forward in its continuing implementation 
of Congress's objectives for the NMS. By modernizing and strengthening 
the nation's regulatory structure, the rules are designed to assure 
that the equity markets will continue to serve the interests of 
investors, listed companies, and the public for years to come.
    In recent years, the equity markets have experienced sweeping 
changes, ranging from new technologies to new types of markets to the 
initiation of trading in penny increments. The pressing need for NMS 
modernization to reflect these changes is inescapable. Thus, for the 
last five years, the Commission has undertaken a broad and systematic 
review to determine how best to keep the NMS up-to-date. This review 
has required the Commission to grapple with many difficult and 
contentious issues that have lingered unresolved for many years. We 
have devoted a great deal of effort to studying these issues, listening 
to the views of the public, and have carefully considered the comments 
contained in the record to craft rule proposals that would achieve the 
statutory objectives for the NMS.
    Given the wide range of perspectives on market structure issues, it 
is perhaps inevitable that there would be differences of opinion on the 
Commission's policy choices. The time has arrived, however, when 
decisions must be made and contentious issues must be resolved so that 
the markets can move forward with certainty concerning their future 
regulatory environment and appropriately respond to fundamental 
economic and competitive forces. The Commission always seeks to achieve 
consensus, but trying to achieve consensus should not impede the 
achievement of the statutory objectives for the NMS and should not 
damage the competitiveness of the U.S. equity markets, both at home and 
internationally. We believe that further delay is not warranted and 
therefore have adopted final rules needed to modernize and strengthen 
the NMS. The following discussion briefly summarizes the deliberate and 
open rulemaking process that the Commission has undertaken and the 
extensive record that supports the adoption of Regulation NMS, 
including the many empirical studies undertaken by the Commission 
staff.

A. Summary of Rulemaking Process and Record

    The Commission has engaged in a thorough, deliberate, and open 
rulemaking process that has provided at every point an opportunity for 
public participation and debate. We have actively sought out the views 
of the public and securities industry participants. Even prior to 
formulating proposals, our review included multiple public hearings and 
roundtables, an advisory committee, three concept releases, the 
issuance of temporary exemptions intended in part to generate useful 
data on policy alternatives, and a constant dialogue with industry 
participants and investors. This process continued after the proposals 
were published for public comment.\3\ We held a public hearing on the 
proposals in April 2004 (``NMS Hearing'') that included more than 30 
panelists representing investors, individual markets, and market 
participants from a variety of different sectors of the securities 
industry.\4\ Because we believed that there were a number of important 
developments at the public hearing, we published a supplemental request 
for comment and extended the comment period on the proposals in May 
2004 to give the public a full opportunity to respond to these 
developments.\5\ We then carefully considered the more than 700 comment 
letters submitted by the public, which encompassed a wide range of 
views.
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    \3\ Proposing Release, 69 FR at 11126.
    \4\ A list of all panelists and full transcript of the NMS 
Hearing (``Hearing Tr.''), as well as an archived video and audio 
webcast, are available on the Commission's Internet Web site (http://www.sec.gov).
    \5\ Supplemental Release, 69 FR at 30142.
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    The insights of the commenters, as well as those of the NMS Hearing 
panelists, contributed to significant refinements of the original 
proposals. In addition, the Commission staff prepared

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several studies of relevant trading data to help evaluate and respond 
to the views of commenters. Consequently, rather than immediately 
adopting rules, the Commission reproposed Regulation NMS in its 
entirety in December 2004 to afford the public an additional 
opportunity to review and comment on the details of the rules and on 
the staff studies. The Commission then received, and carefully 
considered, more than 1500 additional comments on the reproposal.\6\
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    \6\ The Reproposing Release stated that the Commission would 
continue to consider all comments received on the Proposing Release 
and Supplemental Release, in addition to those on the Reproposing 
Release, in evaluating further rulemaking action. 69 FR at 77426. 
Accordingly, this release discusses comments received in response to 
all three previous releases. Comments on the Proposing Release and 
Supplemental Release are referred to as ``[name of commenter] 
Letter.'' Comments on the Reproposing Release are referred to as 
``[name of commenter] Reproposal Letter.''
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    This extensive rulemaking process has generated an equally 
extensive record, which is discussed at length throughout this release 
as it relates to each of the four substantive rulemaking initiatives. 
Indeed, substantial parts of the release are devoted to responding to 
the many public comments (particularly those opposing the proposals) 
and to discussing the estimated costs and benefits of the rules. This 
rulemaking raised difficult policy issues on which commenters submitted 
differing views. To move forward, the Commission necessarily has had to 
make policy decisions that not everyone will agree with.
    The fact that each of the adopted rules provoked conflicting views 
from commenters should not, however, obscure the very substantial 
evidence in the record strongly supporting each of the four substantive 
rulemaking initiatives in Regulation NMS. Clearly, the Order Protection 
Rule was most controversial and attracted the most public comment and 
attention, yet the breadth of support in the record for the Rule is 
compelling. Indeed, support for an intermarket price protection rule 
begins with the adoption by Congress in 1975 of the national market 
system itself. Both the House and Senate committees responsible for 
drafting Section 11A specifically considered and endorsed the 
Commission's authority to adopt a price protection rule as a means to 
achieve the statutory objectives for the NMS.\7\
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    \7\ See infra, notes 920-922 and accompanying text.
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    Consistent with the drafters' views, a broad spectrum of commenters 
supported adoption of the Order Protection Rule for all NMS stocks, 
including investors, listed companies, individual markets, market 
participants, and academics.\8\ Many individual and institutional 
investors particularly supported the Commission's view that significant 
problems exist that require the Commission to modernize its 
regulations. They also suggested the need for strengthened intermarket 
price protection to further their interests, as did major groups 
representing investors, such as the Investment Company Institute (whose 
mutual fund members manage assets of $7.8 trillion that account for 
more than 95% of all U.S. mutual fund assets), the Committee on 
Investment of Employee Benefit Assets (which represents 110 of the 
nation's largest corporate retirement funds managing $1.1 trillion on 
behalf of 15 million plan participants and beneficiaries), the National 
Association of Investors Corporation (whose membership consists of 
investment clubs and individual investors with aggregate personal 
investments of approximately $116 billion), and the Consumer Federation 
of America.
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    \8\ See infra, notes 56-59, 939-941, 957-960, and accompanying 
text.
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    Moreover, the commenters' views on the need for an intermarket 
price protection rule were supported by the various empirical studies 
of trading data performed by Commission staff. These studies found, 
among other things, that an estimated 1 out of 40 trades for both NYSE 
and Nasdaq stocks are executed at prices inferior to the best displayed 
quotations, or approximately 98,000 trades per day in Nasdaq stocks 
alone.\9\ While the Commission believes that the total number of trade-
throughs should not be the sole consideration in making its policy 
choices, the staff studies and analyses demonstrate that trade-through 
rates are significant and indicate the need for strengthened order 
protection for all NMS stocks.
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    \9\ See infra, notes 66-69, 104, and accompanying text.
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    Why did a broad spectrum of commenters, many of which have 
extensive experience and expertise regarding the inner workings of the 
equity markets, support the Order Protection Rule and its emphasis on 
the principle of best price? They based their support on two 
fundamental rationales, with which the Commission fully agrees. First, 
strengthened assurance that orders will be filled at the best prices 
will give investors, particularly retail investors, greater confidence 
that they will be treated fairly when they participate in the equity 
markets. Maintaining investor confidence is an essential element of 
well-functioning equity markets. Second, protection of the best 
displayed and accessible prices will promote deep and stable markets 
that minimize investor transaction costs. More than 84 million 
individual Americans participate, directly or indirectly, in the U.S. 
equity markets.\10\ The transaction costs associated with the prices at 
which their orders are executed represent a continual drain on their 
long-term savings. Although these costs are difficult to calculate 
precisely, they are very real and very substantial, with estimates 
ranging from $30 billion to more than $100 billion per year.\11\ 
Minimizing these investor costs to the greatest extent possible is the 
hallmark of efficient markets, which is a primary objective of the NMS. 
The Order Protection Rule is needed to help achieve this objective, 
thereby improving the long-term financial well-being of millions of 
investors and reducing the cost of capital for listed companies.
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    \10\ See infra, notes 25-26 and accompanying text.
    \11\ See infra, note 990.
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    In sum, the rules adopted today are the culmination of a long and 
comprehensive rulemaking process. Reaching appropriate policy decisions 
in an area as complex as market structure requires an understanding of 
the relevant facts and of the often subtle ways in which the markets 
work, as well as the balancing of policy objectives that sometimes may 
not point in precisely the same direction. Based on the extensive 
record that we have developed over the course of the rulemaking 
process, the Commission firmly believes that Regulation NMS will 
protect investors, promote fair competition, and enhance market 
efficiency, and therefore fulfills its Exchange Act responsibility to 
facilitate the development of the NMS.

B. NMS Principles and Objectives

1. Competition Among Markets and Competition Among Orders
    The NMS is premised on promoting fair competition among individual 
markets, while at the same time assuring that all of these markets are 
linked together, through facilities and rules, in a unified system that 
promotes interaction among the orders of buyers and sellers in a 
particular NMS stock. The NMS thereby incorporates two distinct types 
of competition--competition among individual markets and competition 
among individual orders--that together contribute to efficient markets. 
Vigorous competition among markets promotes more efficient and 
innovative trading services, while

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integrated competition among orders promotes more efficient pricing of 
individual stocks for all types of orders, large and small. Together, 
they produce markets that offer the greatest benefits for investors and 
listed companies.
    Accordingly, the Commission's primary challenge in facilitating the 
establishment of an NMS has been to maintain an appropriate balance 
between these two vital forms of competition. It particularly has 
sought to avoid the extremes of: (1) Isolated markets that trade an NMS 
stock without regard to trading in other markets and thereby fragment 
the competition among buyers and sellers in that stock; and (2) a 
totally centralized system that loses the benefits of vigorous 
competition and innovation among individual markets. Achieving this 
objective and striking the proper balance clearly can be a difficult 
task. Since Congress mandated the establishment of an NMS in 1975, the 
Commission frequently has resisted suggestions that it adopt an 
approach focusing on a single form of competition that, while perhaps 
easier to administer, would forfeit the distinct, but equally vital, 
benefits associated with both competition among markets and competition 
among orders.
    With respect to competition among markets, for example, the record 
of the last thirty years should give pause to those who believe that 
any market structure regulation is inherently inconsistent with 
vigorous market competition. Other countries with significant equity 
trading typically have a single, overwhelmingly dominant public 
market.\12\ The U.S., in contrast, is fortunate to have equity markets 
that are characterized by extremely vigorous competition among a 
variety of different types of markets. These include: (1) Traditional 
exchanges with active trading floors, which even now are evolving to 
expand the range of choices that they offer investors for both 
automated and manual trading; (2) purely electronic markets, which 
offer both standard limit orders and conditional orders that are 
designed to facilitate complex trading strategies; (3) market-making 
securities dealers, which offer both automated execution of smaller 
orders and the commitment of capital to facilitate the execution of 
larger, institutional orders; (4) regional exchanges, many of which 
have adopted automated systems for executing smaller orders; and (5) 
automated matching systems that permit investors, particularly large 
institutions, to seek counter-parties to their trades anonymously and 
with minimal price impact.
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    \12\ These markets include the London Stock Exchange in the 
United Kingdom, the Tokyo Stock Exchange in Japan, Euronext in 
France, and the Deutsche Bourse in Germany.
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    In sum, while NMS regulation may channel specific types of market 
competition (e.g., by mandating the display to investors of 
consolidated prices and including the prices displayed internally by 
significant electronic markets), it has been remarkably successful in 
promoting market competition in its broader forms that are most 
important to investors and listed companies.
    The difficulty, however, is that competition among multiple markets 
trading the same stocks can detract from the most vigorous competition 
among orders in an individual stock, thereby impeding efficient price 
discovery for orders of all sizes. The importance of competition among 
orders has long been recognized. Indeed, when Congress mandated the 
establishment of an NMS, it well stated this basic principle: 
``Investors must be assured that they are participants in a system 
which maximizes the opportunities for the most willing seller to meet 
the most willing buyer.'' \13\ To the extent that competition among 
orders is lessened, the quality of price discovery for all sizes of 
orders can be compromised. Impaired price discovery could cause market 
prices to deviate from fundamental values, reduce market depth and 
liquidity,\14\ and create excessive short-term volatility that is 
harmful to long-term investors and listed companies. More broadly, when 
market prices do not reflect fundamental values, resources will be 
misallocated within the economy and economic efficiency--as well as 
market efficiency--will be impaired.
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    \13\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975). The 
quotation from the text of the House Report concludes a cogent 
description of the importance of maintaining the proper balance 
between competition among markets and competition among orders that 
is worth quoting in full:
    Critics of this development [multiple trading of stocks] suggest 
that the markets are becoming dangerously fragmented. Others contend 
that the dilution of large market dominance is the result of healthy 
competitive forces which have done much to add to the liquidity and 
depth of the securities markets to the benefit of the investing 
public. The Committee shares the opinion that our markets will be 
strengthened by the infusion of marketmaker competition in listed 
securities with the concomitant increase in capital availability and 
diminution of risk which results from increased competition among 
specialists and marketmakers. Nonetheless, market fragmentation 
becomes of increasing concern in the absence of mechanisms designed 
to assure that public investors are able to obtain the best price 
for securities regardless of the type or physical location of the 
market upon which his transaction may be executed. Investors must be 
assured that they are participants in a system which maximizes the 
opportunities for the most willing seller to meet the most willing 
buyer.
    Id.
    \14\ The Proposing Release and Reproposing Release frequently 
emphasized the importance of promoting greater depth and liquidity. 
Some commenters appeared to equate depth and liquidity with other 
factors, such as trading volume and frequency of quotation updates. 
See, e.g., Letter from Edward J. Nicoll, Chief Executive Officer, 
Instinet Group Incorporated, to Jonathan G. Katz, Secretary, 
Commission, dated Jan. 26, 2005 (``Instinet Reproposal Letter'') at 
9; Letter from Marc E. Lackritz, President, Securities Industry 
Association, to Jonathan G. Katz, Secretary, Commission, dated Feb. 
1, 2005 (``SIA Reproposal Letter'') at 12. The Commission, however, 
uses the terms specifically to refer to the ability of investors to 
trade in large size at low cost and in general to a market's 
capacity to absorb order imbalances with minimized price impact. 
Depth is measured in terms of the volume of stock that can be 
readily traded at a particular price point. Liquidity is measured by 
the price movement experienced by investors when attempting to trade 
in large size. See infra, section II.A.6 (estimate of transaction 
costs for equity mutual funds). Although depth and liquidity are 
correlated with trading volume, they are not synonymous. For 
example, one stock might have less trading volume than another 
stock, but still have greater depth available at and close to the 
best quoted prices and lower transaction costs for large 
institutional investors.
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2. Serving the Interests of Long-Term Investors and Listed Companies
    In its extended review of market structure issues and in assessing 
how best to achieve an appropriate balance between competition among 
markets and competition among orders, the Commission has been guided by 
a firm belief that one of the most important goals of the equity 
markets is to minimize the transaction costs of long-term investors and 
thereby to reduce the cost of capital for listed companies. These 
functions are inherently related because the cost of capital of listed 
companies is influenced by the transaction costs of those who are 
willing to accept the risk of holding corporate equity for an extended 
period.\15\
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    \15\ Investors are more willing to own a stock if it can be 
readily traded in the secondary market with low transaction costs. 
The greater the willingness of investors to own a stock, the higher 
its price will be, thereby reducing the issuer's cost of capital.
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    The Reproposing Release touched on this issue in the specific 
context of assessing the effect of the Order Protection Rule on the 
interests of professional traders in conducting extremely short-term 
trading strategies that can depend on millisecond differences in order 
response time from markets. Noting that any protection against trade-
throughs could interfere to some extent with such short-term trading 
strategies, the release framed the Commission's policy choice as 
follows: ``Should the overall efficiency of the NMS defer to the needs 
of professional

[[Page 37500]]

traders, many of whom rarely intend to hold a position overnight? Or 
should the NMS serve the needs of longer-term investors, both large and 
small, that will benefit substantially from intermarket price 
protection?'' \16\ The Reproposing Release emphasized that the NMS must 
meet the needs of longer-term investors, noting that any other outcome 
would be contrary to the Exchange Act and its objectives of promoting 
fair and efficient markets that serve the public interest.\17\
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    \16\ Reproposing Release, 69 FR at 77440.
    \17\ Id.
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    In response, some commenters disputed this focus on the interests 
of long-term investors in formulating Regulation NMS, one even 
questioning the Commission's statutory authority to do so.\18\ Other 
commenters appeared to share this view, as evidenced by their 
downplaying, or failing entirely to address, indications of a need for 
improvements in market quality that are important to long-term 
investors, such as minimizing short-term price volatility.\19\
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    \18\ Letter from Phylis M. Esposito, Executive Vice President, 
Chief Strategy Officer, Ameritrade, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated Jan. 26, 2005 (``Ameritrade Reproposal 
Letter'') at 9 (among other issues, questioning Commission's 
statutory authority); Letter from James A. Duncan, Chairman, and 
John C. Giesea, President and CEO, Security Traders Association, to 
Jonathan G. Katz, Secretary, Commission, dated Jan. 19, 2005 (``STA 
Reproposal Letter'') at 6; Letter from William A. Vance, Stephen 
Kay, and Kimberly Unger, The Security Traders Association of New 
York, Inc., dated Jan. 24, 2005 (``STANY Reproposal Letter'') at 8 
n. 18.
    \19\ See, e.g., Instinet Reproposal Letter at 7-8 (``We further 
believe there is no basis for the Commission's assertion that the 
reproposed trade-through rule would increase fill rates or reduce 
transitory volatility on the Nasdaq market (or, for that matter, 
whether these are in fact `weaknesses' that need to be 
addressed.''). Short-term price volatility for Nasdaq stocks is 
discussed further in section II.A.1.b below.
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    Most of the time, the interests of short-term traders and long-term 
investors will not conflict. Short-term traders clearly provide 
valuable liquidity to the market. But when the interests of long-term 
investors and short-term traders diverge, few issues are more 
fundamentally important in formulating public policy for the U.S. 
equity markets than the choice between these interests. While achieving 
the right balance of competition among markets and competition among 
orders will always be a difficult task, there will be no possibility of 
accomplishing it if in the case of a conflict the Commission cannot 
choose whether the U.S. equity markets should meet the needs of long-
term investors or short-term traders.
    The objective of minimizing short-term price volatility offers an 
important example where the interests of long-term investors can 
diverge from those of short-term traders. Deep and liquid markets that 
minimize volatility are of most benefit to long-term investors. Such 
markets help reduce transaction costs by furthering the ability of 
investors to establish and unwind positions in a stock at prices that 
are as close to previously prevailing prices as possible. Indeed, the 
1975 Senate Report on the NMS emphasized that one of the ``paramount'' 
objectives for the NMS is ``the maintenance of stable and orderly 
markets with maximum capacity for absorbing trading imbalances without 
undue price movements.'' \20\
---------------------------------------------------------------------------

    \20\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 7 (1975).
---------------------------------------------------------------------------

    Excessively volatile markets, in contrast, can generate many 
opportunities for traders to earn short-term profits from rapid price 
swings. Short-term traders, in particular, typically possess the 
systems capabilities and expertise necessary to enter and exit the 
market rapidly to exploit such price swings. Moreover, short-term 
traders have great flexibility in terms of their choice of stocks, 
choice of initially establishing a long or short position, and time of 
entering and exiting the market. Long-term investors (both 
institutional and retail), in contrast, typically have an opinion on 
the long-term prospects for a company. They therefore want to buy or 
sell a particular stock at a particular time. These investors thus are 
inherently less able to exploit short-term price swings and, indeed, 
their buying or selling interest often can initiate short-term price 
movements.\21\ Efficient markets with maximum liquidity and depth 
minimize such price movements and thereby afford long-term investors an 
opportunity to achieve their trading objectives with the lowest 
possible transaction costs.
---------------------------------------------------------------------------

    \21\ Long-term investors, of course, also can be interested in 
fast executions. One of the primary effects of the Order Protection 
Rule adopted today will be to promote much greater speed of 
execution in the market for exchange-listed stocks. The difference 
in speed between automated and manual markets often is the 
difference between a 1-second response and a 15-second response--a 
disparity that clearly can be important to many investors.
---------------------------------------------------------------------------

    The Commission recognizes that it is important to avoid false 
dichotomies between the interests of short-term traders and long-term 
investors, and that many difficult line-drawing issues potentially can 
arise in precisely defining the difference between the two terms. For 
present purposes, however, these issues can be handled by simply noting 
that it makes little sense to refer to someone as ``investing'' in a 
company for a few seconds, minutes, or hours.\22\
---------------------------------------------------------------------------

    \22\ The concept of ownership for a significant time period is 
inherent in the meaning of word ``invest.'' A dictionary definition 
of ``investor,'' for example, is ``one that seeks to commit funds 
for long-term profit with a minimum of risk.'' Webster's Third New 
International Dictionary of the English Language 1190 (Unabridged 
1993).
---------------------------------------------------------------------------

    Short-term traders and market intermediaries unquestionably provide 
needed liquidity to the equity markets and are essential to the welfare 
of investors. Consequently, much, if not most, of the time the 
interests of long-term investors and short-term traders in market 
quality issues such as speed and operational efficiency will coincide. 
Indeed, implementation of Regulation NMS likely will lead to a 
significant expansion of automated trading in exchange-listed stocks 
that both benefits all investors and opens up greater potential for 
electronic trading in such stocks than currently exists. But when the 
interests of long-term investors and short-term traders conflict in 
this context, the Commission believes that its clear responsibility is 
to uphold the interests of long-term investors.
    Indeed, the core concern for the welfare of long-term investors who 
depend on equity investments to meet their financial goals was first 
expressed in the foundation documents of the Exchange Act itself. In 
language that remains remarkably relevant today, the 1934 congressional 
reports noted how the national public interest of the equity markets 
had grown as more and more Americans had begun to place their savings 
in equity investments, both directly and indirectly through investment 
intermediaries.\23\ Given this development, the reports emphasized that 
``stock exchanges which handle the distribution and trading of a very 
substantial part of the entire national wealth * * * cannot operate 
under the same traditions and practices as pre-war stock exchanges 
which handled substantially only the transactions of professional 
investors and speculators.'' \24\
---------------------------------------------------------------------------

    \23\ H.R. Rep. No. 1383, 73rd Cong., 2d Sess. 3-4 (1934) (``It 
is estimated that more than 10,000,000 individual men and women in 
the United States are the direct possessors of stocks and bonds; 
that over one-fifth of all the corporate stock outstanding in the 
country is held by individuals with net incomes of less than $5,000 
a year. Over 15,000,000 individuals held insurance policies, the 
value of which is dependent on the security holdings of insurance 
companies. Over 13,000,000 men and women have savings accounts in 
mutual savings banks and at least 25,000,000 have deposits in 
national and State banks and trust companies--which are in turn 
large holders of corporate stocks and bonds.'').
    \24\ Id. at 4. The Congressional emphasis on the interests of 
long-term investors versus short-term traders also was expressed in 
the 1934 Report on Stock Exchange Practices prepared by 
investigators for the Senate Committee on Banking and Currency:
    ``Transactions in securities on organized exchanges and over-
the-counter markets are affected with the national public interest. 
* * * In former years transactions in securities were carried on by 
a relatively small portion of the American people. During the last 
decade, however, due largely to the development of the means of 
communication * * * the entire Nation has become acutely sensitive 
to the activities on the securities exchanges. While only a fraction 
of the multitude who now own securities can be regarded as actively 
trading on the exchanges, the operations of these few profoundly 
affect the holdings of all.''
    S. Rep. No. 73-1455, 73rd Cong., 2d Sess. 5 (1934).

---------------------------------------------------------------------------

[[Page 37501]]

    In the years since 1934, the priority placed by Congress on the 
interests of long-term investors has grown more and more significant. 
Today, more than 84 million individuals representing more than one-half 
of American households own equity securities.\25\ More than 70 million 
of these individuals participate indirectly in the equity markets 
through ownership of mutual fund shares. Most of them hold their 
investments, at least in part, in retirement plans. Indeed, nearly all 
view their equity investments as savings for the long-term, and their 
median length of ownership of equity mutual funds, both inside and 
outside retirement plans, is 10 years.\26\
---------------------------------------------------------------------------

    \25\ Investment Company Institute and Securities Industry 
Association, Equity Ownership in America 17 (2002).
    \26\ Id. at 85, 89, 92, 96.
---------------------------------------------------------------------------

    In assessing the current state of the NMS and formulating its rule 
proposals, the Commission has focused on the interests of these 
millions of Americans who depend on the performance of their equity 
investments for such vital needs as retirement security and their 
children's college education. Their investment returns are reduced by 
transaction costs of all types, including the explicit costs of 
commissions and mutual fund fees. But the largely hidden costs 
associated with the prices at which trades are executed often can dwarf 
the explicit costs of trading. For example, the implicit transaction 
costs associated with the price impact of trades and liquidity search 
costs of mutual funds and other institutional investors is estimated at 
more than $30 billion per year.\27\ Such hidden costs eat away at the 
long-term returns of millions of individual mutual fund shareholders 
and pension plan participants. One of the primary objectives of the NMS 
is to help reduce such costs by improving market liquidity and depth. 
The best way to promote market depth and liquidity is to encourage 
vigorous competition among orders. As a result, the Commission cannot 
merely focus on one type of competition--competition among markets to 
provide trading services--at the expense of competition among orders. 
The interests of U.S. long-term investors and listed companies require 
that the NMS continue to promote both types of competition.
---------------------------------------------------------------------------

    \27\ See infra, section II.A.6.
---------------------------------------------------------------------------

C. Overview of Adopted Rules

1. Order Protection Rule
    The Order Protection Rule (Rule 611 under Regulation NMS) 
establishes intermarket protection against trade-throughs for all NMS 
stocks. A trade-through occurs when one trading center executes an 
order at a price that is inferior to the price of a protected 
quotation, often representing an investor limit order, displayed by 
another trading center.\28\ Many commenters on the proposals, 
particularly large institutional investors, strongly supported the need 
for enhanced protection of limit orders against trade-throughs.\29\ 
They emphasized that limit orders are the building blocks of public 
price discovery and efficient markets. They stated that a uniform rule 
for all NMS stocks, by enhancing protection of displayed prices, would 
encourage greater use of limit orders and contribute to increased 
market liquidity and depth. The Commission agrees that strengthened 
protection of displayed limit orders would help reward market 
participants for displaying their trading interest and thereby promote 
fairer and more vigorous competition among orders seeking to supply 
liquidity. Moreover, strong intermarket price protection offers greater 
assurance, on an order-by-order basis, that investors who submit market 
orders will receive the best readily available prices for their trades. 
The Commission therefore has adopted the Order Protection Rule to 
strengthen the protection of displayed and automatically accessible 
quotations in NMS stocks.
---------------------------------------------------------------------------

    \28\ The nature and scope of quotations that will be protected 
under the Order Protection Rule are discussed in detail in sections 
II.A.2 and II.B.1 below.
    \29\ See infra, note 56 (overview of commenters supporting 
trade-through proposal).
---------------------------------------------------------------------------

    The Order Protection Rule takes a substantially different approach 
than the trade-through provisions currently set forth in the 
Intermarket Trading System (``ITS'') Plan,\30\ which apply only to 
exchange-listed stocks. The ITS provisions are not promulgated by the 
Commission, but rather are rules of the markets participating in the 
ITS Plan. These rules were drafted decades ago and do not distinguish 
between manual and automated quotations. Moreover, they state that 
markets ``should avoid'' trade-throughs and provide an after-the-fact 
complaint procedure pursuant to which, if a trade-through occurs, the 
aggrieved market may seek satisfaction from the market that traded 
through. Finally, the ITS provisions have significant gaps in their 
coverage, particularly for off-exchange positioners of large, block 
transactions (10,000 shares or greater), that have weakened their 
protection of limit orders.
---------------------------------------------------------------------------

    \30\ The full title of the ITS Plan is ``Plan for the Purpose of 
Creating and Operating an Intermarket Communications Linkage 
Pursuant to Section 11A(c)(3)(B) of the Securities Exchange Act of 
1934.'' The ITS Plan was initially approved by the Commission in 
1978. Securities Exchange Act Release No. 14661 (Apr. 14, 1978), 43 
FR 17419 (Apr. 24, 1978). All national securities exchanges that 
trade exchange-listed stocks and the NASD are participants in the 
ITS Plan. It requires each participant to provide electronic access 
to its displayed best bid or offer to other participants and 
provides an electronic mechanism for routing orders, called 
commitments to trade, to access those displayed prices. The 
participants also agreed to avoid trade-throughs and locked markets 
and to adopt rules addressing such practices.
---------------------------------------------------------------------------

    In contrast, the adopted Order Protection Rule protects only 
quotations that are immediately accessible through automatic execution. 
It thereby addresses a serious weakness in the ITS provisions, which 
were drafted for a world of floor-based markets and fail to reflect the 
disparate speed of response between manual and automated quotations. By 
requiring order routers to wait for a response from a manual market, 
the ITS trade-through provisions can cause an order to miss both the 
best price of a manual quotation and slightly inferior prices at 
automated markets that would have been immediately accessible. The 
Order Protection Rule eliminates this potential inefficiency by 
protecting only automated quotations. It also promotes equal regulation 
and fair competition among markets by eliminating any potential 
advantage that the ITS trade-through provisions may have given manual 
markets over automated markets.
    In addition, the Order Protection Rule incorporates an approach to 
trade-throughs that is stricter and more comprehensive than the ITS 
provisions. First, it requires trading centers to establish, maintain, 
and enforce written policies and procedures that are reasonably 
designed to prevent trade-throughs, or, if relying on one of the rule's 
exceptions, that are reasonably designed to assure compliance with the 
exception. To assure effective compliance, such policies and procedures 
will need to incorporate objective standards that are coded into a 
trading center's automated systems.

[[Page 37502]]

Moreover, a trading center is required to regularly surveil to 
ascertain the effectiveness of its policies and procedures and to take 
prompt action to remedy deficiencies. Second, the Order Protection Rule 
eliminates very significant gaps in the coverage of the ITS provisions 
that have undermined the extent to which they protect limit orders and 
promote fair and orderly trading. In particular, the ITS provisions do 
not cover the transactions of broker-dealers acting as off-exchange 
block positioners in exchange-listed stocks. They also exclude trade-
throughs of 100-share quotations, thereby allowing some limit orders of 
small investors to be bypassed. The Order Protection Rule closes both 
of these gaps in coverage.
    The definition of ``protected bid'' or ``protected offer'' in 
paragraph (b)(57) of adopted Rule 600 controls the scope of quotations 
that are protected by the Order Protection Rule. The Commission is 
adopting the reproposed ``Market BBO Alternative'' that protects only 
the best bids and offers (``BBOs'') of the nine self-regulatory 
organizations (``SROs'') and The Nasdaq Stock Market, Inc. (``Nasdaq'') 
whose members currently trade NMS stocks. As discussed further in 
section II.A.5 below, the Commission has decided not to adopt the 
reproposed ``Voluntary Depth Alternative.'' In particular, it believes 
that the Market BBO Alternative: (1) Strikes an appropriate balance 
between competition among markets and competition among orders; and (2) 
will be less difficult and costly to implement than the Voluntary Depth 
Alternative.
    The rule text of the original proposal included a general ``opt-
out'' exception that would have allowed market participants to 
disregard displayed quotations. While the opt-out proposal was intended 
to provide flexibility to market participants, such an exception would 
have left a gap in protection of the best displayed prices and thereby 
reduced the proposal's potential benefits for investors. The 
elimination of any protection for manual quotations is the principal 
reason that this broad exception is no longer necessary in the Order 
Protection Rule as adopted. In addition, the Rule adds a number of 
tailored exceptions that carve out those situations in which many 
investors may otherwise have felt they legitimately needed to opt-out 
of a displayed quotation. These exceptions are more consistent with the 
principle of protecting the best price than a general opt-out exception 
would have been. The additional exceptions also will help assure that 
the Order Protection Rule is workable for high-volume stocks. Examples 
of these exceptions include intermarket sweep orders, quotations 
displayed by markets that fail to meet the response requirements for 
automated quotations, and flickering quotations with multiple prices 
displayed in a single second.\31\
---------------------------------------------------------------------------

    \31\ Flickering quotations are discussed further in section 
II.A.3 below.
---------------------------------------------------------------------------

    Some commenters questioned the need to extend the Order Protection 
Rule to Nasdaq stocks.\32\ These commenters generally emphasized the 
much improved efficiency of trading in Nasdaq stocks in recent years. 
They particularly were concerned that extension of intermarket price 
protection to Nasdaq stocks, at least in the absence of a general opt-
out exception, would interfere with current trading methods.
---------------------------------------------------------------------------

    \32\ See infra, notes 61-62 and accompanying text.
---------------------------------------------------------------------------

    The Commission believes, however, that intermarket price protection 
will benefit investors and strengthen the NMS in both exchange-listed 
and Nasdaq stocks. It will contribute to the maintenance of fair and 
orderly markets and, thereby, promote investor confidence in the 
markets. As discussed below,\33\ trade-through rates are significant in 
both Nasdaq and exchange-listed stocks. For example, an estimated 1 of 
every 40 trades in both Nasdaq and NYSE stocks represents a significant 
trade-through of a displayed quotation. For many active Nasdaq stocks, 
approximately 1 of every 11 shares traded is a significant trade-
through. The execution of trades at prices inferior to those offered by 
displayed and accessible limit orders is inconsistent with basic 
notions of fairness and orderliness, particularly for investors, both 
large and small, who post limit orders and see those orders routinely 
traded through. These trade-throughs can undermine incentives to 
display limit orders. Moreover, many of the investors whose market 
orders are executed at inferior prices may not, in fact, be aware they 
received an inferior price from their broker and executing market. In 
sum, the Commission believes that a rule establishing price protection 
on an order-by-order basis for all NMS stocks is needed to protect the 
interests of investors, promote the display of limit orders, and 
thereby improve the efficiency of the NMS as a whole.
---------------------------------------------------------------------------

    \33\ See infra, section II.A.1.a.ii.
---------------------------------------------------------------------------

2. Access Rule
    The Access Rule (Rule 610 under Regulation NMS) sets forth new 
standards governing access to quotations in NMS stocks. As emphasized 
by many commenters on the proposals,\34\ protecting the best displayed 
prices against trade-throughs would be futile if broker-dealers and 
trading centers were unable to access those prices fairly and 
efficiently. Accordingly, Rule 610 is designed to promote access to 
quotations in three ways. First, it enables the use of private linkages 
offered by a variety of connectivity providers,\35\ rather than 
mandating a collective linkage facility such as ITS, to facilitate the 
necessary access to quotations. The lower cost and increased 
flexibility of connectivity in recent years has made private linkages a 
feasible alternative to hard linkages, absent barriers to access. Using 
private linkages, market participants may obtain indirect access to 
quotations displayed by a particular trading center through the 
members, subscribers, or customers of that trading center. To promote 
this type of indirect access, Rule 610 prohibits a trading center from 
imposing unfairly discriminatory terms that would prevent or inhibit 
the access of any person through members, subscribers, or customers of 
such trading center.
---------------------------------------------------------------------------

    \34\ See infra, section III.A.1.
    \35\ Private linkages are discussed further in section III.A.1 
below.
---------------------------------------------------------------------------

    Second, Rule 610 generally limits the fees that any trading center 
can charge (or allow to be charged) for accessing its protected 
quotations to no more than $0.003 per share.\36\ The purpose of the fee 
limitation is to ensure the fairness and accuracy of displayed 
quotations by establishing an outer limit on the cost of accessing such 
quotations. For example, if the price of a protected offer to sell an 
NMS stock is displayed at $10.00, the total cost to access the offer 
and buy the stock will be $10.00, plus a fee of no more than $0.003. 
The adopted rule thereby assures order routers that displayed prices 
are, within a limited range, true prices.
---------------------------------------------------------------------------

    \36\ If the price of a protected quotation is less than $1.00, 
the fee cannot exceed 0.3% of the quotation price. The rule as 
adopted also applies the fee limitation to quotations other than 
protected quotations that are the BBOs of an SRO or Nasdaq. See 
infra, section III.A.2.
---------------------------------------------------------------------------

    The adopted fee limitation substantially simplifies the originally-
proposed limitation on fees, which, in general, would have limited the 
fees of individual market participants to $0.001 per share, with an 
accumulated cap of $0.002 per share. Perhaps more than any other single 
issue, the proposed limitation on access fees splintered the 
commenters.\37\ Some supported the proposal as a worthwhile compromise

[[Page 37503]]

on an extremely difficult issue. They believed that it would level the 
playing field in terms of who could charge fees, as well as give 
greater certainty to market participants that quoted prices will, 
essentially, be true prices. Others were strongly opposed to any 
limitation on fees, believing that competition alone would be 
sufficient to address high fees that distort quoted prices. Still 
others were equally adamant that all access fees of electronic 
communications networks (``ECNs'') charged to non-subscribers should be 
prohibited entirely, although they did not see a problem with fees 
charged to a market's members or subscribers. Although consensus could 
not be achieved on any particular approach, commenters expressed a 
strong desire for resolution of a difficult issue that has caused 
discord within the securities industry for many years.
---------------------------------------------------------------------------

    \37\ The comments on access fees are addressed in section 
III.A.2 below.
---------------------------------------------------------------------------

    The Commission believes that a single, uniform fee limitation of 
$0.003 per share is the fairest and most appropriate resolution of the 
access fee issue. First, it will not seriously interfere with current 
business practices, as trading centers have very few fees on their 
books of more than $0.003 per share or earn substantial revenues from 
such fees.\38\ Second, the uniform fee limitation promotes equal 
regulation of different types of trading centers, where previously some 
had been permitted to charge fees and some had not. Finally and most 
importantly, the fee limitation of Rule 610 is necessary to support the 
integrity of the price protection requirement established by the 
adopted Order Protection Rule. In the absence of a fee limitation, some 
``outlier'' trading centers might take advantage of the requirement to 
protect displayed quotations by charging exorbitant fees to those 
required to access the outlier's quotations. Rule 610's fee limitation 
precludes the initiation of this business practice, which would 
compromise the fairness and efficiency of the NMS.
---------------------------------------------------------------------------

    \38\ See infra, section III.A.2.
---------------------------------------------------------------------------

    Finally, Rule 610 requires SROs to establish, maintain, and enforce 
written rules that, among other things, prohibit their members from 
engaging in a pattern or practice of displaying quotations that lock or 
cross the protected quotations of other trading centers. Trading 
centers will be allowed, however, to display automated quotations that 
lock or cross the manual quotations of other trading centers. The 
Access Rule thereby reflects the disparity in speed of response between 
automated and manual quotations, while also promoting fair and orderly 
markets by establishing that the first protected quotation at a price, 
whether it be a bid or an offer, is entitled to an execution at that 
price instead of being locked or crossed by a quotation on the other 
side of the market.
3. Sub-Penny Rule
    The Sub-Penny Rule (adopted Rule 612 under Regulation NMS) 
prohibits market participants from displaying, ranking, or accepting 
quotations in NMS stocks that are priced in an increment of less than 
$0.01, unless the price of the quotation is less than $1.00. If the 
price of the quotation is less than $1.00, the minimum increment is 
$0.0001. A strong consensus of commenters supported the sub-penny 
proposal as a means to promote greater price transparency and 
consistency, as well as to protect displayed limit orders.\39\ In 
particular, Rule 612 addresses the practice of ``stepping ahead'' of 
displayed limit orders by trivial amounts. It therefore should further 
encourage the display of limit orders and improve the depth and 
liquidity of trading in NMS stocks.
---------------------------------------------------------------------------

    \39\ The comments on the sub-penny proposal are discussed in 
section IV.C below.
---------------------------------------------------------------------------

4. Market Data Rules and Plans
    The adopted amendments to the Market Data Rules (adopted Rules 601 
and 603 under Regulation NMS) and joint industry plans (``Plans'') \40\ 
are designed to promote the wide availability of market data and to 
allocate revenues to SROs that produce the most useful data for 
investors. They will strengthen the existing market data system, which 
provides investors in the U.S. equity markets with real-time access to 
the best quotations and most recent trades in the thousands of NMS 
stocks throughout the trading day. For each stock, quotations and 
trades are continuously collected from many different trading centers 
and then disseminated to the public in a consolidated stream of data. 
As a result, investors of all types have access to a reliable source of 
information for the best prices in NMS stocks. When Congress mandated 
the creation of the NMS in 1975, it noted that the systems for 
disseminating consolidated market data would ``form the heart of the 
national market system.'' \41\ Accordingly, one of the Commission's 
most important responsibilities is to preserve the integrity and 
affordability of the consolidated data stream.
---------------------------------------------------------------------------

    \40\ The three joint-industry plans are (1) the CTA Plan, which 
is operated by the Consolidated Tape Association and disseminates 
transaction information for exchange-listed securities, (2) the CQ 
Plan, which disseminates consolidated quotation information for 
exchange-listed securities, and (3) the Nasdaq UTP Plan, which 
disseminates consolidated transaction and quotation information for 
Nasdaq-listed securities. The CTA Plan and CQ Plan are available at 
www.nysedata.com. The Nasdaq UTP Plan is available at 
www.utpdata.com.
    \41\ H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975).
---------------------------------------------------------------------------

    The adopted amendments promote this objective in several different 
respects. First, they update the formulas for allocating revenues 
generated by market data fees to the various SRO participants in the 
Plans. The current Plan formulas are seriously flawed by an excessive 
focus on the number of trades, no matter how small the size, reported 
by an SRO. They thereby create an incentive for distortive behavior, 
such as wash sales and trade shredding,\42\ and fail to reflect an 
SRO's contribution to the best displayed quotations in NMS stocks. The 
adopted formula corrects these flaws. It also is much less complex than 
the original proposal, primarily because, consistent with the approach 
of the Order Protection Rule and Access Rule, the new formula 
eliminates any allocation of revenues for manual quotations. It 
therefore will promote an allocation of revenues to the various SROs 
that more closely reflects the usefulness to investors of each SRO's 
market information.
---------------------------------------------------------------------------

    \42\ Trade shredding, or the splitting of large trades into a 
series of 100-share trades, is discussed further in section V.A.3 
below.
---------------------------------------------------------------------------

    The adopted amendments also are intended to improve the 
transparency and effective operation of the Plans by broadening 
participation in Plan governance. They require the creation of advisory 
committees composed of non-SRO representatives. Such committees will 
give interested parties an opportunity to be heard on Plan business, 
prior to any decision by the Plan operating committees. Finally, the 
amendments promote the wide availability of market data by authorizing 
markets to distribute their own data independently (while still 
providing their best quotations and trades for consolidated 
dissemination through the Plans) and streamlining outdated requirements 
for the display of market data to investors.
    Many commenters on the market data proposals expressed frustration 
with the current operation of the Plans.\43\ These commenters generally 
fell into two groups. One group, primarily made up of individual 
markets that receive market data fees, believed that the current model 
of consolidation should be discarded in favor of a new model, such as a 
``multiple consolidator'' model

[[Page 37504]]

under which each SRO would sell its own data separately. The other 
group, primarily made up of securities industry participants that pay 
market data fees, believed that the current level of fees is too high. 
This group asserted that, prior to modifying the allocation of market 
data revenues, the Commission should address the level of fees that 
generated those revenues.\44\
---------------------------------------------------------------------------

    \43\ Comments on the market data proposals are discussed in 
section V.A below.
    \44\ Some commenters mistakenly believed that the level of 
market data fees had been left unreviewed for many years. In fact, 
the Commission comprehensively reviewed market data fees in 1999, 
which led to a 75% reduction in fees paid by retail investors for 
market data. See infra, note 574.
---------------------------------------------------------------------------

    The Commission has considered these concerns at length in the 
recent past. As was noted in the Proposing Release,\45\ a drawback of 
the current market data model, which requires all SROs to participate 
jointly in disseminating data through a single consolidator, is that it 
affords little opportunity for market forces to determine the overall 
level of fees or the allocation of those fees to the individual SROs. 
Prior to publishing the proposals, therefore, the Commission undertook 
an extended review of the various alternatives for disseminating market 
data to the public in an effort to identify a better model. These 
alternatives were discussed at length in the Proposing Release, but 
each has serious weaknesses. The Commission particularly is concerned 
that the integrity and reliability of the consolidated data stream must 
not be compromised by any changes to the market data structure.
---------------------------------------------------------------------------

    \45\ Proposing Release, 69 FR at 11177.
---------------------------------------------------------------------------

    For example, although allowing each SRO to sell its data separately 
to multiple consolidators may appear at first glance to subject the 
level of fees to competitive forces, this conclusion does not withstand 
closer scrutiny. If the benefits of a fully consolidated data stream 
are to be preserved, each consolidator would need to purchase the data 
of each SRO to assure that the consolidator's data stream in fact 
included the best quotations and most recent trade report in an NMS 
stock. Payment of every SRO's fees would effectively be mandatory, 
thereby affording little room for competitive forces to influence the 
level of fees.
    The Commission also has considered the suggestion of many in the 
second group of commenters that market data fees should be cut back to 
encompass only the costs of the Plans to collect and disseminate market 
data. Under this approach, the individual SROs would no longer be 
allowed to fund any portion of their operational and regulatory 
functions through market data fees.\46\ Yet, as discussed in the 
Commission's 1999 concept release on market data,\47\ nearly the entire 
burden of collecting and producing market data is borne by the 
individual markets, not by the Plans. If, for example, an SRO's systems 
fail on a high-volume trading day and it can no longer provide its data 
to the Plans, investors will suffer the consequences of a flawed data 
stream, regardless of whether the Plan is able to continue operating.
---------------------------------------------------------------------------

    \46\ The U.S. equity markets are not alone in their reliance on 
market information revenues as a significant source of funding. All 
of the other major world equity markets currently derive large 
amounts of revenues from selling market information. See infra, note 
587 and accompanying text.
    \47\ Securities Exchange Act Release No. 42208 (Dec. 9, 1999), 
64 FR 70613 (Dec. 17, 1999) (``Market Information Release'').
---------------------------------------------------------------------------

    If the Commission were to limit market data fees to cover only Plan 
costs, SRO funding would have been cut by $393.7 million in 2004.\48\ 
Given the potential harm if vital SRO functions are not adequately 
funded, the Commission believes that the level of market data fees is 
most appropriately addressed in a context that looks at SRO funding as 
a whole. It therefore has requested comment on this issue in its recent 
concept release on SRO structure.\49\ In addition, the recently 
proposed rules to improve SRO transparency would, if adopted, assist 
the public in assessing the level and use of market data fees by the 
various SROs.\50\
---------------------------------------------------------------------------

    \48\ See infra, text accompanying note 564 (table setting forth 
revenue allocations for 2004).
    \49\ Securities Exchange Act Release No. 50700 (Nov. 18, 2004), 
69 FR 71256 (Dec. 8, 2004) (``SRO Structure Release'').
    \50\ Securities Exchange Act Release No. 50699 (Nov. 18, 2004), 
69 FR 71126 (Dec. 8, 2004) (``SRO Transparency Release'').
---------------------------------------------------------------------------

    In sum, there is inherent tension between assuring consolidated 
price transparency for investors, which is a fundamental objective of 
the Exchange Act,\51\ and expanding the extent to which market forces 
determine market data fees and SRO revenues. Each alternative model for 
data dissemination has its particular strengths and weaknesses. The 
great strength of the current model, however, is that it benefits 
investors, particularly retail investors, by helping them to assess 
quoted prices at the time they place an order and to evaluate the best 
execution of their orders against such prices by obtaining data from a 
single source that is highly reliable and comprehensive. In the absence 
of full confidence that this benefit would be retained if a different 
model were adopted, the Commission has decided to adopt such immediate 
steps as are necessary to improve the operation of the current model.
---------------------------------------------------------------------------

    \51\ Section 11A(a)(1)(C)(iii) of the Exchange Act.
---------------------------------------------------------------------------

II. Order Protection Rule

    The Commission is adopting Rule 611 under Regulation NMS to 
establish protection against trade-throughs for all NMS stocks. Rule 
611(a)(1) requires a trading center (which includes national securities 
exchanges, exchange specialists, ATSs, OTC market makers, and block 
positioners) \52\ to establish, maintain, and enforce written policies 
and procedures that are reasonably designed to prevent trade-throughs 
on that trading center of protected quotations and, if relying on an 
exception, that are reasonably designed to assure compliance with the 
terms of the exception. Rule 611(a)(2) requires a trading center to 
regularly surveil to ascertain the effectiveness of its policies and 
procedures and to take prompt action to remedy deficiencies. To qualify 
for protection, a quotation must be automated. Rule 600(b)(3) defines 
an automated quotation as one that, among other things, is displayed 
and immediately accessible through automatic execution. Thus, Rule 611 
does not require market participants to route orders to access manual 
quotations, which generally entail a much slower speed of response than 
automated quotations.
---------------------------------------------------------------------------

    \52\ An ``OTC market maker'' in a stock is defined in Rule 
600(b)(52) of Regulation NMS as, in general, a dealer that holds 
itself out as willing to buy and sell the stock, otherwise than on a 
national securities exchange, in amounts of less than block size 
(less than 10,000 shares). A block positioner in a stock, in 
contrast, limits its activity in the stock to transactions of 10,000 
shares or greater.
---------------------------------------------------------------------------

    Rule 611(b) sets forth a variety of exceptions to make intermarket 
price protection as efficient and workable as possible. These include 
an intermarket sweep exception, which allows market participants to 
access multiple price levels simultaneously at different trading 
centers--a particularly important function now that trading in penny 
increments has dispersed liquidity across multiple price levels. The 
intermarket sweep exception enables trading centers that receive sweep 
orders to execute those orders immediately, without waiting for better-
priced quotations in other markets to be updated. In addition, Rule 611 
provides exceptions for the quotations of trading centers experiencing, 
among other things, a material delay in providing a response to 
incoming orders and for flickering quotations with prices that have 
been displayed for less than one second. Both exceptions serve to limit 
the application of Rule 611 to

[[Page 37505]]

quotations that are truly automated and accessible.
    By strengthening price protection in the NMS for quotations that 
can be accessed fairly and efficiently, Rule 611 is designed to promote 
market efficiency and further the interests of both investors who 
submit displayed limit orders and investors who submit marketable 
orders.\53\ Price protection encourages the display of limit orders by 
increasing the likelihood that they will receive an execution in a 
timely manner and helping preserve investors' expectations that their 
orders will be executed when they represent the best displayed 
quotation. Limit orders typically establish the best prices for an NMS 
stock. Greater use of limit orders will increase price discovery and 
market depth and liquidity, thereby improving the quality of execution 
for the large orders of institutional investors. Moreover, strong 
intermarket price protection offers greater assurance, on an order-by-
order basis, to investors who submit market orders that their orders in 
fact will be executed at the best readily available prices, which can 
be difficult for investors, particularly retail investors, to monitor. 
Investors generally can know the best quoted prices at the time they 
place an order by referring to the consolidated quotation stream for a 
stock. In the interval between order submission and order execution, 
however, quoted prices can change. If the order execution price 
provided by a market differs from the best quoted price at order 
submission, it can be particularly difficult for retail investors to 
assess whether the difference was attributable to changing quoted 
prices or to an inferior execution by the market. The Order Protection 
Rule will help assure, on an order-by-order basis, that markets effect 
trades at the best available prices. Finally, market orders need only 
be routed to markets displaying quotations that are truly accessible. 
Accordingly, as discussed in detail below, the Commission finds that 
the Order Protection Rule is necessary and appropriate in the public 
interest, for the protection of investors, and otherwise in furtherance 
of the purposes of the Exchange Act.
---------------------------------------------------------------------------

    \53\ For ease of reference in this release, the term ``limit 
order'' generally will refer to a non-marketable order and the term 
``marketable order'' will refer to both market orders and marketable 
limit orders. A non-marketable limit order has a limit price that 
prevents its immediate execution at current market prices. Because 
these orders cannot be executed immediately, they generally are 
publicly displayed to attract contra side interest at the price. In 
contrast, a ``marketable limit order'' has a limit price that 
potentially allows its immediate execution at current market prices. 
As discussed further below, marketable limit orders often cannot be 
filled at current market prices because of insufficient liquidity 
and depth at the market price. See infra, text accompanying notes 
121-123, 134-136.
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A. Response to Comments and Basis for Adopted Rule

    Rule 611 as adopted reflects a number of changes to the rule as 
originally proposed. As discussed below, the Commission has made these 
changes in response to substantial public comment on the proposed rule 
and on the issues arising out of the NMS Hearing that were addressed in 
the Supplemental Release. In addition, the adopted rule includes a new 
exception for certain ``stopped orders'' in response to the suggestions 
of commenters on the reproposal. The public submitted more than 2200 
comments addressing the trade-through proposal and reproposal.\54\ 
Although the comments covered a very wide range of matters, they 
particularly focused on the following issues:
---------------------------------------------------------------------------

    \54\ The Commission has considered the views of all commenters 
in formulating Rule 611 as adopted, as well as the other rules and 
amendments adopted today.
---------------------------------------------------------------------------

    (1) Whether an intermarket trade-through rule is needed to promote 
fair and efficient equity markets, particularly for Nasdaq stocks which 
have not been subject to the current ITS trade-through provisions;
    (2) whether only automated and immediately accessible quotations 
should be given trade-through protection and, if so, what is the best 
approach for defining such quotations;
    (3) whether intermarket protection against trade-throughs can be 
implemented in a workable manner, particularly for high-volume stocks;
    (4) whether the exception in the original proposal allowing a 
general opt-out of protected quotations is necessary or appropriate, 
particularly if manual quotations are excluded from trade-through 
protection;
    (5) whether the scope of quotations entitled to trade-through 
protection should extend beyond the best bids and offers of the various 
markets; and
    (6) whether the benefits of an intermarket trade-through rule would 
justify its cost of implementation.
    In the following sections, the Commission responds to comments on 
the trade-through proposal and reproposal and discusses the basis for 
its adoption of Rule 611.
1. Need for Intermarket Order Protection Rule
    Commenters were divided on the central issue of whether intermarket 
protection of displayed quotations is needed to promote the fairest and 
most efficient markets for investors.\55\ Many commenters strongly 
supported the adoption of a uniform rule for all NMS stocks to promote 
best execution of market orders, to protect the best displayed prices, 
and to encourage the public display of limit orders.\56\ They stressed 
that limit orders are the cornerstone of efficient, liquid markets and 
should be afforded as much protection as possible.\57\ They noted, for

[[Page 37506]]

example, that limit orders typically establish the ``market'' for a 
stock.\58\ In the absence of limit orders setting the current market 
price, there would be no benchmark for the submission and execution of 
marketable orders. Focusing solely on best execution of marketable 
orders (and the interests of orders that take displayed liquidity), 
therefore, would miss a critical part of the equation for promoting the 
most efficient markets (i.e., the best execution of orders that supply 
displayed liquidity and thereby provide the most transparent form of 
price discovery). Commenters supporting the need for an intermarket 
trade-through rule also believed that it would increase investor 
confidence by helping to eliminate the impression of unfairness when an 
investor's order executes at a price that is worse than the best 
displayed quotation, or when a trade occurs at a price that is inferior 
to the investor's displayed order.\59\
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    \55\ Nearly all commenters, both those supporting and opposing 
the need for an intermarket trade-through rule, agreed that the 
current ITS trade-through provisions are seriously outdated and in 
need of reform. They particularly focused on the problems created by 
affording equal protection against trade-throughs to both automated 
and manual quotations. See supra, section II.A.2. Adopted Rule 611 
responds to these problems by protecting only automated quotations.
    \56\ Approximately 1689 commenters on the proposal and 
reproposal favored a uniform trade-through rule without an opt-out 
exception. These commenters included: (1) several mutual fund 
companies and the Investment Company Institute; (2) the Consumer 
Federation of America and the National Association of Individual 
Investors Corporation; (3) the floor-based exchanges and their 
members; (4) approximately 107 listed companies; (5) a variety of 
securities industry participants; and (6) approximately 42 members 
of Congress. Of the commenters supporting the reproposal, 
approximately 452 utilized ``Letter Type G'' (noting the existence 
of two alternative proposals and urging ``support for the Regulation 
NMS proposal without the CLOB'' alternative), 70 utilized ``Letter 
Type H'' (``we support the `top of the book' proposal that has been 
discussed for the past year as part of the Regulation NMS 
discussion''), 204 utilized ``Letter Type I'' (``I believe a better 
approach would be the SEC's proposed alternative to the CLOB, to 
protect the best price in each market center''), 548 utilized 
``Letter Type J'' (``Of the two alternatives laid out in the rule as 
re-proposed on December 15, 2004, protecting the best bid and offer 
in each market center preserves both types of competition in a way 
that benefits all securities industry participants.''), 28 utilized 
``Letter Type K'' (``One alternative is that of protecting the 
``best bid and offer'' in each market center. This concept enhances 
competition, allows for price negotiation, encourages innovation, 
and treats all market participants fairly and equally.''), and 109 
utilized ``Letter Type L'' (noting the existence of two alternative 
proposals and urging support for ``the Regulation NMS proposal 
without the CLOB'' alternative). Each of the letter types is posted 
on the Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Those commenters that only expressed opposition to 
the Voluntary Depth Alternative were not included in the foregoing 
summary. In addition, many commenters supported an opt-out exception 
to a trade-through rule, but varied in the extent to which they made 
clear whether they supported a trade-through rule in general. These 
commenters are not included in the foregoing summary, but are 
included in note 232 below addressing supporters of an opt-out 
exception.
    \57\ See, e.g., Letter from John J. Wheeler, Vice President, 
Director of U.S. Equity Trading, American Century Investment 
Management Inc., to Jonathan G. Katz, Secretary, Commission, dated 
June 30, 2004 (``American Century Letter'') at 2; Letter from Matt 
D. Lyons, Capital Research and Management Company, to Jonathan G. 
Katz, Secretary, Commission, dated June 28, 2004 (``Capital Research 
Letter'') at 2; Letter from Ari Burstein, Associate Counsel, 
Investment Company Institute, to Jonathan G. Katz, Secretary, 
Commission, dated Jan. 26, 2005 (``ICI Reproposal Letter'') at 2; 
Letter from Henry H. Hopkins, Vice President and Chief Legal 
Counsel, and Andrew M. Brooks, Vice President and Head of Equity 
Trading, T. Rowe Price Associates, Inc., to Jonathan G. Katz, 
Commission, dated Jan. 27, 2005 (``T. Rowe Price Reproposal 
Letter'') at 2; Letter from George U. Sauter, Managing Director, The 
Vanguard Group, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated Jan. 27, 2005 (``Vanguard Reproposal Letter'') at 2.
    \58\ Id.
    \59\ See, e.g., Letter from Barbara Roper, Director of Investor 
Protection, Consumer Federation of America, to Jonathan G. Katz, 
Secretary, Commission, dated June 17, 2004 (``Consumer Federation 
Letter'') at 2; Letter from Ari Burstein, Associate Counsel, 
Investment Company Institute, to Jonathan G. Katz, Secretary, 
Commission, dated June 30, 2004 (``ICI Letter'') at 7.
---------------------------------------------------------------------------

    Other commenters, in contrast, opposed any intermarket trade-
through rule.\60\ These commenters did not believe that such a rule is 
necessary to promote the protection of limit orders, the best execution 
of market orders, or efficient markets in general. They asserted that, 
given public availability of each market's quotations and ready access 
by all market participants to such quotations, competition among 
markets, a broker's existing duty of best execution, and economic self-
interest would be sufficient to protect limit orders and produce the 
most fair and efficient markets. They therefore believed that any 
trade-through rule would be unnecessary and costly. These commenters 
also were concerned that any trade-through rule could interfere with 
the ability of competitive forces to produce efficient markets, 
particularly for Nasdaq stocks.
---------------------------------------------------------------------------

    \60\ Approximately 448 commenters on the proposal and reproposal 
opposed a trade-through rule. Approximately 179 of these commenters 
utilized ``Letter Type C,'' which primarily supported an opt-out 
exception to the proposed rule, but also suggested that having no 
trade-through rule would be simpler. Letter Type C is posted on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). The remaining commenters included securities 
industry participants, particularly electronic markets and their 
participants, a variety of local political and community groups and 
individuals, and 34 members of Congress.
---------------------------------------------------------------------------

    Commenters on the original proposal who were opposed to any trade-
through rule also expressed their view that there is a lack of 
empirical evidence justifying the need for intermarket protection 
against trade-throughs. They noted, for example, that trading in Nasdaq 
stocks has never been subject to a trade-through rule, while trading in 
exchange-listed stocks, particularly NYSE stocks, has been subject to 
the ITS trade-through provisions. Given the difference in regulatory 
requirements between Nasdaq and NYSE stocks, many commenters relied on 
two factual contentions to show that a trade-through rule is not 
needed: (1) Fewer trade-throughs occur in Nasdaq stocks than NYSE 
stocks; \61\ and (2) trading in Nasdaq stocks currently is more 
efficient than trading in NYSE stocks.\62\ Based on these factual 
contentions, opposing commenters concluded that a trade-through rule is 
not necessary to promote efficiency or to protect the best displayed 
prices.
---------------------------------------------------------------------------

    \61\ See, e.g., Letter from Kim Bang, President & Chief 
Executive Officer, Bloomberg Tradebook LLC, to Jonathan G. Katz, 
Secretary, Commission, dated June 30, 2004 (``Bloomberg Tradebook 
Letter'') at 10; Letter from Eric D. Roiter, Senior Vice President & 
General Counsel, Fidelity Management and Research Company, to 
Jonathan G. Katz, Secretary, Commission, dated June 22, 2004 
(``Fidelity Letter I'') at 11; Letter from Suhas Daftuar, Managing 
Director, Hudson River Trading, to Jonathan G. Katz, Secretary, 
Commission, dated August 13, 2004 (``Hudson River Trading Letter'') 
at 1; Letter from Edward J. Nicoll, Chief Executive Officer, 
Instinet Group Incorporated, to Jonathan G. Katz, Secretary, 
Commission, dated June 30, 2004 (``Instinet Letter'') at 14; Letter 
from Edward S. Knight, The Nasdaq Stock Market, Inc., to Jonathan G. 
Katz, Secretary, Commission, dated July 2, 2004 (``Nasdaq Letter 
II'') at 6 and Attachment III.
    \62\ See, e.g., Letter from Ellen L. S. Koplow, Executive Vice 
President and General Counsel, Ameritrade Holding Corporation, to 
Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 
(``Ameritrade Letter I''), Appendix at 10; Letter from William 
O'Brien, Chief Operating Officer, Brut LLC, to Jonathan G. Katz, 
Secretary, Commission, dated July 29, 2004 (``Brut Letter'') at 10; 
Fidelity Letter I at 11; Instinet Letter at 3, 9 and Exhibit A; 
Nasdaq Letter II at 6 and Attachment II; Letter from Bruce N. 
Lehmann & Joel Hasbrouck, Organizers, Reg NMS Study Group, to 
Jonathan G. Katz, Secretary, Commission (no date) (``NMS Study Group 
Letter'') at 4; Letter from David Colker, Chief Executive Officer & 
President, National Stock Exchange, to Jonathan G. Katz, Secretary, 
Commission, dated June 29, 2004 (``NSX Letter'') at 3; Letter from 
Huw Jenkins, Managing Director, Head of Equities for the Americas, 
UBS Securities LLC, to Jonathan G. Katz, Secretary, Commission, 
dated June 30, 2004 (``UBS Letter'') at 4.
---------------------------------------------------------------------------

    The Commission has carefully evaluated the views of these 
commenters on both the original proposal and the reproposal. In 
addition, Commission staff has prepared several studies of trading in 
Nasdaq and NYSE stocks to help assess and respond to commenters' 
claims. The studies and the Commission's conclusions are discussed in 
detail below. In general, however, the Commission has found that 
current trade-through rates are not lower for Nasdaq stocks than NYSE 
stocks, despite the fact that nearly all quotations for Nasdaq stocks 
are automated, rather than divided between manual and automated as they 
are for exchange-listed stocks. Moreover, the majority of the trade-
throughs that currently occur in NYSE stocks fall within gaps in the 
coverage of the existing ITS trade-through rules that will be closed by 
the Order Protection Rule. Consequently, the Commission believes that 
the Order Protection Rule, by establishing effective intermarket 
protection against trade-throughs, will materially reduce the trade-
through rates in both the market for Nasdaq stocks and the market for 
exchange-listed stocks.
    In addition, the commenters' claim that the Order Protection Rule 
is not needed because trading in Nasdaq stocks, which currently does 
not have any trade-through rule, is more efficient than trading in NYSE 
stocks, which has the ITS trade-through provisions, also is not 
supported by the relevant data.\63\ This conclusion is particularly 
evident when market efficiency is examined from the perspective of the 
transaction costs of long-term investors, as opposed to short-term 
traders. The data reveals that the markets for Nasdaq and NYSE stocks 
each have their particular strengths and weaknesses. In assessing the 
need for the Order Protection Rule, the Commission has focused 
primarily on whether effective intermarket protection against trade-
throughs will materially contribute to a fairer and more efficient 
market for investors in Nasdaq stocks, given their particular trading 
characteristics, and in exchange-listed stocks, given their particular 
trading characteristics. Thus, the critical issue is whether each of 
the markets would be improved by adoption of the Order Protection Rule, 
not whether one or the other currently is, on some absolute level, 
superior to the other. The Commission believes that effective 
intermarket protection against trade-throughs will produce substantial 
benefits for investors in both markets and, therefore, has adopted the 
Order

[[Page 37507]]

Protection Rule for both Nasdaq and exchange-listed stocks.
---------------------------------------------------------------------------

    \63\ See infra, section II.A.1.b.
---------------------------------------------------------------------------

a. Trade-Through Rates in Nasdaq and NYSE Stocks
    The first principal factual contention of commenters on the 
original proposal who were opposed to a trade-through rule is premised 
on the claim that there are fewer trade-throughs in Nasdaq stocks, 
which are not covered by any trade-through rule, than in NYSE stocks, 
which are covered by the ITS trade-through provisions.\64\ One 
commenter asserted that, outside the exchange-listed markets, 
competition alone had been sufficient to create a ``no-trade through 
zone.'' \65\ To respond to these commenters, the Commissions staff 
reviewed public quotation and trade data to estimate the incidence of 
trade-throughs for Nasdaq and NYSE stocks.\66\ It found that the 
overall trade-through rates for Nasdaq stocks and NYSE stocks were, 
respectively, 7.9% and 7.2% of the total volume of traded shares.\67\ 
When considered as a percentage of number of trades, the overall trade-
through rate for both Nasdaq and NYSE stocks was 2.5%. When considered 
as the size of traded-through quotations as a percentage of total share 
volume, the overall rates for Nasdaq and NYSE stocks were, 
respectively, 1.9% and 1.2%.\68\ In addition, the staff study found 
that the amount of the trade-throughs was significant--2.3 cents per 
share on average for Nasdaq stocks and 2.2 cents per share for NYSE 
stocks.\69\
---------------------------------------------------------------------------

    \64\ See, e.g., Bloomberg Tradebook Letter at 10; Fidelity 
Letter I at 11; Hudson River Trading Letter at 1; Instinet Letter at 
14; Nasdaq Letter II at 6 and Attachment III.
    \65\ Letter from Kevin J. P. O'Hara, Chief Administrative 
Officer & General Counsel, Archipelago Holdings, Inc., to Jonathan 
G. Katz, Secretary, Commission, dated September 24, 2004 (``ArcaEx 
Letter'') at 3.
    \66\ Memorandum to File, from Office of Economic Analysis, dated 
December 15, 2004 (analysis of trade-throughs in Nasdaq and NYSE 
issues) (``Trade-Through Study''). The Trade-Through Study has been 
placed in Public File No. S7-10-04 and is available for inspection 
on the Commission's Internet Web site (http://www.sec.gov). To 
eliminate false trade-throughs, the staff calculated trade-through 
rates using a 3-second window--a reference price must have been 
displayed one second before a trade and still have been displayed 
one second after a trade. In addition, the staff eliminated 
quotations displayed by the American Stock Exchange LLC (``Amex'') 
from the analysis of Nasdaq stocks because they were manual 
quotations. Finally, the staff used the time of execution of a 
trade, if one was given, rather than time of the trade report 
itself. This methodology was designed to address manual trades, such 
as block trades, that might not be reported for several seconds 
after the trade was effected manually.
    \67\ Trade-Through Study, Tables 4, 11. The 7.9% and 7.2% 
figures include the entire size of trades that were executed at 
prices inferior to displayed quotations.
    \68\ Id. at 2. The 1.9% and 1.2% figures include only the total 
displayed size of quotations that were traded through by trades 
executed at prices inferior to the displayed quotations.
    \69\ Id., Tables 3, 10.
---------------------------------------------------------------------------

    The staff study also revealed that a large volume of block 
transactions (10,000 shares or greater) trade through displayed 
quotations. Block transactions represent approximately 50% of total 
trade-through volume for both Nasdaq and NYSE stocks.\70\ Importantly, 
many block transactions currently are not subject to the ITS trade-
through provisions that apply to exchange-listed stocks. Broker-dealers 
that act solely as block positioners are not covered by the ITS trade-
through provisions if they print their trades in the over-the-counter 
(``OTC'') market. In addition to not covering the trades of block 
positioners, the ITS trade-through provisions include an exception for 
100-share quotations. They therefore often may fail to protect the 
small orders of retail investors. When block trade-throughs and trade-
throughs of 100-share quotations are eliminated, the overall trade-
through rate for NYSE stocks is reduced from 7.2% to approximately 2.3% 
of total share volume.\71\ The two gaps in ITS coverage therefore 
account for most of the trade-through volume in NYSE stocks. The Order 
Protection Rule, by closing these gaps in protection against trade-
throughs, will establish much stronger price protection than the ITS 
provisions.
---------------------------------------------------------------------------

    \70\ Id., Tables 4, 11.
    \71\ Id., Table 11.
---------------------------------------------------------------------------

    Commenters opposed to the trade-through reproposal offered a number 
of criticisms of the staff study. Such criticisms generally fall into 
two categories: (1) Possible reasons why the staff study might have 
overestimated trade-through rates, particularly for Nasdaq stocks; and 
(2) even assuming the estimated trade-through rates were accurate, 
arguments for why such rates do not support a conclusion that the Order 
Protection Rule is needed or will benefit the markets, particularly for 
Nasdaq stocks. These criticisms are evaluated below.
i. Accuracy of Estimated Trade-Through Rates
    Several commenters asserted that the staff study overestimated 
trade-through rates because it failed to consider the existence of 
reserve size and sweep orders in the Nasdaq market, which could have 
caused ``false positive'' trade throughs.\72\ In theory, order routers 
could intend to sweep the market of all superior quotations before 
trading at an inferior price, but if they did not effectively sweep 
both displayed size and reserve size, the superior quotations would not 
change and the staff study would report a false indication of a trade-
through when the trade in another market occurred at an inferior price. 
In practice, however, those who truly intend to sweep the best prices 
are quite capable of routing orders to execute against both displayed 
and estimated reserve size, thereby precluding the possibility of a 
false positive trade-through. Indeed, although commenters asserted that 
the staff study failed to consider the existence of reserve size for 
Nasdaq stocks, the validity of their own argument is premised on the 
failure of sophisticated market participants to consider the existence 
of reserve size when routing sweep orders.
---------------------------------------------------------------------------

    \72\ Letter from Kim Bang, Bloomberg L.P., to Jonathan Katz, 
Secretary, dated Jan. 25, 2005 (``Bloomberg Reproposal Letter'') at 
6; Letter from Edward S. Knight, The Nasdaq Stock Market, Inc., to 
Jonathan G. Katz, Secretary, dated Jan. 26, 2005 (``Nasdaq 
Reproposal Letter''), Exhibit A at 4; Letter from Daniel Coleman, 
Managing Director and Head of Equities for the Americas, UBS 
Securities LLC (``UBS Reproposal Letter'') at 4.
---------------------------------------------------------------------------

    It currently is impossible to determine from publicly available 
trade and quotation data whether the initiator of a trade-through in 
one market has simultaneously attempted to sweep better-priced 
quotations in other markets.\73\ The data can reveal, however, the 
extent to which false-positive indications of a trade-through were even 
a possibility by examining trading volume at the traded-through market. 
If the accumulated volume of trades in that market did not equal or 
exceed the displayed size of a traded-through quotation, it shows that 
a sweep order, even one attempting to execute only against displayed 
size, could not have been routed to the market that was traded-through. 
Commission staff therefore has supplemented its trade-through study to 
check this possibility and to help the Commission assess and respond to 
commenters' criticisms. It found that this possibility rarely occurs--a 
finding that fully supports an inference that market participants are 
capable of effectively sweeping the best prices, both displayed and 
reserve, when they intend to do so.\74\ Thus, it is

[[Page 37508]]

very unlikely that the existence of reserve size and sweep orders 
caused a significant number of false positive trade-throughs in Nasdaq 
stocks.\75\
---------------------------------------------------------------------------

    \73\ After implementation of Rule 611, such orders generally 
will be marked as intermarket sweep orders pursuant to the 
exceptions set forth in Rule 611(b)(5) and (6). As discussed in note 
317 below, the Commission intends to request that the NMS trade 
reporting plans consider collecting and disseminating special 
modifiers for all trades that are executed pursuant to an exception 
from Rule 611. Such modifiers would greatly enhance transparency and 
minimize the potential for false appearances of violations of Rule 
611.
    \74\ Memorandum to File, from Office of Economic Analysis, dated 
April 6, 2005, at 1 (supplemental trade-through analysis--reserve 
size analysis, sample day activity analysis, and analysis of quote 
depth) (``Supplemental Trade-Through Study''). For example, the 
Supplemental Trade-Through Study found that, when the trade-through 
statistics are adjusted to reflect possible instances in which sweep 
orders could have failed to execute against reserve size, the 
estimated trade-through rates for Nasdaq stocks declined slightly 
from 2.5% of total trades to 2.3% of total trades, and from 7.9% of 
total share volume to 7.7% of total share volume. These small 
reductions do not support the assertion of commenters that market 
participants systematically fail to take out reserve size when 
routing sweep orders. Rather, the reductions are much more 
consistent with the random distribution of trade volume that would 
be expected to occur in the traded-through markets from time to 
time.
    \75\ ArcaEx noted that it was common practice in the market for 
exchange-listed stocks to send commitments to trade through the ITS 
to avoid trading through quotations in other markets. Letter from 
Kevin J. P. O'Hara, Chief Administrative Officer and General 
Counsel, Archipelago Holdings, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated Jan. 26, 2005 (``ArcaEx Reproposal Letter''), 
Annex A at 1. Given the slowness with which ITS commitments to trade 
often are processed and manual quotations are updated, ArcaEx 
suggested that trade-through rates for exchange-listed stocks might 
be overestimated. The Commission agrees that this criticism may well 
be valid to some extent. Thus, the trade-through rates for NYSE 
stocks in the staff study may be overstated for ArcaEx and other 
markets trading exchange-listed stocks. The occurrence of apparent 
trade-throughs in exchange-listed stocks caused by manual quotations 
under the current ITS provisions is addressed in the Order 
Protection Rule by protecting only automated quotations.
---------------------------------------------------------------------------

    One commenter asserted that the staff study was flawed because its 
sample trading days involved unusual trading activity.\76\ Commission 
staff chose the sample trading days, however, only after affirming that 
they were representative of normal trading. To respond to this 
commenter's claim, Commission staff reaffirmed that all four days were 
well within the norms for trading volume and price volatility.\77\ In 
addition, the trade-through rates remained quite stable across the four 
days (e.g., ranging only from 2.3% to 2.6% for Nasdaq stocks).\78\
---------------------------------------------------------------------------

    \76\ ArcaEx Reproposal Letter, Annex A.
    \77\ Supplemental Trade-Through Study at 3.
    \78\ Id.
---------------------------------------------------------------------------

    Two commenters asserted that, even if the staff study's estimate of 
trade-through rates was correct for the trading days chosen in the Fall 
of 2003, such rates are now outdated for Nasdaq stocks because of 
structural changes in the market.\79\ In particular, they cited the 
merger of the Island and Instinet ECNs and Nasdaq's acquisition of the 
BRUT ECN. Nasdaq also presented statistics indicating that the trade-
through rates for Nasdaq stocks in some trading centers had dropped 
from the Fall of 2003 to the Fall of 2004. The staff study used data 
from the Fall of 2003, however, because it was prior to the 
Commission's proposal of a trade-through rule and its public 
announcement that the staff was reviewing trade-through rates. While 
the conduct of market participants may have changed in certain respects 
when they were a focus of regulatory attention, the Commission cannot 
be assured that such behavior would continue if the Commission did not 
adopt the proposed regulatory action to address trade-throughs.
---------------------------------------------------------------------------

    \79\ Bloomberg Reproposal Letter at 5; Nasdaq Reproposal Letter, 
Exhibit 1 at 3-4.
---------------------------------------------------------------------------

    Indeed, Nasdaq's own data illustrates this possibility.\80\ 
Although Nasdaq asserts that the reduction in trade-through rates from 
2003 to 2004 is a result of fewer independently operating ECNs, its 
data undercuts this explanation. For example, Nasdaq's data shows that 
the trade-through rate at internalizing securities dealers dropped from 
3.2% in 2003 to 1.4% in 2004.\81\ It is unlikely that ECN consolidation 
could have caused such a major reduction in trade-through rates at 
securities dealers when they execute their customer orders 
internally.\82\ The great majority of internalized trades are the small 
trades of retail investors. The fact that, in 2003, nearly 1 of 30 of 
these millions of trades appears to have been executed at a price 
inferior to an automated and accessible quotation is troubling. Given 
that one of the primary benefits of the Order Protection Rule is to 
backstop a broker's duty of best execution on an order-by-order basis, 
Nasdaq's data appears to indicate a continuing need for regulatory 
action to reinforce the fundamental principle of best price for all NMS 
stocks.
---------------------------------------------------------------------------

    \80\ Nasdaq Reproposal Letter, Exhibit 1 at 4.
    \81\ Id.
    \82\ Nasdaq also mentions ``less developed'' matching systems as 
contributing to the high rate of trade-throughs in Fall 2003, but 
does not identify any major technology advances from Fall 2003 to 
Fall 2004 that would have enabled the reduction in trade-through 
rates at internalizing securities dealers. Id. at 4.
---------------------------------------------------------------------------

    Nasdaq also criticized the staff study for failing to address 
whether large block trades ``intentionally avoid interacting with the 
posted quotes.'' \83\ Far from demonstrating a flaw in the staff study, 
however, the fact that large trades intentionally avoid interacting 
with displayed quotations was one of the primary reasons identified in 
the Reproposing Release supporting the need for intermarket order 
protection.\84\ The opportunity for displayed limit orders to begin 
interacting with this substantial volume of block trades is likely to 
be one of the most significant incentives for increased display of 
limit orders after implementation of the Order Protection Rule. 
Moreover, the Order Protection Rule will promote a more level playing 
field for retail investors that currently see their smaller displayed 
orders bypassed by block trades.
---------------------------------------------------------------------------

    \83\ Nasdaq Reproposal Letter, Exhibit 1 at 4. See also UBS 
Reproposal Letter at 4 (describing numbers in staff study as 
``inflated'' because they included institutional block trades).
    \84\ 69 FR at 77434.
---------------------------------------------------------------------------

    Two commenters did not believe the staff study should have included 
trades larger than quoted size, asserting that ``[e]ven in a hard CLOB 
environment, orders larger than the inside quote would still 'trade 
through' the inside quote in effect at the time the order was 
received.'' \85\ These commenters do not appear to have understood the 
methodology of the staff study or the operation of a central limit 
order book (``CLOB''). As discussed above, large trades would not have 
been identified as trade-throughs in the staff study if orders 
simultaneously had been routed to sweep displayed quotations with 
superior prices. To exclude such trades from its analysis, the study 
used a three-second quotation window in which the lowest best bid or 
the highest best offer during the three-second period must be traded-
through before a trade was identified as a trade-through. The 3-second 
quotation window particularly was designed to allow sufficient time for 
quotations to update to reflect the arrival of sweep orders (just as in 
a CLOB environment, the execution of a large order simultaneously would 
eliminate all superior-priced quotations). In sum, large orders would 
trade with, rather than trade through, the superior-priced displayed 
quotations, thereby leaving only quotations that did not have superior 
prices to the trade price. Such large orders therefore would not have 
been identified as trade-throughs in the staff study.
---------------------------------------------------------------------------

    \85\ Letter from James J. Angel, Associate Professor of Finance, 
Georgetown University, to Jonathan G. Katz, Secretary, Commission, 
dated Jan. 25, 2005 (``Angel Reproposal Letter'') at 3; Letter from 
Eric D. Roiter, Senior Vice President and General Counsel, Fidelity 
Management & Research Company, to Jonathan G. Katz, Secretary, 
Commission, dated Jan. 26, 2005 (``Fidelity Reproposal Letter'') at 
7. These commenters also criticized the staff study for including 
average-price trades, even when the individual pieces of such trades 
may have been executed at or within the relevant quotations. The 
staff study, however, addressed this issue by excluding any trade 
reported as an average-price trade, along with all other trades that 
included a non-blank condition code (primarily out-of-sequence 
trades, late trades, and previous reference price trades). Trade-
Through Study at 9.
---------------------------------------------------------------------------

    Commenters also criticized the staff study for allegedly failing to 
consider

[[Page 37509]]

the effect of locked or crossed quotations for Nasdaq stocks.\86\ By 
using a 3-second quotation window, however, the staff study excluded 
any trade-throughs that would have been caused by short periods of 
locking or crossing quotations. The staff analysis appropriately did 
not exclude longer periods of locked quotations. Indeed, locked 
quotations do not qualify for an exception from the Order Protection 
Rule--both the best bid and best offer are readily accessible at the 
same price and should not be traded through. Quotations rarely are 
crossed for three seconds and therefore are unlikely to have caused a 
material number of false trade-throughs.\87\
---------------------------------------------------------------------------

    \86\ Bloomberg Reproposal Letter at 5; Nasdaq Reproposal Letter, 
Exhibit 1 at 5.
    \87\ See, e.g., Nasdaq Reproposal Letter, Exhibit 1 at 5 n. 14 
(``rare'' for market to be crossed for the entirety of the three-
second window).
---------------------------------------------------------------------------

    Finally, commenters asserted a variety of arguments relating to 
timing latencies in the quotation and trade data that might have caused 
the staff study to include false trade-throughs, including delayed 
trade reports, flickering quotations, stale quotations, manual 
quotations, and poor clock synchronization.\88\ The staff study, 
however, used a variety of means to minimize the effect of these 
factors on the data, as well as to check for the extent to which timing 
latencies might affect its results. The goal of the staff study was to 
obtain a reasonable estimate of the true trade-through rates for Nasdaq 
and NYSE stocks. It is important to recognize that, in designing a 
methodology to achieve this goal, the more conservative the methodology 
used to eliminate potentially false indications of trade-throughs, the 
greater the number of true trade-throughs that are likely to be 
eliminated. Thus, a methodology designed simply to assure the 
elimination of every conceivable false indication of a trade-through 
would not have been useful to the Commission in assessing its policy 
options because it would have severely underestimated true trade-
through rates. The staff study's conservative methodology was designed 
to produce reasonable estimates of true trade-through rates, but still 
is more likely to have resulted in an understatement of trade-through 
rates than an overstatement, particularly for Nasdaq stocks. Nasdaq 
stocks are traded primarily on automated markets, and the data for such 
stocks therefore should be less affected by timing latencies than the 
data for NYSE stocks, which is produced by both automated and manual 
markets.
---------------------------------------------------------------------------

    \88\ Angel Reproposal Letter at 3; Bloomberg Reproposal Letter 
at 7; Fidelity Reproposal Letter at 7; Nasdaq Reproposal Letter, 
Exhibit 1 at 5; UBS Reproposal Letter at 4.
---------------------------------------------------------------------------

    For example, the staff study used a three-second quotation window 
for both Nasdaq and NYSE stocks to minimize the effect of possible 
timing lags between trade data and quotation data. Given that in Fall 
2003 the overwhelming proportion of trades in Nasdaq stocks were 
executions of automated orders against automated quotations, with 
automated reporting of trades to the relevant Plan processor, three 
seconds is a conservative time frame to assess overall trade-through 
rates. But even when the quotation window is extended to an overly 
conservative eight seconds and thereby clearly excludes a large number 
of true trade-throughs, trade-through rates remain significant--1.7% of 
trades and 6.8% of share volume in Nasdaq stocks.\89\
---------------------------------------------------------------------------

    \89\ Trade-Through Study, Table 1.
---------------------------------------------------------------------------

    In addition, the trade execution time derived from audit trail data 
for Nasdaq stocks, rather than trade report time, was used when it was 
supplied and whenever the two times differed to minimize timing 
latencies in the data caused by delayed reporting. Separate times 
derived from audit trail data are not reported for NYSE stocks, and 
delayed trade reports therefore could have contributed to false reports 
of trade-throughs in NYSE stocks. Similarly, for Nasdaq stocks, the 
quotations of Amex--the only market that displays manual quotations--
were excluded from the staff study. Because the NYSE currently displays 
primarily manual quotations in NYSE stocks, while other markets display 
automated quotations, the difficulties of integrating data from manual 
and automated markets could have caused false indications of trade-
throughs for NYSE stocks.\90\ The occurrence of false indications of 
trade-throughs caused by manual quotations in exchange-listed stocks is 
addressed in the Order Protection Rule by protecting only automated 
quotations that are immediately accessible and immediately updated.
---------------------------------------------------------------------------

    \90\ See infra, section II.A.2 (discussion of need to limit 
coverage of Order Protection Rule to automated quotations).
---------------------------------------------------------------------------

    Fidelity incorrectly believed that the staff study failed to use 
the time of trade execution derived from audit trail data when 
analyzing trade-through rates in Nasdaq stocks.\91\ Fidelity also 
attached to its comment letter a paper prepared by two academics, 
Robert Battalio and Robert Jennings, which included a variety of 
criticisms of the staff study and the Reproposing Release in general 
(``Battalio/Jennings Paper'').\92\ Among other things, the Battalio/
Jennings Paper cited an academic paper which, for trading in Nasdaq 
stocks in 1996 and 1997, found significant delays between the time of 
trade execution reflected in proprietary trading center data and the 
time of trade report in public data disseminated by Nasdaq as Plan 
processor.\93\ The authors of the Battalio/Jennings Paper, however, did 
not account for significant improvements in the quality of trade data 
for Nasdaq stocks since 1997. In particular, the NASD developed and 
implemented a new order audit trail system (``OATS'').\94\ As 
summarized in a 1998 NASD Notice to Members, OATS specifically was 
designed, among other things, to address the discrepancies between 
proprietary trade data and trade data reported to Nasdaq's Automated 
Confirmation Transaction Service (``ACT''):
---------------------------------------------------------------------------

    \91\ Letter from Eric D. Roiter, Senior Vice President and 
General Counsel, Fidelity Management & Research Company, to Jonathan 
G. Katz, Secretary, Commission, dated Mar. 28, 2005 (``Fidelity 
Reproposal Letter II'') at 2.
    \92\ Robert Battalio and Robert Jennings, Analysis of the Re-
Proposing Release of Reg NMS and the OEA's Trade-Through Study (Mar. 
28, 2005) (attached to Fidelity Reproposal Letter II). Other claims 
made in the Battalio/Jennings Paper are addressed below at notes 
151-158, 296 and accompanying text.
    \93\ Battalio/Jennings Paper at 12-13. For example, the academic 
study of 1996-1997 Nasdaq data found that 65% of trades were 
reported with delays of more than 8 seconds.
    \94\ See, e.g., NASD Notice to Members 98-82 (Oct. 1998) at 1.

    OATS is designed to provide NASD Regulation, Inc. (NASD 
Regulation) with the ability to reconstruct markets promptly, 
conduct efficient surveillance, and enforce NASD and SEC rules. The 
SEC has directed that OATS must provide an accurate, time-sequenced 
record of orders and transactions from the receipt of an order 
through its execution. To accomplish this, NASD Regulation will 
combine information submitted to OATS with transaction data reported 
by members through ACT and quotation information disseminated by 
Nasdaq * * *. The ACT trade data and the OATS order information will 
be used to construct an integrated audit trail. Under the amended 
rules, all trade reports for OATS-eligible securities entered into 
Nasdaq's ACT system will be required to have a time of execution 
expressed in hours, minutes, and seconds.\95\
---------------------------------------------------------------------------

    \95\ Id.

    To obtain the most accurate analysis of trade-through rates in 
Nasdaq stocks, the staff study used the audit trail record of the time 
of trade execution, rather than the time of trade report, whenever it 
was supplied and whenever

[[Page 37510]]

the two times differed.\96\ The Battalio/Jennings Paper therefore was 
mistaken when it stated that ``[w]ith the data OEA chose to use, we 
simply cannot conclude anything about actual trade-through rates'' and 
when it ``urge[d] the OEA to revise their methodology and conduct a 
trade-through analysis using audit-trail data.'' \97\ The staff study 
did indeed use audit trail data when available for Nasdaq stocks and 
therefore provides a reasonable basis for estimating true trade-through 
rates for Nasdaq stocks.
---------------------------------------------------------------------------

    \96\ Trade-Through Study at 8 (``Trade data from the Nastraq 
file was used for the analysis of Nasdaq stocks. This file contains 
the executed price, share volume, trade report time, trade execution 
time, and an indicator of non-regular or unusual trade reporting or 
settlement conditions. The Nastraq trade file was selected over the 
TAQ trade file, as the latter does not have trade execution time, 
only trade report time.'').
    \97\ Battalio/Jennings Paper at 20.
---------------------------------------------------------------------------

    As noted above, however, the data for exchange-listed stocks may be 
more affected by timing latencies because it is generated by both 
automated and manual markets. The trade-through rates estimated in the 
staff study therefore may somewhat overstate the true trade-rates for 
NYSE stocks. Given that the ITS trade-through provisions currently 
apply to exchange-listed stocks, however, the Commission does not 
believe that the possibility that true trade-through rates potentially 
are lower than estimated in the staff study detracts from the strong 
policy reasons to maintain and strengthen trade-through protection for 
exchange-listed stocks. Rather, eliminating any trade-through 
protection for exchange-listed stocks could lead to rates that are as 
high, or higher, than were conservatively estimated for Nasdaq stocks, 
which have not been subject to any trade-through restrictions.
    Moreover, the evidence from the staff study itself indicates that 
the concerns about delayed trade reporting discussed at length in the 
Battalio/Jennings Paper with respect to historical data have largely 
been resolved. For example, if delayed trade reporting were truly a 
serious problem that caused the staff study to be flawed, one would 
expect to see significant rates of trade-throughs by a single trading 
center's trades of its own quotations--the two data feeds would be out 
of synchronization with each other because trades were reported slower 
than quotation updates. In fact, however, the staff study found very 
low trade-through rates for single trading centers of their own 
quotations.\98\ The primary exception is for trades reported on Nasdaq 
that trade through Nasdaq quotations, but Nasdaq, unlike the other 
major markets, does not consist of a single trading center. Rather, it 
includes the NASDAQ Market Center, several ECNs, and many market makers 
that trade, to a great extent, separately. Thus, the trade-through 
rates for Nasdaq reflect true trade-throughs among different trading 
centers, not false trade-throughs of a single trading center of its own 
quotations.
---------------------------------------------------------------------------

    \98\ See, e.g., Trade-Through Study, Table 5 (a rounded 0.0% of 
CSE trades are trade-throughs of CSE quotations in Nasdaq stocks; a 
rounded 0.0% of PCX trades are trade-throughs of PCX quotations in 
Nasdaq stocks), and Table 12 (0.2% of NYSE trades are trade-throughs 
of NYSE quotations in NYSE stocks).
---------------------------------------------------------------------------

    Finally, problems with clock synchronization at the various trading 
centers are unlikely to have materially detracted from the accuracy of 
the staff study. The great majority of time stamps were assigned to 
quotations and trades as the data was received by a single entity--
Nasdaq as the Plan processor for Nasdaq stocks and SIAC as the Plan 
processor for NYSE stocks.\99\ One commenter, however, asserted that 
the two Plan processors themselves had major clock synchronization 
problems between quotation data and trade data.\100\ If this were in 
fact the case, the staff study likely would have found a high rate of 
trade-throughs by a single market of its own quotations, because the 
Plan processor's time stamps for the market's quotations would have 
been out of synchronization with its time stamps for the market's 
trades. As noted in the preceding paragraph, the staff study found few 
trade-throughs by a single market of its own quotations, thereby 
indicating that the Plan processors' quotation data and trade data are 
not materially out of synchronization.
---------------------------------------------------------------------------

    \99\ As discussed above, the staff study used the time of trade 
execution assigned by individual trading centers in their audit 
trail data for Nasdaq stocks when this time was available and 
differed from the time of trade report. The staff study noted that 
this occurred for approximately 5-10% of Nasdaq trades. Trade-
Through Study at 8 n. 8. As a result, problems with synchronization 
of clocks at the various Nasdaq trading centers (which must be 
synchronized within three seconds of the standard set by the 
National Institute of Standards and Technology) could have affected 
the time stamps for these trades. Nevertheless, the fact that trade-
through rates remain significant for both Nasdaq stocks and 
exchange-listed stocks even when the quotation window is extended to 
a full eight seconds (thereby eliminating many true trade-throughs 
as well as false trade-throughs caused by unsynchronized time 
stamps) indicates that the staff study's estimates of trade-through 
rates were not materially affected by potential clock 
synchronization problems. Moreover, the trades most likely to be 
reported with different trade execution times than trade report 
times are large, manually-executed block trades reported by dealers. 
These are the very types of trades that commenters admitted often 
deliberately bypass displayed quotations. See, e.g., Fidelity 
Reproposal Letter at 3; Nasdaq Reproposal Letter, Exhibit 1 at 4.
    \100\ Angel Reproposal Letter at 3.
---------------------------------------------------------------------------

ii. Significance of Trade-Through Rates
    Some commenters questioned whether the trade-through rates found by 
the staff study were significant enough to warrant adoption of the 
trade-through reproposal.\101\ They believed, for example, that the 
rates were low, particularly when considered as a percentage of total 
trades (2.5% for both Nasdaq and NYSE stocks) and as the percentage of 
total share volume represented by the total displayed size of 
quotations that were traded through (1.9% and 1.2%, respectively, for 
Nasdaq and NYSE stocks).\102\ They therefore asserted that the rates 
did not demonstrate a serious problem or a need for regulatory action 
to address trade-throughs.
---------------------------------------------------------------------------

    \101\ ArcaEx Reproposal Letter at 6; Fidelity Reproposal Letter 
at 8; Instinet Reproposal Letter at 6 n. 6; Nasdaq Reproposal 
Letter, Exhibit 1 at 4; UBS Reproposal Letter at 4.
    \102\ The 1.9% and 1.2% figures include only the total displayed 
size of quotations that were traded through by trades executed at 
prices inferior to the displayed quotations.
---------------------------------------------------------------------------

    The Commission does not agree that the trade-through rates found in 
the staff study are insignificant, nor does it believe that the total 
number of trade-throughs is the sole consideration in evaluating the 
need for the Order Protection Rule. A valid assessment of their 
significance and the need for intermarket protection against trade-
throughs must be made in light of the Exchange Act objectives for the 
NMS that would be furthered by the Order Protection Rule, including: 
(1) To promote best execution of customer market orders; (2) to promote 
fair and orderly treatment of customer limit orders; and (3) by 
strengthening protection of limit orders, to promote greater depth and 
liquidity for NMS stocks and thereby minimize investor transaction 
costs. The staff study examined trade-through rates from a variety of 
different perspectives, including percentage of trades, percentage of 
total share volume, percentage of share volume of trades of less than 
10,000 shares, and percentage of total share volume of traded-through 
quotations.\103\ In evaluating the need for the Order Protection Rule, 
the different measures vary in their relevance depending on the 
particular objective under consideration.
---------------------------------------------------------------------------

    \103\ See, e.g., Trade-Through Study at 1-2 and Tables 1, 4, 6, 
7-8, 11, 13.
---------------------------------------------------------------------------

    For example, the percentage of total trades that receive inferior 
prices is a particularly important measure when assessing the need to 
promote best

[[Page 37511]]

execution of customer market orders. The staff study found that 1 of 
every 40 trades (2.5%) for both Nasdaq and NYSE stocks have an 
execution price that is inferior to the best displayed price, or 
approximately 98,000 trades per day in Nasdaq stocks alone.\104\ As 
discussed above,\105\ investors (and particularly retail investors) 
often may have difficulty monitoring whether their orders receive the 
best available prices, given the rapid movement of quotations in many 
NMS stocks. The Commission believes that furthering the interests of 
these investors in obtaining best execution on an order-by-order basis 
is a vitally important objective that warrants adoption of the Order 
Protection Rule.
---------------------------------------------------------------------------

    \104\ Id., Tables 1, 8. In October 2004, there were 3.9 million 
average daily trades reported in Nasdaq stocks. Source: http://www.nasdaqtrader.com. The average trade-through rate of 2.5% for 
Nasdaq stocks yields average daily trade-throughs of approximately 
98,000.
    \105\ Supra, note 53 and accompanying text.
---------------------------------------------------------------------------

    The percentage of total trades that receive inferior prices also is 
quite relevant when assessing the need to promote fair and orderly 
treatment of limit orders for NMS stocks. Many of the limit orders that 
are bypassed are small orders that often will have been submitted by 
retail investors. One of the strengths of the U.S. equity markets and 
the NMS is that the trading interests of all types and sizes of 
investors are integrated, to the greatest extent possible, into a 
unified market system. Such integration ultimately works to benefit 
both retail and institutional investors. Retail investors will 
participate directly in the U.S. equity markets, however, only to the 
extent they perceive that their orders will be treated fairly and 
efficiently. The perception of unfairness created when a retail 
investor has displayed an order representing the best price for an NMS, 
yet sees that price bypassed by 1 in 40 trades, is a matter of a great 
concern to the Commission. The Order Protection Rule is needed to 
maintain the confidence of all types of investors that their orders 
will be treated fairly and efficiently in the NMS.
    The third principal objective for the Order Protection Rule is to 
promote greater depth and liquidity for NMS stocks and thereby minimize 
investor transaction costs. Depth and liquidity will be increased only 
to the extent that limit order users are given greater incentives than 
currently exist to display a larger percentage of their trading 
interest. The potential upside in terms of greater incentives for 
display is most appropriately measured in terms of the share volume of 
trades that currently do not interact with displayed orders. It is this 
volume of trading interest that will begin interacting with displayed 
orders after implementation of the Order Protection Rule.
    The share volume of trade-throughs, rather than the number of 
trade-throughs, is most useful for assessing the effect of the Order 
Protection Rule on depth and liquidity because very small trades 
represent such a large percentage of trades in today's markets, but a 
small percentage of share volume. For example, the staff study found 
that, for Nasdaq stocks, 100-share trades represented 32.7% of the 
number of trade-throughs, but only 0.8% of the share volume of trade-
throughs.\106\ Thus, the number of trade-throughs is useful for 
assessing the number of investors, particularly retail investors, 
affected by trade-throughs, while the share volume of trade-throughs is 
useful for assessing the extent to which depth and liquidity are 
affected by trade-throughs. For example, 41.1% of the share volume of 
trade-throughs in Nasdaq stocks is attributable to trades of greater 
than 1000 shares that bypass quotations of greater than 1000 
shares.\107\ Addressing the failure of this substantial volume of 
trading interest to interact with significant displayed quotations is a 
primary objective of the Order Protection Rule.
---------------------------------------------------------------------------

    \106\ Trade-Through Study, Table 6.
    \107\ Id.
---------------------------------------------------------------------------

    In contrast, the share volume of quotations that currently are 
traded through grossly underestimates the potential for increased 
incentives to display because it reflects only the current size of 
displayed quotations in the absence of strong price protection. As a 
result, the share volume of quotations that currently are traded 
through is a symptom of the problem that the Order Protection Rule is 
designed to address--a shortage of quoted depth--rather than an 
indication of the benefits that the Order Protection Rule will achieve. 
For example, when many Nasdaq stocks can trade millions of shares per 
day, but have average displayed size of less than 2000 shares at the 
NBBO, it will be nearly impossible for trade-throughs of displayed size 
to account for a large percentage of total share volume--there simply 
is not enough displayed depth.\108\ Small displayed depth is evidence 
of a market problem, not market quality.
---------------------------------------------------------------------------

    \108\ See Supplemental Study at 4. Commission staff examined the 
average displayed depth in Nasdaq stocks to help evaluate 
commenters' claims concerning the current level of depth and 
liquidity for such stocks. The Supplemental Study measured the total 
depth displayed at the NBBO in Nasdaq stocks as follows: an average 
of 1,833 shares, a median of 581 shares, 384 shares at the 25th 
percentile, and 987 shares at the 75th percentile.
---------------------------------------------------------------------------

    Every trade-through transaction in today's markets potentially 
sends a message to limit order users that their displayed quotations 
can be and are ignored by other market participants. The cumulative 
effect of such messages over time as trade-throughs routinely occur 
each trading day should not be underestimated. When the total share 
volume of trade-through transactions that do not interact with 
displayed quotations reaches 9% or more for many of the most actively 
traded Nasdaq stocks,\109\ this message is unlikely to be missed by 
those who watched their quotations being traded through. Certainly, the 
routine practice of trading through displayed size is most unlikely to 
prompt market participants to display even greater size.
---------------------------------------------------------------------------

    \109\ See Trade-Through Study, Tables 4 and 11.
---------------------------------------------------------------------------

    Thus, the Commission believes that the percentage of share volume 
in a stock that trades through displayed and accessible quotations is a 
useful measure for assessing the potential increase in incentives for 
display of limit orders after implementation of the Order Protection 
Rule. In particular, the dual measurements of percentage of share 
volume of traded-through quotations (an overall 1.9% for Nasdaq stocks) 
and the percentage of share volume of trades that bypass displayed 
quotations (an overall 7.9% for Nasdaq stocks) likely represent the 
lower and upper bounds for a potential improvement in depth and 
liquidity after implementation of the Order Protection Rule.
    Commenters opposing the trade-through reproposal questioned whether 
protection against trade-throughs would lead to any increase in the use 
of limit orders, particularly given the many reasons militating against 
display (e.g., displayed limit orders give a free option to all other 
market participants to trade at the limit order price).\110\ The 
Commission is aware of a variety of reasons that currently deter market 
participants from displaying their trading interest in full. Indeed, it 
is the existence of these negative factors, combined with a shortage of 
positive incentives for display, that have contributed to the 
relatively small displayed depth at the best prices that characterizes 
the market for many NMS stocks today. A large investor interested in 
buying 50,000 shares of a stock is unlikely to suddenly decide to 
display all of its trading interest simply because its order is given 
trade-through

[[Page 37512]]

protection. The objective for the Order Protection Rule is more modest. 
The Rule is designed to increase the perceived benefits of order 
display, against which the negatives are balanced. As a result, the 
market participant that currently displays only 500 shares of its 
50,000-share trading interest might be willing to display 1000 shares. 
The collective effect of many market participants reaching the same 
conclusion would be a material increase in the total displayed depth in 
the market, thereby improving the transparency of price discovery and 
reducing investor transaction costs.
---------------------------------------------------------------------------

    \110\ See, e.g., Instinet Reproposal Letter at 6 and n. 6; UBS 
Reproposal Letter at 3.
---------------------------------------------------------------------------

    Moreover, because of the enormous volume of trading in NMS stocks, 
even a small percentage improvement in depth and liquidity could lead 
to very significant dollar benefits for investors in the form of 
reduced transaction costs. As discussed in section II.A.6 below, for 
example, the annual implicit transaction costs of large institutional 
investors are estimated at more than $30 billion in 2003.\111\ As a 
result, even a small percentage reduction in these costs because of 
improved depth and liquidity would result in very substantial annual 
savings for millions of mutual fund and pension fund investors. The 
Commission therefore believes that the estimated trade-through rates in 
the staff study support the need for enhanced protection of limit 
orders as a means to promote greater depth and liquidity in NMS stocks.
---------------------------------------------------------------------------

    \111\ Implicit transaction costs are associated with the prices 
at which trades are executed, in contrast with explicit transaction 
costs such as commissions. Implicit costs include the adverse price 
movements experienced by institutional investors when searching for 
the liquidity and executing the orders necessary to trade in large 
size. See infra, notes 146, 300-305, 990, and accompanying text.
---------------------------------------------------------------------------

b. Efficiency of Trading in Nasdaq and NYSE Stocks
    A few commenters on the original proposal submitted empirical data 
to support their claim that trading in Nasdaq stocks currently is more 
efficient than trading in NYSE stocks.\112\ Specifically, they 
submitted tables asserting that effective spreads in Nasdaq stocks in 
the S&P 500 are significantly narrower than effective spreads in NYSE 
stocks in the S&P 500.\113\ To help assess and respond to the views of 
commenters on market efficiency, the Commission staff analyzed Rule 
11Ac1-5 reports and other trading data to evaluate the markets for 
Nasdaq and NYSE stocks.\114\
---------------------------------------------------------------------------

    \112\ Instinet Letter, Exhibit A; Nasdaq Letter II, Attachment 
II. One commenter on the reproposal referred the Commission to an 
academic study of trading in Nasdaq and NYSE stocks, asserting that 
its conclusion was that ``bid-ask spreads were shown to be narrower 
and liquidity shown to be greater in Nasdaq stocks.'' STANY 
Reproposal Letter at 8. The referred study was Lehn, Patro, and 
Shastri, Information Shocks and Stock Market Liquidity: A Comparison 
of the New York Stock Exchange and Nasdaq (presented at the American 
Enterprise Institute on June 10, 2004) (available at www.aei.com). 
The commenter misinterpreted, however, the results of the study. The 
study found that ``during both the calm and stress periods, quoted 
and effective bid-ask spreads are significantly lower for NYSE 
versus Nasdaq stocks, a result generally consistent with the 
existing literature.'' Id. at 2. Finally, the Mercatus Center 
referenced several statistical studies in its comment letter and 
concluded that the findings of such studies are mixed. Letter from 
Susan E. Dudley, Director, Regulatory Studies Program, Mercatus 
Center, George Mason University, to Jonathan G. Katz, Secretary, 
Commission, dated May 24, 2004 (``Mercatus Center Letter'') at 3.
    \113\ Nasdaq and Instinet based their tables on statistics 
derived from the reports (``Dash 5 Reports'') on order execution 
quality made public by markets pursuant to Exchange Act Rule 11Ac1-5 
(redesignated as Rule 605 under Regulation NMS). Their source for 
these reports is Market Systems, Inc. (``MSI''), a private vendor 
that collects the reports of all markets each month and includes 
them in a searchable database. MSI also is the source of the Dash 5 
Reports used in the staff analyses.
    \114\ Memorandum to File, from Office of Economic Analysis, 
dated December 15, 2004 (comparative analysis of execution quality 
for NYSE and NASDAQ stocks based on a matched sample of stocks) 
(``Matched Pairs Study''); Memorandum to File, from Division of 
Market Regulation, dated December 15, 2004 (comparative analysis of 
Rule 11Ac1-5 statistics by S&P Index) (``S&P Index Study''). The 
Matched Pair Study and S&P Index Study are in Public File No. S7-10-
04 and are available for inspection on the Commission's Internet Web 
site (http://www.sec.gov).
---------------------------------------------------------------------------

    In its comment on the reproposal, Nasdaq argued that the staff 
studies contained flaws in their methodologies.\115\ With respect to 
the S&P Index Study, Nasdaq stated that the execution quality 
statistics were drawn from an atypical month and that the methodology 
for analyzing effective spreads favored higher-priced NYSE stocks over 
lower-priced Nasdaq stocks. The S&P Index Study presented statistics 
from January 2004, however, because this was the month selected by 
Nasdaq in the comment letter that it submitted on the proposal in July 
2004. Moreover, the general statistics reported by Nasdaq for later 
months do not appear to differ materially from those for January 
2004.\116\ In addition, the S&P Index Study analyzed investor 
transaction costs in terms of a percentage of investment rather cents 
per share because, as discussed below, the percentage of investment 
methodology most reflects economic reality for investors.\117\
---------------------------------------------------------------------------

    \115\ Nasdaq Reproposal Letter, Exhibit 1 at 1.
    \116\ See, e.g., id., Exhibit 1 at 15 (table showing that 
blended effective spread statistics in terms of cents-per-share for 
both market orders and marketable limit orders generally declined 
throughout 2004 for both Nasdaq and NYSE stocks).
    \117\ To the extent Nasdaq has more low-priced stocks than the 
NYSE, the Dash 5 statistics favor Nasdaq in the larger order size 
categories because of ``bracket creep'' `` i.e., it typically will 
be easier to execute a 2000 share order in a $5 stock ($10,000 total 
volume) than to execute a 2000 share order in a $40 stock ($80,000 
total volume), assuming the stocks are otherwise comparable.
---------------------------------------------------------------------------

    With respect to the Matched Pairs Study, Nasdaq asserted that it 
largely examined small stocks. Nasdaq noted, for example, that more 
than 25% of the stocks included in the Matched Pairs Study were not 
eligible for NYSE listing and that only 10% of the stocks were included 
in the Nasdaq-100 Index. The purpose of the Matched Pairs Study, 
however, was to compare execution quality in Nasdaq and NYSE across a 
broad range of stocks, not solely for large stocks or those that were 
eligible for NYSE listing. Although 25% of the stocks may not have been 
eligible for NYSE listing, the staff analysis used matching criteria 
more directly designed to produce an ``apples-to-apples'' comparison--
market capitalization, price, average daily dollar volume (adjusted 
downward by 30% for Nasdaq stocks to reflect trade reporting practices 
in such stocks), and relative price range. The Commission therefore 
believes that the staff studies provide a valid basis to compare 
trading in Nasdaq stocks and NYSE stocks.
    The staff studies indicate that the execution quality statistics 
submitted by commenters on the original proposal are flawed. The 
claimed large and systematic disparities between Nasdaq and NYSE 
effective spreads disappear when an analysis of execution quality more 
appropriately controls for differences in stocks, order types, and 
order sizes.\118\ The staff studies reveal that both the market for 
Nasdaq stocks and the market for NYSE stocks have significant 
strengths. But, as discussed below, both markets also have weaknesses 
that could be reduced by strengthened protection against trade-
throughs.
---------------------------------------------------------------------------

    \118\ Matched Pairs Study, Tables 4-10; S&P Index Study, Tables 
2-9.
---------------------------------------------------------------------------

    First, the effective spread analyses submitted by commenters do 
not, in a number of respects, reflect appropriately the comparative 
transaction costs in Nasdaq and NYSE stocks.\119\ They were

[[Page 37513]]

presented in terms of ``cents-per-share'' and therefore failed to 
control for the varying level of stock prices between Nasdaq stocks and 
NYSE stocks in the S&P 500. Lower priced stocks naturally will tend to 
have lower spreads in terms of cents-per-share than higher priced 
stocks, even when such cents-per-share spreads constitute a larger 
percentage of stock price and therefore represent transaction costs for 
investors that consume a larger percentage of their investment. By 
using cents-per-share statistics, commenters did not adjust for the 
fact that the average prices of Nasdaq stocks are significantly lower 
than the average prices of NYSE stocks. For example, the average price 
of Nasdaq stocks in the S&P 500 in January 2004 was $34.14, while the 
average price of NYSE stocks was $41.32.\120\
---------------------------------------------------------------------------

    \119\ The effective spread is a useful measure of transaction 
costs for market orders, particularly for small order sizes, because 
it reflects the prices actually received by investors when compared 
to the best quotes at the time a market received an order. 
Consequently, unlike the quoted spread, the effective spread 
reflects any cost to investors caused by movement in prices during a 
delay between receipt of an order and execution of an order. In 
other words, the effective spread penalizes slow markets for failing 
to execute trades at their quoted prices at the time they received 
an order. It therefore provides an appropriate criterion with which 
to compare execution quality between automated and manual markets 
for comparable stocks, order types, and order sizes. As discussed 
below, however, effective spread statistics do not capture 
transaction costs that are attributable to low fill rates--the 
failure to obtain an execution--for marketable limit orders.
    \120\ S&P Index Study, Table 1.
---------------------------------------------------------------------------

    The effective spread analyses submitted by commenters also were 
weakened by their failure to address the much lower fill rates of 
orders in Nasdaq stocks than orders in NYSE stocks. The commenters 
submitted ``blended'' statistics that encompassed both market orders 
and marketable limit orders. The effective spread statistics for these 
order types are not comparable, however, because market orders do not 
have a limit price that precludes their execution at prices inferior to 
the prevailing market price at time of order receipt. In contrast, the 
limit price of marketable limit orders often precludes an execution, 
particularly when there is a lack of liquidity and depth at the 
prevailing market price. For example, the fill rates for marketable 
limit orders in Nasdaq stocks generally are less than 75%, and often 
fall below 50% for larger order sizes.\121\
---------------------------------------------------------------------------

    \121\ Matched Pairs Study, Table 10; S&P Index Study, Tables 7, 
9.
---------------------------------------------------------------------------

    Accordingly, investors must accept trade-offs when deciding whether 
to submit market orders or marketable limit orders (particularly when 
the limit price equals the current market price). Use of a limit price 
generally assures a narrower spread by precluding an execution at an 
inferior price. By precluding an execution, however, the limit price 
may cause the investor to ``miss the market'' if prices move away (for 
example, if prices rise when an investor is attempting to buy). 
Effective spreads for marketable limit orders therefore represent 
transaction costs that are conditional on execution, while effective 
spreads for market orders much more completely reflect the entire 
implicit transaction cost for a particular order. Market orders 
represent only approximately 14% of the blended flow of market and 
marketable limit orders in Nasdaq stocks (reflecting the fact that ECNs 
now dominate Nasdaq order flow and limit orders represent the vast 
majority of ECN order flow).\122\ In contrast, market orders represent 
approximately 36% of the blended order flow in NYSE stocks.\123\ 
Accordingly, the effective spread statistics for marketable limit 
orders, and particularly for orders in Nasdaq stocks, must be 
considered in conjunction with the fill rate for such orders `` while a 
narrow spread is good, the benefits are greatly limited if investors 
are unable to obtain an execution at that spread. The analyses 
presented by the commenters, however, did not address the respective 
fill rates for Nasdaq stocks and NYSE stocks or reflect the inherent 
differences in measuring the transaction costs of market orders and 
marketable limit orders.
---------------------------------------------------------------------------

    \122\ Most market orders in Nasdaq stocks are executed by 
market-making dealers pursuant to agreement with their correspondent 
or affiliated brokers.
    \123\ Matched Pairs Study at 1.
---------------------------------------------------------------------------

    The analyses prepared by Commission staff are designed to provide 
appropriate evaluations of comments on the efficiency of trading in 
Nasdaq and NYSE stocks. In particular, they are more finely tuned to 
evaluate trading for different types of stocks with varying trading 
volume, different types of orders, and different sizes of orders. These 
analyses indicate that the markets for Nasdaq and NYSE stocks each have 
weaknesses that an intermarket price protection rule could help 
address. By ``weakness,'' the Commission simply means that there 
appears to be considerable room for improvement. For example, the 
effective spread statistics for large, electronically-received market 
orders in NYSE stocks show significant ``slippage''--the amount by 
which orders are executed at prices inferior to the national best bid 
or offer (``NBBO'') at the time of order receipt.\124\ Slippage often 
results in effective spreads for large orders that are many times wider 
than the effective spreads for small orders in the same NYSE stocks. By 
protecting automated quotations, the Order Protection Rule should 
enhance the depth and liquidity available for large, electronic orders 
in NYSE stocks and thereby improve their execution quality.
---------------------------------------------------------------------------

    \124\ Matched Pairs Study, Tables 4, 7; S&P Index Study, Tables 
2, 4, 6, 8.
---------------------------------------------------------------------------

    For Nasdaq stocks, the Rule 11Ac1-5 statistics reveal very low fill 
rates for larger sizes of marketable limit orders (e.g., 2000 shares or 
more), which generally fall below 50% for most Nasdaq stocks. Contrary 
to the assertion of some commenters,\125\ certainty of execution for 
large marketable limit orders clearly is not a strength of the current 
market for Nasdaq stocks. Certainty of a fast response is a strength, 
but much of the time the response to large orders will be a ``no fill'' 
at any given trading center.\126\
---------------------------------------------------------------------------

    \125\ See, e.g., Instinet Reproposal Letter at 7; Nasdaq Letter 
II at 6. In addition to effective spread statistics, Instinet 
submitted statistics indicating that combined market and marketable 
limit orders in Nasdaq stocks were more likely to be executed at or 
inside the NBBO than such orders in NYSE stocks. Instinet Letter, 
Table I-C. These statistics, however, only reflect orders that in 
fact receive an execution--not the large volume of orders in Nasdaq 
stocks that fail to receive any execution at all.
    \126\ Some commenters asserted that the large number of limit 
orders in Nasdaq stocks indicates that sufficient incentives exist 
for the placement of limit orders in such stocks. See, e.g., 
Instinet Letter at 11; Letter from Thomas N. McManus, Managing 
Director & Counsel, Morgan Stanley & Co. Incorporated, to Jonathan 
G. Katz, Secretary, Commission, dated August 19, 2004 (``Morgan 
Stanley Letter'') at 14. Strengthened intermarket trade-through 
protection, however, is designed to improve the quality of limit 
orders in a stock, particularly their displayed size, and thereby 
promote greater depth and liquidity. This goal is not achieved, for 
example, by a large number of limit orders with small sizes and high 
cancellation rates.
---------------------------------------------------------------------------

    Two commenters on the reproposal disputed whether low fill rates 
for marketable limit orders in Nasdaq stocks indicate any weakness that 
needed to be addressed.\127\ Instinet, for example, believed that ``the 
Commission is misplaced in its contention that low fill rates in Nasdaq 
stocks are a weakness of that market,'' and that they are a phenomenon 
``intrinsic to electronic markets in which market participants are free 
to cancel and replace orders.'' \128\ Instinet also noted that many 
market centers in Nasdaq stocks have significant reserve size in 
addition to displayed size and that market participants commonly routed 
oversized marketable limit orders to attempt to interact with reserve 
size.\129\

[[Page 37514]]

Similarly, Nasdaq stated that the staff studies ``erroneously conclude 
that differential fill rates for large marketable limit orders in 
Nasdaq-listed and NYSE-listed stocks are evidence of a defect in 
Nasdaq's market structure,'' and that they failed ``to consider a 
widely used order routing technique of intentionally sending oversized 
orders at displayed quotes searching (also known as ``pinging'') for 
reserves within the many limit order books trading Nasdaq-listed 
securities.'' \130\ Nasdaq also asserted that marketable limit orders 
are ``exceedingly popular in electronic venues where they have 
effectively supplanted market orders as the order of choice in 
accessing availability liquidity at the current price.'' \131\
---------------------------------------------------------------------------

    \127\ Instinet Reproposal Letter at 6-7; Nasdaq Reproposal 
Letter at 5.
    \128\ Instinet Reproposal Letter at 6-7.
    \129\ Instinet Reproposal Letter at 7. Instinet also asserted 
that low fill rates for large marketable limit orders might be 
attributable to the frequent locking of markets in low-priced 
stocks. In fact, however, the Dash 5 fill rates for large orders in 
low-priced stocks generally are higher than those for high-priced 
stocks, likely because the dollar value of such orders is low (i.e., 
5000 shares of a $5 stock ($25,000) generally will be easier to 
trade than 5000 shares of a $50 stock ($250,000)). See infra, text 
accompanying notes 141-142 (average fill rates for large orders in 
low-priced stocks in Nasdaq-100 Index are much higher than fill 
rates for most other stocks in Index).
    \130\ Nasdaq Reproposal Letter at 5.
    \131\ Id., Exhibit 1 at 8.
---------------------------------------------------------------------------

    The Commission continues to believe that fill rates for large 
marketable limit orders are a useful measure of order execution quality 
for Nasdaq stocks. They are especially useful because they measure the 
availability of both displayed and undisplayed liquidity, whereas 
simply measuring displayed size would understate the total liquidity 
readily available for Nasdaq stocks. Indeed, the existence of 
``pinging'' orders searching for reserve size in Nasdaq stocks at 
electronic markets is widely known. Such oversized orders (i.e., orders 
with sizes greater than displayed size) could as aptly be labeled 
``liquidity search'' orders as ``pinging'' orders. Given the relatively 
small displayed size in nearly all Nasdaq stocks (i.e., significantly 
less than 2000 shares),\132\ orders with sizes of 2000 to 4999 shares 
and 5000 to 9999 shares (the two largest Dash 5 size categories) 
generally will exceed the displayed size. Thus, low fill rates 
demonstrate that the total displayed and reserve liquidity available 
for Nasdaq stocks at any particular trading center typically is small 
compared to the demand for liquidity at the inside prices. Moreover, 
increased displayed liquidity--a principal goal of the Order Protection 
Rule--would promote market efficiency by reducing the uncertainty and 
costs associated with the need for market participants to ``ping'' 
electronic markets for liquidity that is held in reserve.
---------------------------------------------------------------------------

    \132\ Supplemental Trade-Through Study at 5. In Fall 2003, only 
273 Nasdaq stocks had average displayed size at the NBBO of 2000 or 
greater shares, 213 of which were low-priced stocks (prices of less 
than $10 per share).
---------------------------------------------------------------------------

    The Reproposing Release did not suggest, however, that the 
differential fill rates for large marketable limit orders in Nasdaq and 
NYSE stocks were useful in comparing the liquidity and depth available 
in each market. Instead, the Reproposing Release focused on the most 
relevant Dash 5 statistic for each market, given its particular trading 
characteristics. As noted above, the significant amount of ``slippage'' 
in the execution of electronically-received large market orders in NYSE 
stocks suggest that improved incentives for display of automated 
trading interest will help improve execution quality for NYSE stocks. 
Notably, Instinet and Nasdaq agreed that slippage rates for automated 
market orders represented a problem in the market for NYSE stocks.\133\ 
Because market participants generally choose not to submit market 
orders to electronic markets in Nasdaq stocks, however, the fill rates 
for marketable limit orders are a more relevant Dash 5 statistic to 
assess depth and liquidity in Nasdaq stocks.
---------------------------------------------------------------------------

    \133\ Instinet Reproposal Letter at 6 (``we ourselves make a 
point of a high level of slippage as being an issue in the NYSE 
market''); Nasdaq Letter II, Attachment II (table comparing market 
order shares traded outside the quote for Nasdaq and NYSE stocks).
---------------------------------------------------------------------------

    Accordingly, the Commission's concern with fill rates for larger 
orders in Nasdaq stocks is not that they are lower than those for NYSE 
stocks, but that they are very low in absolute terms--often falling 
well below 50%.\134\ Moreover, the larger order sizes typically account 
for a small percentage of executed shares compared to the executed 
shares of smaller order sizes.\135\ When considered in conjunction with 
one another, the low fill rates and small percentage of executed shares 
indicate substantial room for improvement in depth and liquidity in 
many Nasdaq stocks. An important objective for Regulation NMS as a 
whole is to facilitate more efficient trading in larger sizes, an 
objective that has become much more important to large investors since 
decimalization.\136\ An improvement in fill rates for larger sized 
orders (or an increase in their percentage of executed shares) would 
evidence progress toward this objective.
---------------------------------------------------------------------------

    \134\ See, e.g., Matched Pairs Study, Table 10.
    \135\ See, e.g., Matched Pairs Study, Table 3. Nasdaq also 
asserted that the difference in share volume of Dash 5 marketable 
limit orders for Nasdaq stocks versus NYSE stocks indicated the 
superiority of Nasdaq execution quality for marketable limit orders. 
The difference in marketable limit order share volume in Nasdaq and 
NYSE stocks, however, is attributable to structural differences 
between the two markets. For example, many large orders in NYSE 
stocks are handled manually by brokers on the NYSE floor and 
therefore are not included in the Dash 5 statistics, which only 
encompass electronic orders. In addition, a greater volume of market 
orders are executed in NYSE stocks than in Nasdaq stocks. Matched 
Pairs Study, Table 3. As discussed below, the need for a restrictive 
limit price to prevent outside-the-quote executions likely is an 
additional reason that Nasdaq market participants choose to use 
marketable limit orders rather than market orders. See infra, notes 
138-139 and accompanying text.
    \136\ See Reproposing Release, 69 FR at 77425.
---------------------------------------------------------------------------

    Fill rates for marketable limit orders, however, offer only 
indirect evidence of the total transaction costs incurred by investors. 
They indicate that no execution was obtained for an investor order at a 
particular trading center, but do not indicate how the investor 
subsequently fared in obtaining an execution. As discussed above, there 
are significant trade-offs between marketable limit orders and market 
orders. The use of a restrictive limit price at the NBBO precludes any 
slippage in execution price, but also may cause an investor to miss the 
market if prices subsequently move away from the order (i.e., rise when 
an investor is attempting to buy or fall when an investor is attempting 
to sell). To evaluate the total transaction costs associated with an 
order that goes unfilled or receives a partial fill, it is necessary to 
know the price at which the investor ultimately obtained an execution 
for its full order.
    To help the Commission evaluate and respond to commenters' 
criticisms and, in particular, to supplement its analysis of fill rates 
as a measure of depth and liquidity for Nasdaq stocks and to evaluate 
the extent to which missed fills may lead to higher investor 
transaction costs, Commission staff also examined execution quality 
statistics for marketable limit orders in Nasdaq-100 Index stocks that 
are executed outside the best quotes at the Inet ATS and the NASDAQ 
Market Center.\137\ By definition, such orders have been placed with 
liberal limit prices that give more flexibility for executions away 
from the NBBO than orders with limit prices that are restrictively set 
at the NBBO. Accordingly, the slippage rates for such orders give 
another indication of

[[Page 37515]]

available liquidity for Nasdaq-100 stocks.
---------------------------------------------------------------------------

    \137\ Memorandum to File, from Division of Market Regulation, 
dated April 6, 2005 (analysis of Rule 11Ac1-5 statistics for Nasdaq-
100 Index) (``Nasdaq-100 Index Supplemental Study''). The Nasdaq100 
Index Supplemental Study has been placed in Public File No. S7-10-04 
and is available for inspection on the Commission's Internet Web 
site (http://www.sec.gov). The staff examined Nasdaq-100 stocks in 
response to Nasdaq's suggestion that they are most appropriate for 
evaluating execution quality in the market for Nasdaq stocks. See 
Nasdaq Reproposal Letter, Exhibit 1 at 1, 11. The statistics are 
from December 2004 and are equal-stock weighted to give a more 
representative view of trading across all stocks, rather than a view 
concentrated on a few stocks that are much more actively traded than 
the others.
---------------------------------------------------------------------------

    The statistics for outside-the-quote executions in marketable limit 
orders buttress a conclusion that there is significant room for 
improved depth and liquidity in Nasdaq stocks. For example, the Inet 
ATS did not fill 83.0% of its large marketable limit orders.\138\ Of 
the orders it executed, 19.5% of shares were executed outside the quote 
by an average of 2.7 cents. Thus, while the overall quoted and 
effective spreads for executed shares for large orders were, 
respectively, 1.6 cents and 2.5 cents, the spread for outside the quote 
executions was 7.0 cents--438% wider than the narrow quoted spread. The 
statistics for the NASDAQ Market Center are similar. It did not fill 
68.4% of its large marketable limit orders.\139\ Of the orders it 
executed, 14.7% were executed outside the quote by an average of 2.3 
cents. The overall quoted and effective spreads for large orders were, 
respectively, 1.6 cents and 2.5 cents, compared to 6.2 cents for 
outside the quote executions--388% wider than the narrow quoted spread. 
The outside-the-quote spreads provide the best available indication of 
execution quality that otherwise would have been obtained at the time 
orders were placed for the 83.0% and 68.4% of shares that were not 
filled due to their restrictive limit price. The outside-the-quote 
spreads also are relevant in assessing the reasons why market 
participants most often use marketable limit orders with limit prices 
at the NBBO rather than market orders when trading Nasdaq stocks.
---------------------------------------------------------------------------

    \138\ Nasdaq-100 Index Supplemental Study, Table 1 (orders with 
sizes of 5000 to 9999 shares).
    \139\ Nasdaq-100 Index Supplemental Study, Table 5 (orders with 
sizes of 5000 to 9999 shares).
---------------------------------------------------------------------------

    In addition, the supplemental staff study separately examined fill 
rates and executed share volume for types of Nasdaq-100 stocks where 
liquidity for orders with large share sizes can reasonably be expected 
to be highest.\140\ These stock groupings were selected primarily to 
assess whether low fill rates for large marketable limit orders are an 
inherent part of the structure of the market for Nasdaq stocks. 
Specifically, the supplemental staff study calculated fill rates and 
executed share volume for the three Nasdaq stocks with the largest 
capitalization--Microsoft, Intel, and Cisco. These three stocks are 
widely recognized among all Nasdaq stocks as having markets with 
significant depth and liquidity. In addition, the supplemental staff 
study examined the seven Nasdaq-100 stocks with share prices of less 
than $10 per share. Liquidity for orders with large share sizes in 
these stocks can be expected to be higher than for stocks with higher 
prices because the dollar sizes are much smaller (e.g., a 5000 share 
order in a $5 stock totals $25,000, whereas a 5000 share order in a $30 
stock totals $150,000). In terms of economic reality, therefore, large 
orders in a low-priced stock generally are easier to execute than large 
orders in a higher-priced stock, assuming the stocks are otherwise 
comparable. Finally, the supplemental staff study separately examined 
the other 90 stocks in the Nasdaq-100 Index (i.e., stocks with prices 
of at least $10 per share other than Microsoft, Intel, and Cisco).
---------------------------------------------------------------------------

    \140\ Nasdaq-100 Index Supplemental Study, Tables 2-3, 6-7.
---------------------------------------------------------------------------

    The supplemental staff study reveals that low fill rates for large 
marketable limit orders are not an inherent feature of the market for 
Nasdaq stocks. For example, the NASDAQ Market Center fill rates for 
large orders are 76.7% for the three large-cap stocks, 70.1% for the 
low-priced stocks, and 27.1% for the other 90 stocks in the Nasdaq-100 
Index.\141\ Similarly, the Inet ATS fill rates for large orders are 
58.5% for the three large-cap stocks, 55.0% for low-priced stocks, and 
12.6% for the other 90 stocks in the Nasdaq-100 Index.\142\
---------------------------------------------------------------------------

    \141\ Nasdaq-100 Index Supplemental Study, Tables, 6-8.
    \142\ Nasdaq-100 Index Supplemental Study, Tables 2-4.
---------------------------------------------------------------------------

    The order execution quality measures included in Dash 5 reports do 
not, of course, reflect all types of investor transaction costs. They 
generally focus on the execution price of individual orders in 
comparison with the best quoted prices at the time orders are received. 
As a result, they do not capture transaction costs that are associated 
with the short-term movement of quoted prices. To further assist the 
Commission in evaluating the views of commenters, Commission staff has 
analyzed price volatility for trading in Nasdaq and NYSE stocks.\143\ 
This analysis particularly focuses on transitory volatility--short-term 
fluctuations away from the fundamental or ``true'' value of a stock. 
Transitory volatility should be distinguished from fundamental 
volatility--price fluctuations associated with factors independent of 
market structure, such as earnings changes and other economic 
determinants of stock prices. The staff analysis found that on average 
both intraday volatility and transitory volatility are higher for 
Nasdaq stocks than for NYSE stocks.\144\ Excessive transitory 
volatility indicates a shortage of depth and liquidity that otherwise 
would minimize the effect of short-term order imbalances. Such 
volatility may provide benefits in the form of profitable trading 
opportunities for short-term traders or market makers, but these 
benefits come at the expense of other investors, who would be buying at 
artificially high or selling at artificially low prices. Retail 
investors, in particular, tend to be relatively uninformed concerning 
short-term price movements and are apt to bear the brunt of the trading 
costs associated with excessive transitory volatility.\145\ The Order 
Protection Rule, by promoting greater depth and liquidity, is designed 
to help reduce excessive transitory volatility in Nasdaq stocks.
---------------------------------------------------------------------------

    \143\ Memorandum to File, from Office of Economic Analysis, 
dated December 15, 2004 (analysis of volatility for stocks switching 
from NASDAQ to NYSE) (``Volatility Study''). The Volatility Study 
has been placed in Public File No. S7-10-04 and is available for 
inspection on the Commission's Internet Web site (http://www.sec.gov).
    \144\ Volatility Study at 1. Nasdaq raised a number of 
objections to the Volatility Study in its comment on the reproposal. 
Nasdaq Reproposal Letter, Exhibit 1 at 16-19. To help the Commission 
evaluate these objections, Commission staff performed supplemental 
analysis to reflect Nasdaq's concerns and to provide a fuller 
description of volatility for Nasdaq and NYSE stocks. The results of 
the additional analysis confirm the basic conclusions reached in the 
original analysis `` the stocks that switched from Nasdaq listing to 
NYSE listing during the sample period experienced a decrease in 
total volatility and in transitory volatility. Memorandum to File, 
from Office of Economic Analysis, dated April 6, 2005 (additional 
analysis of volatility for stocks switching from NASDAQ to NYSE) 
(``Supplemental Volatility Study''). The Supplemental Volatility 
Study has been placed in Public File No. S7-10-04 and is available 
for inspection on the Commission's Internet Web site (http://www.sec.gov).
    \145\ See infra, section I.A.2 (discussion of Exchange Act 
emphasis on minimizing volatility to protect interests of 
investors).
---------------------------------------------------------------------------

    Finally, an important measure of depth and liquidity for NMS stocks 
is the transaction costs actually incurred by institutional investors 
when they trade in large size. These costs are not readily available 
for public view because their measurement requires access to a large 
volume of private order and execution data of institutional investors. 
One of the leading authorities on institutional transaction costs uses 
an extensive database of such data obtained from its clients to 
calculate their transaction costs. It recently published calculations 
of average transaction costs for Nasdaq and NYSE stocks during the 
fourth quarter of 2003 as, respectively, 83 basis points and 55 basis 
points.\146\ Given the significant

[[Page 37516]]

differences in the overall nature of Nasdaq and NYSE stocks, these 
figures cannot be used to assess the relative efficiency of the two 
markets. The figures for both, however, suggest room for improved depth 
and liquidity, particularly when compared with the average quoted 
spreads in NMS stocks, which generally are less, and often much less, 
than 10 basis points for large capitalization stocks that dominate 
trading volume.\147\
---------------------------------------------------------------------------

    \146\ Wayne H. Wagner, Faster!, 1 FIXGlobal 54, 55 (3rd Quarter 
2004) (estimate of Plexus Group, Inc.). Explicit transaction costs 
such as commissions represent only a small part of total transaction 
costs calculated by Plexus (e.g., 12 basis points for large 
capitalization stocks). The remaining implicit transaction costs are 
attributable to the impact of the trade on market price as it 
interacts with other buyers and sellers, delay or liquidity search 
costs that occur when portions of the trade are held back for fear 
of upsetting the supply/demand balance, and opportunity costs that 
arise when the trade is abandoned before all desired shares have 
been acquired. Id.
    \147\ See, e.g., Matched Pairs Study, Tables 3, 8.
---------------------------------------------------------------------------

c. Need for Intermarket Rule to Achieve Effective Protection Against 
Trade-Throughs
    As discussed in the preceding section, the relevant data, as well 
as the policy choices the Commission has articulated above, supports 
the need for strengthened protection against trade-throughs in both 
Nasdaq and exchange-listed stocks. Some commenters argued, however, 
that competitive forces alone would achieve the fairest and most 
efficient markets.\148\ In particular, they asserted that reliance on 
efficient access to markets and brokers' duty of best execution would 
be sufficient without the need for an intermarket rule against trade-
throughs. This argument, however, fails to take into account two 
structural problems--principal/agent conflicts of interest and ``free-
riding'' on displayed prices.
---------------------------------------------------------------------------

    \148\ See, e.g., ArcaEx Reproposal Letter at 5; STA Reproposal 
Letter at 3; STANY Reproposal Letter at 2.
---------------------------------------------------------------------------

    Agency conflicts may occur when brokers have incentives to act 
otherwise than in the best interest of their customers. For example, 
brokers may have strong financial and other interests in routing orders 
to a particular market, which may or may not be displaying the best 
price for a stock. Moreover, the Commission has not interpreted a 
broker's duty of best execution for retail orders as requiring that a 
separate best execution analysis be made on an order-by-order 
basis.\149\ Nevertheless, retail investors generally expect that their 
small orders will be executed at the best displayed prices. They may 
have difficulty monitoring whether their individual orders miss the 
best displayed prices at the time they are executed and evaluating the 
quality of service provided by their brokers.\150\ Given the large 
number of trades that fail to obtain the best displayed prices (e.g., 
approximately 1 in 40 trades for both Nasdaq and NYSE stocks), the 
Commission is concerned that many of the investors that ultimately 
received the inferior price in these trades may not be aware that their 
orders did not, in fact, obtain the best price. The Order Protection 
Rule will backstop a broker's duty of best execution on an order-by-
order basis by prohibiting the practice of executing orders at inferior 
prices, absent an applicable exception.
---------------------------------------------------------------------------

    \149\ See, e.g., Securities Exchange Act Release No. 37619A 
(Sept. 6, 1996), 61 FR 48290, 48323 n. 362 (``Order Handling Rules 
Release'') (``Commission has recognized that it may be impractical, 
both in terms of time and expense, for a broker that handles a large 
volume of orders to determine individually where to route each order 
it received.''). See also infra, section II.B.4 (discussion of duty 
of best execution).
    \150\ See supra, note 53 and accompanying text (discussion of 
difficulty for investors to monitor whether their order execution 
prices equal the best quoted prices at the time of order execution).
---------------------------------------------------------------------------

    Just as importantly, even when market participants act in their own 
economic self-interest, or brokers act in the best interests of their 
customers, they may deliberately choose, for various reasons, to bypass 
(i.e., not protect) limit orders with the best displayed prices. For 
example, an institution may be willing to accept a dealer's execution 
of a particular block order at a price outside the NBBO, thereby 
transferring the risk of any further price impact to the dealer. Market 
participants that execute orders at inferior prices without protecting 
displayed limit orders are effectively ``free-riding'' on the price 
discovery provided by those limit orders. Displayed limit orders 
benefit all market participants by establishing the best prices, but, 
when bypassed, do not themselves receive a benefit, in the form of an 
execution, for providing this public good. This economic externality, 
in turn, creates a disincentive for investors to display limit orders 
and ultimately could negatively affect price discovery and market depth 
and liquidity.
    Fidelity's comment letters on the reproposal questioned whether 
large trades that bypass displayed quotations should be considered as 
free-riding on the price discovery provided by displayed limit 
orders.\151\ It emphasized that the price-formation process reflects 
information stemming from all trading interest and that institutional 
trading interest is an important part of the process. As evidence, it 
noted that almost one-third of reported volume on the NYSE in 2004 was 
of block size, typically representing undisplayed institutional trading 
interest.
---------------------------------------------------------------------------

    \151\ Fidelity Reproposal Letter at 5; Fidelity Reproposal 
Letter II at 2. See also Battalio/Jennings Paper at 2.
---------------------------------------------------------------------------

    Institutional trading interest, both displayed and undisplayed, 
undoubtedly is an important part of the price discovery process. 
Notably, the large volume of block trades currently executed on the 
NYSE is subject both to the NYSE's order interaction rules and the ITS 
trade-through rules. Accordingly, NYSE block trades cannot be 
considered as free-riding on displayed limit orders, in contrast to 
block trades reported by block positioners in the OTC market that 
currently do not interact with (and thereby are free-riding on) 
displayed liquidity and are not covered by the ITS provisions.
    Moreover, the Order Protection Rule does not require that all 
institutional trading interest be displayed. Rather, the Rule 
strengthens the incentive for the voluntary display of a greater 
proportion of latent trading interest by assuring that, when such 
interest is displayed, it is protected against most trade-throughs. In 
these circumstances, institutions will choose to display when they 
determine it is in their own interests, not because it is mandated by 
Commission rule. Greater displayed size will improve the quality and 
transparency of price discovery for all market participants.
    Fidelity also asserted that ``an institutional investor, seeking to 
acquire or dispose a large block of stock will be put to a distinct and 
unfair advantage if it is deprived of the ability to negotiate, at one 
time and at a specified price, an all-in price for its block trade with 
a dealer.'' \152\ Similarly, the Battalio/Jennings Paper suggests that, 
for large marketable limit orders of institutions, ``it might be better 
to ignore a penny quote for a few hundred shares in order to get a 
large order done quickly rather than try to chase the small quote and 
risk losing the ability to fill the size desired.'' \153\ These 
contentions do not recognize that the Order Protection Rule does not, 
in fact, preclude institutions from negotiating ``all-in'' prices for 
their trades with dealers or immediately routing orders to access 
larger-sized depth-of-book quotations. Rather, the Rule simply requires 
a dealer, at the same time as executing a large institutional order at 
an all-in price, to route an intermarket sweep order to execute against 
the displayed size of protected quotations with superior prices to the 
institution's trade price. Similarly, the Rule allows an institution to 
simultaneously route intermarket sweep orders to execute against both

[[Page 37517]]

small-sized quotations at the best prices and larger-sized depth-of-
book quotations. The Rule therefore does not require institutions to 
parcel out their block orders in a series of transactions over time.
---------------------------------------------------------------------------

    \152\ Fidelity Reproposal Letter at 3.
    \153\ Battalio/Jennings Paper at 29.
---------------------------------------------------------------------------

    Fidelity and the Battalio/Jennings Paper also incorrectly asserted 
that the Commission's concern about free-riding on displayed quotations 
related only to the limit orders of retail investors, citing a number 
of academic studies indicating that institutional trades and quotations 
are important contributors to price discovery.\154\ In fact, however, 
the Reproposing Release did not distinguish between the limit orders of 
retail investors and those of institutions when discussing the problem 
of free-riding.\155\ Rather, the Order Protection Rule is designed to 
promote displayed liquidity from all sources, and institutional limit 
orders clearly are a significant source of such liquidity. Indeed, the 
Battalio/Jennings Paper itself notes that ``institutions dominate price 
discovery via quoting'' and that ``the preponderance of quote-based 
discovery for NYSE-listed securities takes place at the NYSE'' where 
``institutions dominate trading.'' \156\ Many institutional investors 
and the NYSE are strong supporters of strengthened limit order 
protection for all NMS stocks.\157\ For example, the ICI, whose members 
manage assets that account for more than 95% of assets of all U.S. 
mutual funds, stated that it ``strongly supports the establishment of a 
marketwide trade-through rule. * * * [S]uch a rule represents a 
significant step in providing protection for limit orders. By affirming 
the principle of price priority, a trade-through rule should encourage 
the display of limit orders, which in turn would improve the price 
discovery process and contribute to increased market depth and 
liquidity.'' \158\
---------------------------------------------------------------------------

    \154\ Battalio/Jennings Paper at 4 n. 1, 30-36; Fidelity 
Reproposal Letter II at 2.
    \155\ See, e.g., Reproposing Release, 69 FR at 77434 
(``Displayed limit orders benefit all market participants by 
establishing the best prices, but, when bypassed, do not themselves 
receive a benefit, in the form of an execution, for providing this 
public good. This economic externality, in turn, creates a 
disincentive for investors to display limit orders, particularly 
limit orders of any substantial size.'') (emphasis added). In 
contrast, the Commission's concern specifically for the limit orders 
of retail investors relates primarily to the perception of 
unfairness created when retail orders are ignored by other market 
participants. Although some of these orders may subsequently be 
executed or cancelled, the retail investors that submitted orders 
with the best prices have not received the appropriate reward for 
their use of an aggressive limit price--a prompt, efficient 
execution consistent with the principle of price priority. Moreover, 
the orders that ultimately never receive an execution are also 
likely to be the very orders that would have been most profitable 
for the investor (e.g., when the order was to buy a stock and the 
stock's price climbed after the trade-through occurred). To meet the 
Exchange Act's objectives for the NMS, investors of all types should 
have confidence that their orders will be handled in a fair and 
orderly fashion.
    \156\ Battalio/Jennings Paper at 35.
    \157\ See, e.g., American Century Letter at 2; Capital Research 
Letter at 2; ICI Reproposal Letter at 2; NYSE Reproposal Letter at 
3; T. Rowe Price Reproposal Letter at 2; Vanguard Reproposal Letter 
at 2.
    \158\ ICI Reproposal Letter at 2.
---------------------------------------------------------------------------

    Another commenter asserted that the reproposal overly emphasized 
the importance of displayed limit orders in the price discovery 
process.\159\ It stated that the interaction of displayed limit orders 
with marketable orders is only one aspect of price discovery, which is 
``a dynamic process that operates in the context of other transactions 
that have recently been made, current quotes, and a richer tapestry of 
the expressed and latent interest of a broader array of market 
participants.'' \160\ The Commission generally concurs with this 
characterization of the price discovery process, but believes that 
displayed limit orders are a critically important element of efficient 
price discovery that deserve greater protection against trade-throughs. 
Publicly displayed and automated limit orders are the most transparent 
and accessible source of liquidity in the equity markets. Moreover, 
displayed limit orders provide price discovery on a going forward 
basis--they indicate the prices at which trades can be effected in the 
future. Trade reports, in contrast, look backward at the prices of 
trades that already have occurred, which may or may not be still 
available.
---------------------------------------------------------------------------

    \159\ Letter from Stewart P. Greene, Chief Counsel, Securities 
Law, to Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 
(``TIAA-CREF Reproposal Letter''), Attachment at 15-16. This 
commenter also asserted that the reproposal failed to appreciate the 
importance of ``quantity discovery,'' in addition to price 
discovery. Id. at 9. As evidenced by the repeated concern expressed 
in both the proposal and reproposal for improving market depth and 
liquidity, the Commission considers the term ``price discovery'' to 
encompass both the inside prices for a stock and the quantity of 
stock that can be traded at and away from the inside prices. It 
believes, however, that displayed limit orders are a vital source of 
price discovery in all of its forms.
    \160\ Id. at 16.
---------------------------------------------------------------------------

    There are, of course, other sources of liquidity, including: (1) 
Reserve size (limit orders with undisplayed size); (2) ``not held'' 
institutional orders that are worked by floor brokers on an exchange; 
(3) automated matching networks that allow large buyers and sellers to 
meet directly and anonymously; and (4) securities dealers that are 
willing to commit capital to facilitate customer orders. Displayed 
limit orders, however, give anyone the ability to trade when they want 
to trade on a first-come, first-served basis. They thereby act as a 
vital reference point for all other sources of liquidity. Specifically, 
reserve size, undisplayed floor interest, automated matching, and 
dealer capital commitments all are facilitated by displayed information 
concerning the price and size of stock that is available for immediate 
trading in the public markets.
    As demonstrated by the current rate of trade-throughs of the best 
quotations in Nasdaq and NYSE stocks, the problems of agent/principal 
conflicts and the free-riding externality often can lead to executions 
at prices that are inferior to displayed quotations, meaning that limit 
orders are being bypassed. The frequent bypassing of limit orders can 
cause fewer limit orders to be placed. The Commission therefore 
believes that the Order Protection Rule is needed to encourage greater 
use of limit orders. The more limit orders available at better prices 
and greater size, the more liquidity available to fill incoming 
marketable orders. Moreover, greater displayed liquidity will at least 
lower the search costs associated with trying to find liquidity. 
Increased liquidity, in turn, could lead market participants to 
interact more often with displayed orders, which would lead to greater 
use of limit orders, and thus begin the cycle again. We expect that the 
end result will be an NMS that more fully meets the needs of a broad 
spectrum of investors.
2. Limiting Protection to Automated and Accessible Quotations
    The original trade-through proposal sought to strengthen protection 
against trade-throughs, while also addressing problems posed by the 
inherent differences in quotations displayed by automated markets 
(which are immediately accessible) and quotations displayed by manual 
markets (which are not), by distinguishing between automated and non-
automated markets with respect to trade-through protection. The 
proposal included an exception that would have allowed automated 
markets to trade through manual markets, but only up to certain amounts 
that varied depending upon the price of the security. Under the 
proposal, a market would have been classified as ``manual'' if it did 
not provide for an immediate automated response to all incoming orders 
attempting to access its displayed quotations.\161\
---------------------------------------------------------------------------

    \161\ Proposing Release, 69 FR at 11140.
---------------------------------------------------------------------------

    At the NMS Hearing, a significant portion of the discussion of the 
trade-through proposal addressed issues relating to quotations of 
automated and

[[Page 37518]]

manual markets. Representatives of two floor-based exchanges announced 
their intent to establish ``hybrid'' trading facilities that would 
offer automatic execution of orders seeking to interact with their 
displayed quotations, while at the same time maintaining a traditional 
floor.\162\ These representatives acknowledged the difficulties posed 
in developing an efficient hybrid market, but emphasized that they were 
committed to developing such facilities and that such facilities were 
likely to become operational prior to any implementation of Regulation 
NMS.
---------------------------------------------------------------------------

    \162\ Hearing Tr. at 90-92, 94-97, 120.
---------------------------------------------------------------------------

    Other panelists at the NMS Hearing strongly believed that manual 
quotations should not receive any protection against trade-throughs and 
that the proposed trade-through amounts should be eliminated.\163\ They 
noted, however, that existing order routing technologies are capable of 
identifying, on a quote-by-quote basis, indications from a market that 
a particular quotation is not immediately and automatically accessible 
(i.e., is a manual quotation). Using this functionality, a trade-
through rule could classify individual quotations as automated or 
manual, rather than classifying an entire market as manual solely 
because it displayed manual quotations on occasion.
---------------------------------------------------------------------------

    \163\ Hearing Tr. at 57-58, 67, 142-143, 157-158.
---------------------------------------------------------------------------

    To give the public a full opportunity to comment on these issues, 
the Supplemental Release described the developments at the NMS Hearing 
and requested comment on whether a trade-through rule should protect 
only automated quotations and whether the rule should adopt a ``quote-
by-quote'' approach to identifying protected quotations.\164\ The 
Supplemental Release also requested comment on the requirements for an 
automated quotation, including whether the rule should impose a maximum 
response time, such as one second, on the total time for a market to 
respond to an order in an automated manner. Comment also was requested 
on mechanisms for enforcing compliance with the automated quotation 
requirements.
---------------------------------------------------------------------------

    \164\ Supplemental Release, 69 FR at 30142-30144.
---------------------------------------------------------------------------

    Nearly all commenters on the original proposal believed that only 
automated quotations should receive protection against trade-throughs 
and that therefore the proposed limitation on trade-through amounts for 
manual markets should be eliminated.\165\ In response to these 
commenters, the Commission modified the proposed Rule in the 
Reproposing Release to protect only those quotations that are 
immediately and automatically accessible. As noted above in Section 
II.A.1, a substantial number of commenters supported the reproposed 
Order Protection Rule, with some commenters specifically supporting 
limiting trade-through protection to automated and immediately 
accessible quotations.\166\
---------------------------------------------------------------------------

    \165\ See, e.g., Ameritrade Letter I at 8; Letter from Lou 
Klobuchar Jr., President and Chief Brokerage Officer, E*TRADE 
Financial Corporation, to Jonathan G. Katz, Secretary, Commission, 
dated June 30, 2004 (``E*Trade Letter'') at 6; ICI Letter at 12; 
Nasdaq Letter II at 9, 14; Letter from Marc Lackritz, President, 
Securities Industry Association, to Jonathan G. Katz, Secretary, 
Commission, dated June 30, 2004 (``SIA Letter'') at 15.
    \166\ See, e.g., Letter from George W. Mann, Jr., General 
Counsel, Boston Stock Exchange, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``BSE Reproposal 
Letter'') at 5; Letter from David Baker, Global Head of Cash Trading 
and Global Head of Portfolio Trading, Deutsche Bank Securities Inc., 
to Jonathan G. Katz, Secretary, Commission, dated February 3, 2005 
(``Deutsche Bank Reproposal Letter'') at 2; ICI Reproposal Letter at 
3, n. 6; Letter from James T. Brett, Managing Director, J.P. Morgan 
Securities Inc., to Jonathan G. Katz, Secretary, Commission, dated 
January 28, 2005 (``JP Morgan Reproposal Letter'') at 3-4; Letter 
from Bernard L. Madoff and Peter B. Madoff, Bernard L. Madoff 
Investment Securities L.L.C., to Jonathan G. Katz, Secretary, 
Commission, dated February 3, 2005 (``Madoff Reproposal Letter'') at 
1; Letter from David Humphreville, President, The Specialist 
Association of the New York Stock Exchange, to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``Specialist Assoc. 
Reproposal Letter'') at 2-3.
---------------------------------------------------------------------------

    The Commission agrees with commenters that providing protection to 
manual quotations, even limited to trade-throughs beyond a certain 
amount, potentially would lead to undue delays in the routing of 
investor orders, thereby not justifying the benefits of price 
protection. The Commission therefore is adopting, as reproposed, an 
approach that excludes manual quotations from trade-through protection. 
Under the Order Protection Rule as adopted, investors will have the 
choice of whether to access a manual quotation and wait for a response 
or to access an automated quotation with an inferior price and obtain 
an immediate response. Moreover, those who route limit orders will be 
able to control whether their orders are protected by evaluating the 
extent to which various trading centers display automated versus manual 
quotations.
    Commenters expressed differing views, however, on the appropriate 
standards for automated quotations and on the standards that should 
govern ``hybrid'' markets--those that display both automated and manual 
quotations. These issues are discussed below.
a. Standards for Automated Quotations
    Nearly all commenters addressing the issue believed that only 
quotations that are truly firm and fully accessible should qualify as 
``automated.'' \167\ To achieve this goal, they suggested that, at a 
minimum, the market displaying an automated quotation should be 
required to provide a functionality for an incoming order to receive an 
immediate and automated (i.e., without human intervention) execution up 
to the full displayed size of the quotation. In addition, they believed 
the market should be required to provide an immediate and automated 
response to the sender of the order indicating whether the order had 
been executed (in full or in part) and an immediate and automated 
updating of the quotation. A number of commenters advocated requiring a 
specific time standard for distinguishing between manual and automated 
quotations, ranging from one second down to 250 milliseconds.\168\ 
Other commenters did not believe the definition of automated quotation 
should require a specific time standard, generally because setting a 
specific standard might discourage innovation and become a ``ceiling'' 
on market performance.\169\
---------------------------------------------------------------------------

    \167\ See, e.g., Letter from John J. Wheeler, Vice President, 
Director of U.S. Equity Trading, American Century Investment 
Management Inc., to Jonathan G. Katz, Secretary, Commission, dated 
June 30, 2004 (``American Century Letter'') at 3; Letter from C. 
Thomas Richardson, Citigroup Global Markets, Inc., to Jonathan G. 
Katz, Secretary, Commission, dated July 20, 2004 (``Citigroup 
Letter'') at 6-7; Letter from Gary Cohn, Managing Director, Goldman, 
Sachs & Co., to Jonathan G. Katz, Secretary, Commission, dated July 
19, 2004 (``Goldman Sachs Letter'') at 4-5; ICI Letter at 13; Morgan 
Stanley Letter at 7; SIA Letter at 6.
    \168\ See, e.g., Ameritrade Letter I at 6; Bloomberg Tradebook 
Letter at 13; Letter from Kenneth R. Leibler, Chairman, Boston Stock 
Exchange, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
June 30, 2004 (``BSE Letter'') at 7; Consumer Federation Letter at 
3; Letter from David A. Herron, Chief Executive Officer, Chicago 
Stock Exchange, to Jonathan G. Katz, Secretary, Commission, dated 
June 30, 2004 (``CHX Letter'') at 7-8; Letter from C. Thomas 
Richardson, Citigroup Global Markets, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated July 20, 2004 (``Citigroup Letter'') at 
7; Letter from Gary Cohn, Managing Director, Goldman, Sachs & Co., 
to Jonathan G. Katz, Secretary, Commission, dated July 20, 2004 
(``Goldman Sachs Letter'') at 4; ICI Letter at 3, 10; Nasdaq Letter 
II at 3, 13; Letter from John Martello, Managing Director, Tower 
Research Capital LLC, to Jonathan G. Katz, Secretary, Commission, 
dated June 30, 2004 (``Tower Research Letter'') at 5.
    \169\ See, e.g., American Century Letter at 3; Letter from 
Salvatore F. Sodano, Chairman & Chief Executive Officer, American 
Stock Exchange LLC, to Jonathan G. Katz, Secretary, Commission, 
dated June 30, 2004 (``Amex Letter''), Exhibit A at 6; Letter from 
Matt D. Lyons, Capital Research and Management Company, to Jonathan 
G. Katz, Secretary, Commission, dated June 28, 2004 (``Capital 
Research Letter'') at 2; Fidelity Letter I at 8; Letter from John H. 
Bluher, Executive Vice President & General Counsel, Knight Trading 
Group, to William H. Donaldson, Chairman, Commission, dated July 2, 
2004 (``Knight Letter II'') at 5; Letter from James T. Brett, J.P. 
Morgan Securities Inc., to Jonathan G. Katz, Secretary, Commission, 
dated July 8, 2004 (``JP Morgan Letter'') at 3; Morgan Stanley 
Letter at 7; Letter from Darla C. Stuckey, Corporate Secretary, New 
York Stock Exchange, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated July 2, 2004 (``NYSE Letter''), Attachment at 3; 
Letter from David Humphreville, President, The Specialist 
Association, to Jonathan G. Katz, Secretary, Commission, dated June 
30, 2004 (``Specialist Assoc. Letter'') at 8; Letter from Lisa M. 
Utasi, President, et al., The Security Traders Association of New 
York, Inc., to Jonathan G. Katz, Secretary, Commission, dated June 
30, 2004 (``STANY Letter'') at 4; Letter from George U. Sauter, 
Managing Director, The Vanguard Group, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated July 14, 2004 (``Vanguard Letter'') at 
4.

---------------------------------------------------------------------------

[[Page 37519]]

    The Commission included in the Reproposing Release a definition of 
automated quotation that incorporated the three elements suggested by 
commenters: \170\ (1) Acting on an incoming order; (2) responding to 
the sender of the order; and (3) updating the quotation. The proposed 
definition of automated quotation did not set forth a specific time 
standard for responding to an incoming order. As noted above, a 
significant number of commenters on the Reproposing Release supported 
the reproposed Order Protection Rule,\171\ with a few commenters 
specifically supporting the definition of automated quotation.\172\ As 
discussed in detail below, the Commission has adopted the definition of 
automated quotation as proposed.
---------------------------------------------------------------------------

    \170\ See, e.g., Letter from Kevin J. P. O'Hara, Chief 
Administrative Officer and General Counsel, Archipelago Holdings, 
Inc., to Jonathan G. Katz, Secretary, Commission, dated September 
24, 2004 (``Archipelago Letter'') at 7; Brut Letter at 7; Letter 
from Lisa M. Utasi, President, et al., The Security Traders 
Association of New York, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated June 30, 2004 (``STANY Letter'') at 4; Letter from 
George U. Sauter, Managing Director, The Vanguard Group, to Jonathan 
G. Katz, Secretary, Commission, dated July 14, 2004 (``Vanguard 
Letter'') at 4.
    \171\ See supra section II.A.1.
    \172\ Letter from Adam Cooper, Senior Managing Director and 
General Counsel, Citadel Investment Group, L.L.C., to Jonathan G. 
Katz, Secretary, Commission, dated July 9, 2004 (``Citadel 
Reproposal Letter'') at 3; ICI Reproposal Letter at 3, n. 6; SIA 
Reproposal Letter at 4-5.
---------------------------------------------------------------------------

    In particular, Rule 600(b)(3) requires that the trading center 
displaying an automated quotation must provide an ``immediate-or-
cancel'' (``IOC'') functionality for an incoming order to execute 
immediately and automatically against the quotation up to its full 
size, and for any unexecuted portion of such incoming order to be 
cancelled immediately and automatically without being routed elsewhere. 
The trading center also must immediately and automatically respond to 
the sender of an IOC order. To qualify as ``automatic,'' no human 
discretion in determining any action taken with respect to an order may 
be exercised after the time an order is received. Trading centers are 
required to offer this IOC functionality only to market participants 
that request immediate action and response by submitting an IOC order. 
Market participants therefore have the choice of whether to require an 
immediate response from the trading center, or to allow the market to 
take further action on the order (such as by routing the order 
elsewhere, seeking additional liquidity for the order, or displaying 
the order). Finally, trading centers are required to immediately and 
automatically update their automated quotations to reflect any change 
to their material terms (such as a change in price, displayed size, or 
``automated'' status).
    The definition of automated quotation as adopted does not set forth 
a specific time standard for responding to an incoming order. The 
Commission agrees with commenters that the standard should be 
``immediate'' `` i.e., a trading center's systems should provide the 
fastest response possible without any programmed delay. Nevertheless, 
the Commission also is concerned that trading centers with well-
functioning systems should not be unnecessarily slowed down waiting for 
responses from a trading center that is experiencing a systems problem. 
Consequently, rather than specifying a specific time standard that may 
become obsolete as systems improve over time, Rule 611(b)(1) addresses 
the problem of slow trading centers by providing an exception for 
quotations displayed by trading centers that are experiencing, among 
other things, a material delay in responding to incoming orders. Given 
current industry conditions, the Commission believes that repeatedly 
failing to respond within one second after receipt of an order would 
constitute a material delay.\173\ Accordingly, a trading center would 
act reasonably in the current technological environment if it bypassed 
the quotations of another trading center that had repeatedly failed to 
respond to orders within a one-second time frame (after adjusting for 
any potential delays in transmission not attributable to the other 
trading center).\174\ This ``self-help'' remedy, discussed further in 
sections II.A.3 and II.B.3 below, will give trading centers needed 
flexibility to deal with another trading center that is experiencing 
systems problems, rather than forcing smoothly-functioning trading 
centers to slow down for a problem trading center.
---------------------------------------------------------------------------

    \173\ Cf. Ameritrade Letter I at 6 (one second response time is 
appropriate); Letter from David A. Herron, Chief Executive Officer, 
The Chicago Stock Exchange, to Jonathan G. Katz, Secretary, 
Commission, dated June 30, 2004 (``CHX Letter'') at 8 (receive, 
execute, and report back within one second); Citigroup Letter at 7 
(turnaround time of no more than one second); Goldman Sachs Letter 
at 4 (orders executed or cancelled within not more than one second).
    \174\ As discussed further in section II.B.3 below, a trading 
center utilizing the material delay exception will be required to 
establish specific objective parameters for its use of the exception 
in its required policies and procedures.
---------------------------------------------------------------------------

b. Standards for Automated Trading Centers
    The original trade-through proposal would have classified a market 
as manual if it did not provide automated access to all orders seeking 
access to its displayed quotations. Many commenters responded 
positively to the concept of allowing hybrid markets to display both 
automated and manual quotations that was raised at the NMS Hearing and 
discussed in the Supplemental Release. Most national securities 
exchanges believed that focusing on whether individual quotations are 
automated or manual would permit hybrid markets to function, thereby 
expanding the range of trading choices for investors.\175\ For example, 
Amex stated that hybrid markets would offer investors the choice to 
utilize auction markets when advantageous for them to do so, while at 
the same time offering automatic execution to those investors desiring 
speed and certainty of a fast response.\176\ A majority of other 
commenters also believed that the application of any trade-through rule 
should depend on whether a particular quotation is automated.\177\ They 
believed that such a rule would achieve the benefits of encouraging 
limit orders and improving market depth and liquidity, while avoiding 
indirectly mandating a particular market structure.
---------------------------------------------------------------------------

    \175\ See, e.g., Amex Letter at 5; Letter from William J. 
Brodsky, Chairman & Chief Executive Officer, Chicago Board Options 
Exchange, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
July 1, 2004 (``CBOE Letter'') at 3; CHX Letter at 7; NYSE Letter at 
4.
    \176\ Amex Letter, Appendix A at 4-5.
    \177\ See, e.g., Letter from Joseph M. Velli, Senior Executive 
Vice President, The Bank of New York, to Jonathan G. Katz, 
Secretary, Commission, dated June 30, 2004 (``BNY Letter'') at 2; 
Letter from Lou Klobuchar Jr., President and Chief Brokerage 
Officer, E*Trade Financial Corporation, to Jonathan G. Katz, 
Secretary, Commission, dated June 30, 2004 (``E*Trade Letter'') at 
6; ICI Letter at 13; Morgan Stanley Letter at 6.
---------------------------------------------------------------------------

    Although generally supportive of the concept of hybrid markets, 
several commenters on the original proposal expressed concern about how 
the ``quote-by-quote'' approach to protected quotations would operate 
in practice.\178\

[[Page 37520]]

The ICI noted that ``[w]e are concerned that if it is left completely 
up to an individual market's discretion when a quote is `automated' or 
manual, that market could base its decision on what is in the best 
interests of that market and its members, as opposed to the best 
interests of investors and other market participants.'' \179\ These 
commenters suggested that the Commission should provide clear 
guidelines as to when and how a market could switch its quotations from 
automated to manual, and vice versa, so as to prevent abuse by the 
market.
---------------------------------------------------------------------------

    \178\ See, e.g., Citigroup Letter at 6; ICI Letter at 13; Morgan 
Stanley Letter at 7; Nasdaq Letter II at 13-14; Vanguard Letter at 
5.
    \179\ ICI Letter at 13.
---------------------------------------------------------------------------

    After considering the views of commenters, the Commission included 
in the reproposed Rule certain requirements for a trading center to 
qualify as an ``automated trading center,'' one of which requires that 
a trading center adopt reasonable standards limiting when its 
quotations change from automated quotations to manual quotations (and 
vice versa) to specifically defined circumstances that promote fair and 
efficient access to its automated quotations and that are consistent 
with the maintenance of fair and orderly markets. The reproposed Rule 
also provided that only a trading center that met all of the 
requirements could display protected quotations. Although a substantial 
number of commenters supported the reproposed Rule,\180\ a few 
commenters continued to express concern with the ability of a trading 
center to switch from automated to manual quotations.\181\
---------------------------------------------------------------------------

    \180\ See supra section II.A.1.
    \181\ See Ameritrade Reproposal Letter at 7 (questioning whether 
certain aspects of NYSE's hybrid proposal are ``consistent with the 
requirement that an automated trading center has `adopted reasonable 
standards limiting when its quotations change from automated 
quotations to manual quotations, and vice versa' ''); Letter from 
Alistair Brown, Managing Director, Lime Brokerage LLC, to Jonathan 
G. Katz, Secretary, Commission, dated January 26, 2005 (``Lime 
Brokerage Reproposal Letter'') at 1 (expressing concerns regarding 
the operation of NYSE's hybrid proposal in conjunction with the 
Order Protection Rule); Letter from J. Greg Mills, Managing 
Director, Head of Global Equity Trading, RBC Capital Markets 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
January 26, 2005 (``RBC Capital Markets Reproposal Letter'') at 8-9 
(requesting that the Commission establish and define standards as to 
when a hybrid market can switch from automated to manual 
quotations).
---------------------------------------------------------------------------

    The Commission recognizes the concerns of commenters regarding the 
ability of a trading center to change from automated to manual 
quotation mode, but believes that the requirements necessary to qualify 
as an automated trading center will sufficiently mitigate this concern. 
Any standards established by an SRO trading center to govern when its 
quotations change from automated to manual will be subject to public 
notice and comment and Commission approval pursuant to the rule filing 
process of Section 19(b) of the Exchange Act. If a non-SRO trading 
center intends to display both automated and non-automated quotations, 
it will be subject to the oversight of the SRO through whose facilities 
its quotations are displayed with respect to the reasonableness of its 
procedures, as well as Commission oversight.
    The Commission therefore is adopting the definition of automated 
trading center as reproposed. The adopted approach offers flexibility 
for a hybrid market to display both automated and manual quotations, 
but only when such a market meets basic standards that promote fair and 
efficient access by the public to the market's automated quotations. 
This approach is designed to allow markets to offer a variety of 
trading choices to investors, but without requiring other markets and 
market participants to route orders to a hybrid market with quotations 
that are not truly accessible.
    To qualify as an automated trading center, the trading center must 
have implemented such systems, procedures, and rules as are necessary 
to render it capable of displaying quotations that meet the action, 
response, and updating requirements set forth in the definition of an 
automated quotation.\182\ Further, the trading center must identify all 
quotations other than automated quotations as manual quotations, and 
must immediately identify its quotations as manual quotations whenever 
it has reason to believe that it is not capable of displaying automated 
quotations.\183\ These requirements will enable other trading centers 
readily to determine whether a particular quotation displayed by a 
hybrid trading center is protected by the Order Protection Rule. 
Finally, an automated trading center must adopt reasonable standards 
limiting when its quotations change from automated quotations to manual 
quotations, and vice versa, to specifically defined circumstances that 
promote fair and efficient access to its automated quotations and are 
consistent with the maintenance of fair and orderly markets.\184\
---------------------------------------------------------------------------

    \182\ Rule 600(b)(4)(i). The Commission is modifying this 
requirement from the reproposal to include the term ``procedures,'' 
to clarify that non-SRO trading centers have procedures, not rules.
    \183\ Rule 600(b)(4)(ii) and (iii).
    \184\ Rule 600(b)(4)(iv).
---------------------------------------------------------------------------

    These requirements are designed to promote efficient interaction 
between a hybrid market and other trading centers. The requirement that 
automated quotations cannot be switched on and off except in 
specifically defined circumstances is particularly intended to assure 
that hybrid markets do not give their members, or anyone else, 
overbroad discretion to control the automated or manual status of the 
trading center's quotations, which potentially could disadvantage 
market participants that must protect these quotations. Changes from 
automated to manual quotations, and vice versa, must be subject to 
specific, enforceable limitations as to the timing of switches. For a 
trading center to qualify as entitled to display any protected 
quotations, the public in general must have fair and efficient access 
to a trading center's quotations.
    Some commenters on the Reproposing Release expressed a concern 
about the scope of the exception for single-priced reopenings in Rule 
611(b)(3), particularly in the context of a trading center switching 
back and forth from automated quotation to manual quotation mode.\185\ 
They asserted that the applicability of the exception to the 
recommencement of trading after a non-regulatory trading halt in one 
market (such as a trading halt due to an intra-day order imbalance) 
could lead to disruptive trading activity and provide an unfair 
competitive advantage for the trading center that halted trading. They 
believed this could create a significant loophole in the protections 
provided by the Rule. For instance, one commenter expressed concern 
that a trading center could halt trading and reopen solely to enable it 
to trade-through other trading centers.\186\ Another commenter 
expressed concern regarding the interplay of the proposed exception and 
the operation of the NYSE's proposed hybrid trading system, stating 
that it is unclear what would be considered a reopening under NYSE's 
proposal, particularly with respect to when a liquidity refreshment 
point is reached or when the quotation is gapped.\187\ Two commenters 
suggested that the exception apply only to reopenings after regulatory 
trading halts.\188\
---------------------------------------------------------------------------

    \185\ See Letter from C. Thomas Richardson, Citigroup Global 
Markets, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
January 26, 2005 (``Citigroup Reproposal Letter'') at 8; Nasdaq 
Reproposal Letter at 6-7; SIA Reproposal Letter at 20-21.
    \186\ Citigroup Reproposal Letter at 8.
    \187\ Nasdaq Reproposal Letter at 6. See also infra, note 190.
    \188\ Nasdaq Reproposal Letter at 7; SIA Reproposal Letter at 21 
(agreeing that the exception should apply to regulatory halts).
---------------------------------------------------------------------------

    The Commission recognizes the commenters' concern, but emphasizes 
that the exception will not permit a trading center to declare a 
trading halt

[[Page 37521]]

merely to be able to circumvent the operation of the Order Protection 
Rule upon reopening. The exception applies only to single-priced 
reopenings and therefore requires that a trading center conduct, 
pursuant to its rules or written procedures, a formalized and 
transparent process for executing orders during reopening after a 
trading halt that involves the queuing and ultimate execution of 
multiple orders at a single equilibrium price.\189\ In addition, the 
trading center must have formally declared a trading halt pursuant to 
its rules or written procedures. Thus, the exception would not include 
a situation where a trading center merely spread its quotations or 
switched back to automated quotation mode from manual quotation 
mode.\190\
---------------------------------------------------------------------------

    \189\ See section III.D.3 of the Proposing Release for a 
discussion of the practical need for an exception for single-priced 
openings and reopenings. 69 FR at 11142.
    \190\ Under NYSE's hybrid proposal, the turning off of automatic 
execution, for example, for a gap-quoting situation, the triggering 
of a liquidity refreshment point, or the reporting of a block 
transaction, would not in and of itself halt trading and thus 
trigger a reopening pursuant to paragraph (b)(3) of Rule 611.
---------------------------------------------------------------------------

3. Workable Implementation of Intermarket Trade-Through Protection
    Several commenters expressed concern that the original proposed 
trade-through rule could not be implemented in a workable manner, 
particularly for high-volume stocks.\191\ Morgan Stanley, for example, 
asserted that an inefficient trading center might have inferior systems 
that would delay routed orders and potentially diminish their quality 
of execution.\192\ Instinet emphasized that protecting a market's 
quotations ``confers enormous power on a market * * * Such power can 
and will be abused either directly (e.g., by quoting slower than 
executing orders) or indirectly (e.g., not investing in more than 
minimum system capacity or redundancy).'' \193\ Hudson River Trading 
noted that markets sometimes experience temporary systems problems and 
questioned how a trade-through rule would address these scenarios.\194\ 
Nasdaq observed that quotations in many Nasdaq stocks are updated more 
than two times per second. It said that these frequent changes could 
lead to many false indications of trade-throughs and that eliminating 
these ``false positives'' would greatly reduce the percentage of 
transactions subject to a trade-through rule.\195\ Finally, many 
commenters noted that market participants need the ability to sweep 
multiple price levels simultaneously at different trading centers. They 
emphasized that a trade-through rule should accommodate this trading 
strategy by freeing each trading center to execute orders immediately 
without waiting for other trading centers to update their better priced 
quotations.\196\
---------------------------------------------------------------------------

    \191\ See, e.g., Hudson River Trading Letter at 3; Instinet 
Letter at 18-19; Morgan Stanley Letter at 11-12; Letter from Edward 
S. Knight, The Nasdaq Stock Market, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated September 29, 2004 (``Nasdaq Letter 
III'') at 3.
    \192\ Morgan Stanley Letter at 12.
    \193\ Instinet Letter at 17.
    \194\ Hudson River Trading Letter at 3. This commenter also 
raised a number of specific questions concerning the operation of an 
intermarket trade-through rule. To address these detailed order 
sequencing and response scenarios, trading centers will be able to 
adopt policies and procedures that reasonably resolve the practical 
difficulties of handling fast-arriving orders in a fair and orderly 
fashion. For example, if a trading center routed orders to another 
market to access the full displayed size of its protected quotations 
under the Order Protection Rule, the routing trading center will be 
allowed to continue trading without regard to that market's 
quotations until it has received a response from such market. With 
respect to concern that traders will not be able to control the 
routing of their own orders if markets are required to route out to 
other markets, a trader's use of the IOC functionality specified in 
Rule 600(b)(3) will preclude the first market from routing to other 
markets.
    \195\ Nasdaq Letter III at 3-4.
    \196\ See, e.g., Brut Letter at 10; Citigroup Letter at 10; 
E*Trade Letter at 8; Goldman Sachs Letter at 7.
---------------------------------------------------------------------------

    The Commission agreed with these commenters that intermarket 
protection against trade-throughs must be workable and implemented in a 
way that promotes fair and orderly markets, and therefore amended the 
original proposal in the reproposal to better achieve this objective in 
a variety of ways. As discussed below, commenters were generally 
supportive of the measures included in the reproposal as providing 
necessary flexibility, although several commenters made specific 
recommendations as to how to improve the operation of the exceptions. 
In response to these comments, the Commission has made additional 
modifications to the Order Protection Rule that, in conjunction with 
the reproposed measures, will further promote its workability.
    First and most importantly, as included in the reproposal and as 
adopted today, only automated trading centers, as defined in Rule 
600(b)(4), that are capable of providing immediate responses to 
incoming orders are eligible to have their quotations protected. 
Moreover, an automated trading center is required to identify its 
quotations as manual (and therefore not protected) whenever it has 
reason to believe that it is not capable of providing immediate 
responses to orders.\197\ Thus, a trading center that experiences a 
systems problem, whether because of a flood of orders or otherwise, 
must immediately identify its quotations as manual.
---------------------------------------------------------------------------

    \197\ Rule 600(b)(4)(iii).
---------------------------------------------------------------------------

    The Commission will monitor and enforce the adopted requirements 
for automated trading centers and automated quotations. Nevertheless, 
it concurs with commenters' concerns that well-functioning trading 
centers should not be dependent on the willingness and capacity of 
other markets to meet, and the Commission's ability to enforce, these 
automation requirements. The adopted Order Protection Rule therefore 
provides a ``self-help'' remedy that will allow trading centers to 
bypass the quotations of a trading center that fails to meet the 
immediate response requirement. Rule 611(b)(1) sets forth an exception 
that applies to quotations displayed by trading centers that are 
experiencing a failure, material delay, or malfunction of its systems 
or equipment. To implement this exception consistent with the 
requirements of Rule 611(a), trading centers will have to adopt 
policies and procedures reasonably designed to comply with the self-
help remedy. Such policies and procedures will need to set forth 
specific objective parameters for dealing with problem trading centers 
and for monitoring compliance with the self-help remedy, consistent 
with Rule 611. Given current industry capabilities, the Commission 
believes that trading centers should be entitled to bypass another 
trading center's quotations if it repeatedly fails to respond within 
one second to incoming orders attempting to access its protected 
quotations. Accordingly, trading centers will have the necessary 
flexibility to respond to problems at another trading center as they 
occur during the trading day.
    Most commenters that addressed the self-help exception supported 
the exception as providing necessary flexibility to trading centers to 
avoid inaccessible quotations.\198\ Some commenters, however, objected 
to a statement in the Reproposing Release that a trading center must 
attempt to contact the non-responsive trading center to resolve a 
problem prior to disregarding its quotations.\199\ They believed that 
such a requirement would not be practicable or workable, especially 
during real-time trading.\200\

[[Page 37522]]

One commenter recommended that, instead of requiring notice as a 
``condition precedent,'' the Commission require the trading center 
electing the self-help exception to contact the slow or non-responding 
trading center immediately after it elects self-help.\201\
---------------------------------------------------------------------------

    \198\ See, e.g., BSE Reproposal Letter at 5; Citigroup 
Reproposal Letter at 7; ICI Reproposal Letter at 6, n. 10; Nasdaq 
Reproposal Letter at 7; SIA Reproposal Letter at 19.
    \199\ Citigroup Reproposal Letter at 7; Nasdaq Reproposal Letter 
at 7-8; SIA Reproposal Letter at 19.
    \200\ Citigroup Reproposal Letter at 7; Nasdaq Reproposal Letter 
at 7-8.
    \201\ Nasdaq Reproposal Letter at 7.
---------------------------------------------------------------------------

    The Commission agrees with the concerns of the commenters that a 
prior notice requirement may not be practicable or workable in real-
time, and that a trading center should be allowed simply to notify the 
non-responding trading center immediately after (or at the same time 
as) electing self-help pursuant to objective standards consistent with 
Rule 611 that are contained in its policies and procedures. An electing 
trading center must also assess, however, whether the cause of a 
problem lies with its own systems and, if so, take immediate steps to 
resolve the problem appropriately.
    Another commenter suggested that third-party vendors that provide 
connectivity among trading centers should be allowed to determine when 
a trading center has failed to meet the immediate response 
requirement.\202\ The Commission agrees that a third-party vendor could 
perform such a function, but, as with use of the intermarket sweep 
order exception, the responsibility for compliance with the exception 
remains with the relevant trading center that uses the services of the 
third-party vendor. Thus, a trading center is responsible for 
compliance with the requirements of the exception, including the 
obligation to establish, maintain, and enforce written policies and 
procedures and to surveil for their effectiveness, regardless of 
whether it routes orders using its own systems or a third-party 
vendor's systems.
---------------------------------------------------------------------------

    \202\ Letter from Richard A. Kornhammer, Chairman and Chief 
Executive Officer, Lava Trading Inc., to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``Lava Reproposal 
Letter'') at 3.
---------------------------------------------------------------------------

    Some commenters believed that the trading center experiencing a 
problem should have primary responsibility for notifying other trading 
centers and market participants when such problems occur and when they 
are resolved.\203\ The definition of automated market center in both 
the reproposed and adopted rule directly imposes this responsibility on 
the trading center experiencing difficulties.\204\ It requires such a 
trading center immediately to identify its quotations as manual 
whenever it has reason to believe that it is not capable of displaying 
automated quotations. The trading center must continue to identify its 
quotations as manual until it no longer has reason to believe that 
there will be a problem with its quotations. A trading center that 
continues to identify its quotations as automated when it has reason to 
believe otherwise would make a material misstatement to other trading 
centers, investors, and the public.
---------------------------------------------------------------------------

    \203\ SIA Reproposal Letter at 19-20; STANY Reproposal Letter at 
12.
    \204\ Rule 600(b)(4)(iii).
---------------------------------------------------------------------------

    One commenter believed that, in the absence of an opt-out, the 
material delay exception was too narrowly drawn, and that market 
participants should be allowed to avoid trading with trading centers 
for any objective, reasonable basis as they do today in the context of 
fiduciary and best execution obligations, and not just for slow 
response times.\205\ The Commission does not believe that the scope of 
the exception should be expanded to give a trading center the ability 
to avoid another trading center for reasons not related to reliable and 
efficient accessibility because to do so would be inconsistent with the 
objectives of the Rule. The exception in paragraph (b)(1) of Rule 611, 
however, covers any failure or malfunction of a trading center's 
systems or equipment, as well as any material delay. The Commission 
believes that there may be certain limited instances where repeated, 
critical system problems, even those that do not necessarily cause a 
delayed response time during trading (such as systems problems that 
repeatedly result in the breaking of trades), would justify use of the 
exception by other trading centers until the problem trading center has 
provided reasonable assurance to all other trading centers that the 
problems have been corrected.\206\
---------------------------------------------------------------------------

    \205\ Letter from Thomas N. McManus, Managing Director and 
Counsel, Morgan Stanley & Co. Incorporated, to Jonathan G. Katz, 
Secretary, Commission, dated February 7, 2005 (``Morgan Stanley 
Reproposal Letter'') at 11-12.
    \206\ During the implementation period for the Order Protection 
Rule, the Commission staff will be available to provide guidance to 
trading centers as they develop objective standards to implement 
this exception consistent with Rule 611.
---------------------------------------------------------------------------

    In many active NMS stocks, the price of a trading center's best 
displayed quotations can change multiple times in a single second 
(``flickering quotations''). These rapid changes can create the 
impression that a quotation was traded-through, when in fact the trade 
was effected nearly simultaneously with display of the quotation.\207\ 
To address the problem of flickering quotations, the Commission 
included in the reproposal a proposed exception from Rule 611 that 
would allow trading centers a one-second ``window'' prior to a 
transaction for trading centers to evaluate the quotations at another 
trading center. Specifically, the Commission proposed that pursuant to 
Rule 611(b)(8) trading centers would be entitled to trade at any price 
equal to or better than the least aggressive best bid or best offer, as 
applicable, displayed by the other trading center during that one-
second window. For example, if the best bid price displayed by another 
trading center has flickered between $10.00 and $10.01 during the one-
second window, the trading center that received the order could execute 
a trade at $10.00 without violating Rule 611.
---------------------------------------------------------------------------

    \207\ A number of commenters on the original proposal were 
concerned about flickering quotations and recommended an exemption 
to address the problem. CHX Letter at 7, n.19; E*Trade Letter at 9; 
JP Morgan Letter at 3; Letter from Richard A. Korhammer, Chairman & 
Chief Executive Officer, Lava Trading Inc., to Jonathan G. Katz, 
Secretary, Commission (no date) (``Lava Trading Letter'') at 5; 
Letter from Marc Lackritz, President, Securities Industry 
Association, to Jonathan G. Katz, Secretary, Commission, dated June 
30, 2004 (``SIA Letter'') at 10; Letter from Mary McDermott-Holland, 
Chairman & John C. Giesea, President, Security Traders Association, 
to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 
(``STA Letter'') at 5.
---------------------------------------------------------------------------

    Most of the commenters that addressed this exception supported 
it.\208\ The SIA noted that the exception would provide ``much-needed 
practical relief.'' \209\ Several commenters, however, raised issues 
regarding the time frame for the exception, with some supporting a 
longer window \210\ and some questioning whether it was necessary to 
establish a specific time frame in the rule, rather than through 
interpretive guidance.\211\ One commenter opposed the exception because 
it believed that it would create an arbitrage opportunity that could be 
taken advantage of by computerized market participants.\212\ Another 
commenter expressed concern that the exception would enable trading 
centers to execute trades internally and route

[[Page 37523]]

orders using the worst quotation during the one second window.\213\
---------------------------------------------------------------------------

    \208\ BSE Reproposal Letter at 5; ICI Reproposal Letter at 6, n. 
10; JP Morgan Reproposal Letter at 4; Letter from Michael J. Lynch, 
Managing Director, Merrill Lynch, Pierce, Fenner & Smith 
Incorporated, to Jonathan G. Katz, Secretary, Commission, dated 
February 4, 2005 (``Merrill Lynch Reproposal Letter'') at 7; SIA 
Reproposal Letter at 3, 18.
    \209\ SIA Reproposal Letter at 18.
    \210\ Letter from Bruce C. Turner, Managing Director, CIBC World 
Markets Corp., to Jonathan G. Katz, Secretary, Commission, dated 
February 4, 2005 (``CIBC Reproposal Letter'') at 3 (supporting a 3 
second window); SIA Reproposal Letter at 18 (questioning whether the 
proposed one second window is too narrow).
    \211\ Merrill Lynch Reproposal Letter at 7; SIA Reproposal 
Letter at 18-19.
    \212\ Letter from Meyer S. Frucher, Chairman and Chief Executive 
Officer, Philadelphia Stock Exchange, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated January 31, 2005 (``Phlx Reproposal 
Letter'') at 3.
    \213\ Nasdaq Reproposal Letter at 8. As emphasized in section 
II.B.4 below, Rule 611 is designed to facilitate intermarket trade-
through protection only. It does not lessen the best execution 
responsibilities of broker-dealers. In making a best execution 
determination, for example, a broker-dealer can not rely on the 
Rule's exception for flickering quotations to justify ignoring a 
recently displayed, better-priced quotation when experience shows 
that the quotation is likely to be accessible.
---------------------------------------------------------------------------

    After reviewing the response from commenters, the Commission is 
adopting the exception as proposed. Allowing a one-second ``window'' 
prior to a transaction for trading centers to evaluate the quotations 
at another trading center will ease implementation of and compliance 
with the Order Protection Rule by giving trading centers added 
flexibility to deal with the practical difficulties of protecting 
quotations displayed by other trading centers, without significantly 
reducing the benefits of the Rule.\214\ It appears that many of the 
potential implementation difficulties with respect to high-volume 
stocks are related to the problem of dealing with sub-second time 
increments. The Commission generally does not believe that the benefits 
would justify the costs imposed on trading centers of attempting to 
implement an intermarket price priority rule at the level of sub-second 
time increments. Accordingly, Rule 611 has been formulated to relieve 
trading centers of this burden.\215\ The Commission does not believe, 
however, that it is necessary to allow more than a one second window, 
given the realities of today's trading environment and the frequency 
with which many quotations update.\216\ The Commission also is 
concerned that allowing for a greater than one second window would 
permit the execution of many trade-throughs that could have been 
reasonably prevented. The Commission also notes that opportunities for 
arbitrage between trading centers displaying different prices for the 
same NMS stock would exist irrespective of whether the Commission 
adopted an order protection rule, and does not believe that the 
adoption of the flickering quotation exception to the Rule increases 
these arbitrage opportunities.
---------------------------------------------------------------------------

    \214\ Even with the one-second exception for flickering 
quotations, Rule 611 will address a large number of trade-throughs 
that currently occur in the equity markets. The substantial trade-
through rates discussed in section II.A.1 above were calculated 
using a 3-second window. Rule 611 will address all of these trade-
throughs, assuming no other exception is applicable.
    \215\ Several commenters raised questions concerning ``clock 
drift'' and time lags between different data sources. See, e.g., 
Hudson River Trading Letter at 2; Letter from Edward S. Knight, The 
Nasdaq Stock Market, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated September 29, 2004 (``Nasdaq Letter III'') at 4. 
These implementation issues are most appropriately addressed in the 
context of a trading center's reasonable policies and procedures. 
Clearly, one essential procedure will be implementation of clock 
synchronization practices that meet or exceed industry standards. In 
addition, a trading center's compliance with the Order Protection 
Rule will be assessed based on the times that orders and quotations 
are received, and trades are executed, at that trading center.
    \216\ Specifically, given the advanced trading and routing 
technology available today, a one-second window should significantly 
ease the compliance burden of trading centers for stocks with many 
quotation updates.
---------------------------------------------------------------------------

    The Commission also included in the reproposal paragraphs (b)(5) 
and (b)(6) of Rule 611 that provided exceptions for intermarket sweep 
orders that respond to the need of market participants to access 
multiple price levels simultaneously at different trading centers. 
Commenters that addressed this exception overwhelmingly supported 
it.\217\ Citadel, for instance, stated that the intermarket sweep 
exception is crucial, addresses most of its concerns about the 
Commission's initial trade-through proposal, and would have many 
benefits.\218\ The ICI believed that the exception would allow 
institutional investors to continue to execute large-sized orders in an 
efficient manner.\219\ As discussed below, the Commission is adopting 
this exception as reproposed.
---------------------------------------------------------------------------

    \217\ See, e.g., BSE Reproposal Letter at 5; Citadel Reproposal 
Letter at 1, 2; ICI Reproposal Letter at 5; JP Morgan Reproposal 
Letter at 4; Merrill Lynch Reproposal Letter at 3; SIA Reproposal 
Letter at 3.
    \218\ Citadel Reproposal Letter at 1, 2.
    \219\ ICI Reproposal Letter at 5.
---------------------------------------------------------------------------

    An intermarket sweep order is defined in Rule 600(b)(30) as a limit 
order that meets the following requirements: (1) The limit order is 
identified as an intermarket sweep order when routed to a trading 
center; and (2) simultaneously with the routing of the limit order, one 
or more additional limit orders are routed to execute against all 
better-priced protected quotations displayed by other trading centers 
up to their displayed size. These additional orders also must be marked 
as intermarket sweep orders to inform the receiving trading center that 
they can be immediately executed without regard to protected quotations 
in other markets. Paragraph (b)(5) allows a trading center to execute 
immediately any order identified as an intermarket sweep order, without 
regard for better-priced protected quotations displayed at one or more 
other trading centers. The exception is fully consistent with the 
principle of protecting the best displayed prices because it is 
premised on the condition that the trading center or broker-dealer 
responsible for routing the order will have attempted to access all 
better-priced protected quotations up to their displayed size.\220\ 
Consequently, there is no reason why the trading center that receives 
an intermarket sweep order while displaying an inferior-priced 
quotation should be required to delay an execution of the order.
---------------------------------------------------------------------------

    \220\ Reserve size, in contrast, is not displayed. Trading 
centers and broker-dealers therefore will not be required to route 
orders to access reserve size.
---------------------------------------------------------------------------

    Paragraph (b)(6) authorizes a trading center itself to route 
intermarket sweep orders and thereby enable immediate execution of a 
transaction at a price inferior to a protected quotation at another 
trading center. For example, paragraph (b)(6) can be used by a dealer 
that wishes immediately to execute a block transaction at a price three 
cents away from the NBBO, as long as the dealer simultaneously routed 
orders to access all better-priced protected quotations. By 
facilitating intermarket sweep orders of all kinds, Rule 611 as adopted 
will allow a much wider range of beneficial trading strategies than as 
originally proposed. In addition, the intermarket sweep exception will 
help prevent an ``indefinite loop'' scenario in which waves of orders 
otherwise might be required to chase the same quotations from trading 
center to trading center, one price level at a time.\221\
---------------------------------------------------------------------------

    \221\ The indefinite loop scenario also is addressed by: (1) The 
self-help remedy in Rule 611(b)(1) for trading centers to deal with 
slow response times; and (2) the requirement that trading centers 
immediately stop displaying automated (and therefore protected) 
quotations when they can no longer meet the immediate response 
requirement for automated quotations.
---------------------------------------------------------------------------

    Several commenters suggested that the Commission provide an 
exception from the Rule for very actively-traded and highly liquid NMS 
stocks.\222\ They argued that the trading of these stocks already is 
highly efficient and does not raise the concerns that the Commission is 
trying to address through the proposed Order Protection Rule, and that 
imposing the Rule on the trading of these stocks would not improve 
efficiency or protect limit orders in any meaningful way. They also 
believed that providing such an exception would make the Rule more 
workable, particularly for NMS stocks with rapid quotation updates, 
thus easing compliance and surveillance costs of the Rule. Some of 
these commenters

[[Page 37524]]

suggested defining liquidity and active trading by reference to the 
frequency of quotation updates.\223\
---------------------------------------------------------------------------

    \222\ CIBC Reproposal Letter at 1; Citigroup Reproposal Letter 
at 2-3 (advocating granting the exception on a pilot basis); Letter 
from Richard M. Whiting, Executive Director and General Counsel, 
Financial Services Roundtable, to Jonathan G. Katz, Secretary, 
Commission, dated February 4, 2005 (``FSR Reproposal Letter'') at 4; 
Merrill Lynch Reproposal Letter at 7; SIA Reproposal Letter at 2, 
12-14 (advocating granting the exception on a pilot basis).
    \223\ CIBC Reproposal Letter at 1; Citigroup Reproposal Letter 
at 3; SIA Reproposal Letter at 12. The Commission notes that the 
existence of rapid quotation updates does not necessarily mean that 
a security is actively traded or highly liquid.
---------------------------------------------------------------------------

    The Commission recognizes that commenters have raised a serious 
concern regarding implementation of the Order Protection Rule, 
particularly for many Nasdaq stocks that are very actively traded and 
whose trading is spread across many different individual trading 
centers. An exemption for active stocks, however, would be particularly 
inconsistent with the investor protection objectives of the Order 
Protection Rule because these also are the stocks that have the highest 
level of investor participation. For example, the need for a trade-
through rule to backstop a broker's duty of best execution by assuring 
that retail investors receive the best available price on an order-by-
order basis is perhaps most acute with respect to the most active NMS 
stocks.
    One of the Commission's goals throughout its review of market 
structure issues has been to formulate rules for the national market 
system that adequately reflect current technologies and trading 
practices and that promote equal regulation of stocks and markets. This 
goal does not reflect a mere desire for uniformity, but is identified 
in the Exchange Act as a vital component of a truly national market 
system.\224\ Active stocks obviously are a vital part of the national 
market system. It should not be that the orders of ordinary investors 
are protected by a Commission rule for some NMS stocks, but that caveat 
emptor still prevails for others.
---------------------------------------------------------------------------

    \224\ Exchange Act Section 11A(c)(1)(F).
---------------------------------------------------------------------------

    A number of provisions in the Order Protection Rule are 
specifically designed to address the legitimate concern that the Rule 
must be workable for active stocks. These include the flickering 
quotation exception, the intermarket sweep order exception, and the 
self-help exception. The Commission is committed to working closely 
with trading centers and the securities industry in general to make 
these exceptions as practical and useful as possible, consistent with 
the price protection objectives of the Rule and the technology 
currently available. In addition, the operative provision of the Order 
Protection Rule requires each trading center to establish, maintain, 
and enforce policies and procedures that are reasonably designed to 
prevent trade-throughs on that trading center of protected quotations 
and to comply with the Rule's exceptions. Implementation of intermarket 
trade-through protection is likely to present the greatest challenge 
for agency markets trading active stocks that handle a large volume of 
buy and sell orders and must assure that such orders interact in an 
orderly and efficient manner in compliance with all applicable priority 
rules. The requirements to have procedures reasonably designed to 
prevent trade-throughs will mitigate this challenge. In this regard, 
the Commission is encouraged that several trading centers executing the 
largest number of agency orders currently exhibit the lowest rates of 
trade-throughs.\225\
---------------------------------------------------------------------------

    \225\ See Trade-Through Study, Tables 2, 9.
---------------------------------------------------------------------------

4. Elimination of Proposed Opt-Out Exception
    The rule text of the original proposal included a broad exception 
for persons to opt-out of the best displayed prices if they provided 
informed consent. The Proposing Release indicated that the exception 
was particularly intended to allow investors to bypass manual markets, 
to execute block transactions without moving the market price, and to 
help discipline markets that provided slow executions or inadequate 
access to their quotations.\226\ The Commission also noted, however, 
that an opt-out exception would be inconsistent with the principle of 
price protection and, if used frequently, could undermine investor 
confidence that their orders will receive the best available price. It 
therefore requested comment on an automated execution alternative to 
the opt-out exception, under which all markets would be required to 
provide an automated response to electronic orders. At the subsequent 
NMS Hearing, some panelists questioned whether, assuming only truly 
accessible and automated quotations were protected, there was a valid 
reason for opting-out of such a quotation.\227\ To address this issue, 
the Commission requested comment in the Supplemental Release on whether 
the proposed opt-out exception would be necessary if manual quotations 
were excluded from trade-through protection.
---------------------------------------------------------------------------

    \226\ Proposing Release, 69 FR at 11138.
    \227\ Hearing Tr. at 32, 58, 65, 74, 80, 84-85, 154.
---------------------------------------------------------------------------

    Many commenters on the original proposal opposed a general opt-out 
exception.\228\ They believed that it would be inconsistent with the 
principle of price protection and undermine the very benefits the 
trade-through rule is designed to provide. American Century, for 
example, asserted that the Commission should focus on the limit order 
investors who have ``opted-in'' to the NMS, rather than on those that 
wish to opt-out.\229\ Vanguard noted that an opt-out exception might 
serve a short-term desire to obtain an immediate execution, but 
``without recognizing the second order effect of potentially 
significantly reducing liquidity in the long term.'' \230\ Similarly, 
the ICI stated that ``while our members may be best served on a 
particular trade by 'opting-out' from executing against the best price 
placed in another market, we believe that in the long term, all 
investors will benefit by having a market structure where all limit 
orders are protected and investors are provided with an incentive to 
place those orders in the markets.'' \231\ All of the foregoing views 
were conditioned on an assumption that only accessible, automated 
quotations would be protected by a trade-through rule.
---------------------------------------------------------------------------

    \228\ See supra note 56 (overview of commenters supporting a 
strong trade-through rule without an opt-out exception).
    \229\ American Century Letter at 4.
    \230\ Vanguard Letter at 5.
    \231\ ICI Letter at 14 (emphasis in original).
---------------------------------------------------------------------------

    Many other commenters, in contrast, supported the proposed opt-out 
exception.\232\ Aside from concerns that a trade-through rule would be 
unworkable without an opt-out exception, which were discussed in the 
preceding section, the primary concerns of these commenters were that, 
without an opt-out exception, a trade-through rule would: (1) Dampen 
competition among markets, particularly with respect to factors other 
than price; and (2) restrict the freedom of choice for market 
participants to route marketable orders to trading centers that are 
most appropriate for their particular trading objectives and to achieve 
best execution. The Commission formulated the reproposed Order 
Protection Rule to respond to these concerns, while still preserving 
the benefits of intermarket price protection.
---------------------------------------------------------------------------

    \232\ Approximately 371 commenters supported an opt-out 
exception. Approximately 211 of these commenters opposed a trade-
through rule and endorsed an opt-out to remediate what they viewed 
as its adverse effects. Of these 211 commenters, 179 commenters 
utilized Form Letter C. The remaining commenters supporting an opt-
out exception included a variety of securities industry participants 
and 22 members of Congress.
---------------------------------------------------------------------------

    In response to the Reproposing Release, many commenters supported 
the reproposed Order Protection Rule,\233\ with some specifically 
addressing, and supporting, the elimination of the opt-out 
exception.\234\

[[Page 37525]]

For example, the ICI noted its strong support of the decision to 
eliminate the opt-out exception, agreeing that the elimination of 
protection for manual quotations makes such an exception 
unnecessary.\235\ Other commenters continued to express the concern 
that a trade-through rule without an opt-out exception would impede 
intermarket competition and innovation and restrict the ability of 
investors and market intermediaries to choose how best to execute their 
or their customers' orders to achieve best execution.\236\ For the 
reasons discussed more fully below, after carefully considering the 
views of all commenters, the Commission has determined to adopt the 
Order Protection Rule as reproposed, without an opt-out exception.
---------------------------------------------------------------------------

    \233\ See supra, section II.A.1.
    \234\ Letter from Barbara Roper, Director of Investor 
Protection, Consumer Federation of America, to Jonathan G. Katz, 
Secretary, Commission, dated January 24, 2005 (``CFA Reproposal 
Letter'') at 1; ICI Reproposal Letter at 5, n. 8; Letter from 
Kenneth S. Janke, Chairman, National Association of Investors 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
January 14, 2005 (``NAIC Reproposal Letter'') at 2.
    \235\ ICI Reproposal Letter at 5, n. 8.
    \236\ See, e.g., Letter from Daniel M. Clifton, Executive 
Director, American Shareholder Association, to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``ASA Reproposal 
Letter'') at 2; Fidelity Reproposal Letter at 3-6; Instinet 
Reproposal Letter at 5; Morgan Stanley Reproposal Letter at 2, 5-6; 
Nasdaq Reproposal Letter at 3-4; RBC Capital Markets Reproposal 
Letter at 3-5. Comments discussing concerns that a trade-through 
rule would be unworkable without an opt-out exception are discussed 
in the preceding section.
---------------------------------------------------------------------------

a. Preserving Competition Among Markets
    Many commenters believed that an opt-out exception was necessary to 
promote competition among trading centers, particularly competition 
based on factors other than price, such as speed of response. For 
example, 179 commenters on the original proposal submitted letters 
stating that, in the absence of an opt-out exception, ``Reg. NMS will 
freeze market development and, over the long term, could hurt 
investors.'' \237\ Morgan Stanley asserted that allowing market 
participants to opt-out ``would reward markets that provide faster and 
surer executions, and conversely, would penalize those markets that are 
materially slower or are displaying smaller quote sizes by ignoring 
those quotes.'' \238\ Although agreeing that changes made to the 
reproposal in the absence of an opt-out exception generally would 
strengthen any Order Protection Rule, Morgan Stanley continued to be 
concerned that, without an opt-out exception, the Order Protection Rule 
may not provide a sufficient amount of flexibility to market 
participants that encounter a minimally competitive or outright non-
compliant trading center.\239\ Instinet believed that, without an opt-
out exception, a trade-through rule ``would virtually eliminate 
intermarket competition by forcing operational and technological 
uniformity on each marketplace, negating price competition, system 
performance, or any other differentiating feature that a market may 
develop.'' \240\ In its comments on the Reproposing Release, Instinet 
continued to oppose an Order Protection Rule without an opt-out 
exception, stating that it does not believe that the exclusion of 
manual quotations from protection and the proposed ``tailored 
exceptions'' are adequate substitutes for an opt-out exception.\241\
---------------------------------------------------------------------------

    \237\ Letter Type C.
    \238\ Morgan Stanley Letter at 11-12.
    \239\ Morgan Stanley Reproposal Letter at 6.
    \240\ Instinet Letter at 19.
    \241\ Instinet Reproposal Letter at 5. Other commenters on the 
Reproposing Release also continued to express a concern about the 
impact the reproposed Rule would have on competition and innovation. 
See, e.g., JP Morgan Reproposal Letter at 7-8; RBC Capital 
Reproposal Letter at 3-4; Letter from Jeffrey T. Brown, Senior Vice 
President, Charles Schwab & Co., Inc., to Jonathan G. Katz, 
Secretary, Commission, dated February 1, 2005 (``Schwab Reproposal 
Letter'') at 2.
---------------------------------------------------------------------------

    The Commission recognizes the vital importance of preserving 
vigorous competition among markets, but continues to believe that 
commenters have overstated the risk that such competition will be 
eliminated by adoption of an order protection rule without a general 
opt-out exception. The Commission believes that markets likely will 
have strong incentives to continue to compete and innovate to attract 
both marketable orders and limit orders. Market participants and 
intermediaries responsible for routing marketable orders, consistent 
with their desire to achieve the best price and their duty of best 
execution, will continue to rank trading centers according to the total 
range of services provided by those markets. Such services include 
cost, speed of response, sweep functionality, and a wide variety of 
complex order types.\242\ The most competitive trading center will be 
the first choice for routing marketable orders, thereby enhancing the 
likelihood of execution for limit orders routed to that trading center. 
Because likelihood of execution is of such great importance to limit 
orders, routers of limit orders will be attracted to this preferred 
trading center. More limit orders will enhance the depth and liquidity 
offered by the preferred trading center, thereby increasing its 
attractiveness for marketable orders, and beginning the cycle all over 
again. Importantly, Rule 611 will not require that limit orders be 
routed to any particular market. Consequently, competitive forces will 
be fully operative to discipline markets that offer poor services to 
limit orders, such as limiting the extent to which limit orders can be 
cancelled in changing market conditions or providing slow speed of 
cancellation.
---------------------------------------------------------------------------

    \242\ One commenter expressed the view that market participants 
would continue to compete on a total range of services even with an 
Order Protection Rule without an opt-out and with depth-of-book 
protection. Vanguard Reproposal Letter at 4.
---------------------------------------------------------------------------

    Conversely, trading centers that offer poor services, such as a 
slower speed of response, likely will rank near the bottom in order-
routing preference of most market participants and intermediaries. 
Whenever the least-preferred trading center is merely posting the same 
price as other trading centers, orders will be routed to other trading 
centers. As a result, limit orders displayed on the least preferred 
trading center will be least likely to be executed in general. 
Moreover, such limit orders will be the least likely to be executed 
when prices move in favor of the limit orders, and the most likely to 
be executed only when prices are moving against the limit order, adding 
the cost of ``adverse selection'' to the cost of a low likelihood of 
execution. In sum, the lowest ranked trading center in order-routing 
preference, with or without intermarket price protection, will suffer 
the consequences of offering a poor range of services to the routers of 
marketable orders.\243\ The Commission therefore does not believe that 
the absence of an opt-out exception would freeze market development or 
eliminate competition among markets.
---------------------------------------------------------------------------

    \243\ As discussed below in section III.A.2, a competitive 
problem could arise if a least preferred market was allowed to 
charge exorbitant fees to access its protected quotations, and then 
pass most of the fee on as rebates to liquidity providers to offset 
adverse selection costs. To address the problem of such an 
``outlier'' market, Rule 610(c) sets forth a uniform fee limitation 
for accessing protected quotations, as well as manual quotations 
that are the best bid or best offer of an exchange, The NASDAQ 
Market Center, or the ADF.
---------------------------------------------------------------------------

    Commenters have, however, identified a troubling potential for 
intermarket price protection to lessen the competitive discipline that 
market participants now can impose on inefficient trading centers in 
Nasdaq stocks. The Order Protection Rule generally requires that 
trading centers match the best quoted prices, cancel orders without an 
execution, or route orders to the trading centers quoting the best 
prices. This is good for investors generally, but may not be if the 
quoting market is inefficient. For example, a trading center may have 
poor systems that do not process orders quickly and

[[Page 37526]]

reliably. Or a low-volume trading center may not be nearly as 
accessible as a high-volume trading center.
    Currently, consistent with their best execution and other agency 
responsibilities, participants in the market for Nasdaq stocks can 
choose not to deal with any trading center that they believe provides 
unsatisfactory services. Under the Order Protection Rule, market 
participants can limit their involvement with any trading center to 
routing IOC orders to access only the best bid or best offer of the 
trading center. Nevertheless, even this limited involvement potentially 
could lessen the competitive discipline that otherwise would be imposed 
on an inefficient trading center. The Commission therefore believes 
that this potentially serious effect must be addressed at multiple 
levels in addition to the specific exceptions included in the Rule that 
were discussed above.
    First, trading centers themselves have a legal obligation to meet 
their responsibilities under the Exchange Act to provide venues for 
trading that is orderly and efficient.\244\ Through registration and 
other requirements, the Exchange Act regulatory regime is designed to 
preclude entities that are not capable of meeting high standards of 
conduct from doing business with the public. This critically important 
function would be undermined by a trading center that displayed 
quotations in the consolidated data stream, but could not, because of 
poor systems or otherwise, provide efficient access to market 
participants and efficient handling of their orders. In addition, a 
trading center would violate its Exchange Act responsibilities if it 
failed to comply fully with the requirements set forth in Rule 
600(b)(3) and (4) for automated quotations and automated trading 
centers. In particular, an automated trading center must implement such 
systems, procedures, and rules as are necessary to render it capable of 
meeting the requirements for automated quotations and must immediately 
identify its quotations as manual whenever it has reason to believe 
that it is not capable of displaying automated quotations. These 
requirements place an affirmative and vitally important legal duty on 
trading centers to identify their quotations as manual at the first 
sign of a problem, not after a problem has fully manifested itself and 
thereby caused a rippling effect at other trading centers that damages 
investors and the public interest.
---------------------------------------------------------------------------

    \244\ See, e.g., Exchange Act Sections 6(b)(1) and 6(b)(5); 
Exchange Act Section 15; Exchange Act Sections 15A(b)(2) and 
15A(b)(6); Exchange Act Section 11A(a)(1)(C); Regulation ATS.
---------------------------------------------------------------------------

    Second, those responsible for the regulatory function at SROs have 
an affirmative responsibility to examine for and enforce all Exchange 
Act requirements and the SRO rules that apply to the trading centers 
that fall within their regulatory authority. One of the key policy 
justifications for a self-regulatory system is that industry regulators 
have close proximity to, and significant expertise concerning, their 
particular trading centers. In addition, industry regulators typically 
have greater flexibility to address problems than governmental 
authorities. Implementation of the Order Protection Rule will heighten 
the importance of effective self-regulation. Those responsible for the 
market operation functions of an SRO may have business incentives that 
militate against dealing with potential problems in an effective and 
forthright manner. Regulatory personnel are expected to be independent 
of such business concerns and have an affirmative responsibility to 
prevent improper factors from interfering with an SRO's full compliance 
with regulatory requirements.
    Finally, the Commission itself plays a critical role in the 
Exchange Act regulatory regime. Effective implementation of the Order 
Protection Rule also will depend on the Commission taking any action 
that is necessary and appropriate to address trading centers that fail 
to meet fully their regulatory requirements. The Commission and its 
staff must continue to monitor the markets closely for signs of 
problems and listen to the concerns of market participants as they 
arise, especially with regard to the new requirements imposed by the 
Order Protection Rule. Quick and effective action will be needed to 
assure that all responsible parties do not feel that inattention to 
problems is an acceptable course of action.
b. Promoting the Interests of Both Marketable Orders and Limit Orders
    Many commenters that supported an opt-out exception believed that 
an ability to opt-out of the best displayed prices was necessary to 
promote full freedom of choice in the routing of marketable orders, and 
particularly to allow factors other than quoted prices to be 
considered. For example, 179 commenters on the original proposal 
submitted a letter stating that ``[i]nvestors are driven by price, but 
prices that are inaccessible either because of lagging execution time 
within a market or insufficient liquidity at the best price point 
impact the overall costs associated with trading securities in today's 
markets. The Trade Through rule may harm investors by restricting their 
ability to achieve best execution, and investors deserve the 
opportunity to make choices.'' \245\ Similarly, Fidelity asserted that 
``as a fiduciary to the mutual funds under our management, we should be 
free to reach our own informed judgment regarding the market center 
where our funds' trades are to be executed, particularly when delay may 
open the way for exchange floor members and others to exploit an 
informational advantage that arises not from their greater investment 
or trading acumen but merely from their privileged presence on the 
physical trading floor.'' \246\ Fidelity continues to support an opt-
out exception, stating in response to the Reproposing Release that 
there is a substantial risk that an institutional investor, seeking to 
trade a large block of stock, will be put to a ``distinct and unfair'' 
disadvantage if it cannot negotiate an all-in price for a block trade 
with a dealer.\247\
---------------------------------------------------------------------------

    \245\ Letter Type C.
    \246\ Fidelity Letter I at 6-7.
    \247\ Fidelity Reproposal Letter at 3. Other commenters 
continued to express a concern that the reproposed Order Protection 
Rule would limit the ability of investors and market intermediaries 
to choose how to best execute orders, and, by focusing exclusively 
on price, would interfere with the ability of institutional 
investors to achieve best execution. See, e.g., JP Morgan Reproposal 
Letter at 4-5; Morgan Stanley Reproposal Letter at 5; RBC Capital 
Reproposal Letter at 4-5; UBS Reproposal Letter at 2.
---------------------------------------------------------------------------

    The Commission agrees that the interests of investors in choosing 
the trading center to which to route marketable orders are vitally 
important, but believes that advocates of the opt-out exception have 
failed to consider the interests of all investors--both those who 
submit marketable orders and those who submit limit orders. A fair and 
efficient NMS must serve the interests of both types of investors. 
Moreover, their interests are inextricably linked together. Displayed 
limit orders are the primary source of public price discovery. They 
typically set quoted spreads, supply liquidity, and in general 
establish the public ``market'' for a stock. The quality of execution 
for marketable orders, which, in turn, trade with displayed liquidity, 
depends to a great extent on the quality of markets established by 
limit orders (i.e., the narrowness of quoted spreads and the available 
liquidity at various price levels).
    Limit orders, however, make the first move--when submitted, they 
must be displayed rather than executed, and therefore offer a ``free 
option'' for other

[[Page 37527]]

market participants to trade a stock by submitting marketable orders 
and taking the liquidity supplied by limit orders. Consequently, the 
fate of limit orders--whether or when they receive an execution--is 
dependent on the choices made by those who route marketable orders. 
Much of the time, the interests of marketable orders in obtaining the 
best available price are aligned with those of limit orders that are 
displaying the best available price. But, as shown by the significant 
trade-through rates discussed in section II.A.1 above (even for 
automated quotations in Nasdaq stocks), the interests of marketable 
orders and limit orders are not always aligned.
    One important example of where the interests of limit orders and 
marketable orders often diverge is large, block trades. Several 
commenters noted that they often are willing to bypass the best quoted 
prices if they can obtain an immediate execution of large orders at a 
fixed price that is several cents away from the best prices.\248\ Yet 
these block trades often will be priced based on the displayed 
quotations in a stock. They thereby demonstrate the ``free-riding'' 
economic externality that, as discussed in section II.A.1 above, is one 
of the factors at the heart of the need for intermarket price 
protection. To achieve the full benefits of intermarket price 
protection, all investors should be governed by a uniform rule that 
encompasses their individual trades. For any particular trade, an 
investor may believe that the best course of action is to bypass 
displayed quotations in favor of executing larger size immediately. The 
Commission believes, however, that the long-term strength of the NMS as 
a whole is best promoted by fostering greater depth and liquidity, and 
it follows from this that the Commission should examine the extent to 
which it can encourage the limit orders that provide this depth and 
liquidity to the market at the best prices. Allowing individual market 
participants to pick and choose when to respect displayed quotations 
could undercut the fundamental reason for displaying the liquidity in 
the first place.
---------------------------------------------------------------------------

    \248\ See, e.g., Fidelity Letter I at 9; Morgan Stanley Letter 
at 12.
---------------------------------------------------------------------------

    Consequently, the Commission is adopting the Order Protection Rule 
as reproposed without an opt-out exception because such an exception 
could severely detract from the benefits of intermarket order 
protection. Instead, Rule 611 addresses the concerns of those who 
otherwise may have felt they needed to opt-out of protected quotations 
in a more targeted manner. In particular, the Rule incorporates an 
approach that seeks to serve the interests of both marketable orders 
and limit orders by appropriately balancing these interests in the 
contexts where they may diverge. In this way, the Order Protection Rule 
is designed to promote the fairness and efficiency of the NMS for all 
investors.
    First and most importantly, Rule 611 protects only immediately 
accessible quotations that are available through automatic execution. 
It does not require investors submitting marketable orders to access 
``maybe'' quotations that, after arrival of the order, are subject to 
human intervention and thereby create the potential for other market 
participants to determine whether to honor the quotation. Moreover, as 
discussed in section II.A.2 above, Rule 611 includes a variety of 
provisions designed to assure that marketable orders must be routed 
only to well-functioning trading centers displaying executable 
quotations.
    Second, Rule 611 has been formulated to promote the interests of 
investors seeking immediate execution of specific order types that 
reduce their total trading costs, particularly for larger orders. 
Although the Rule does not provide a general exception for block 
orders, it addresses the legitimate interest of investors in obtaining 
an immediate execution in large size (and thereby minimizing price 
impact). The intermarket sweep order exception will allow broker-
dealers to continue to facilitate the execution of block orders.\249\ 
The entire size of a large order can be executed immediately at any 
price, so long as the broker-dealer routes orders seeking to execute 
against the full displayed size of better-priced protected quotations. 
The size of the order therefore need not be parceled out over time in 
smaller orders that might tip the market about pending orders. By both 
allowing immediate execution of the large order and protecting better-
priced quotations, Rule 611 is designed to appropriately balance the 
interests for investors on both sides of the market.\250\
---------------------------------------------------------------------------

    \249\ Cf. ICI Reproposal Letter at 5 (stating its belief that 
the intermarket sweep exception would allow institutional investors 
to continue to execute large-sized orders in an efficient manner).
    \250\ One commenter requested that the Commission consider the 
practical aspects of executing and reporting large block 
transactions in compliance with the Rule. For instance, if a dealer 
agreed to execute a large institutional investor order at three 
cents outside the market and sent intermarket sweep orders to 
execute against protected quotations at the same time that it 
executed and reported the trade, practical issues could arise as to 
how the dealer could pass through to the investor any better-priced 
executions of the sweep orders without canceling and correcting the 
reported block trade. Morgan Stanley Reproposal Letter at 7-9. The 
Commission agrees that compliance with Rule 611 should not interfere 
with the ability of a dealer to provide its customers the benefit of 
better executions and should not cause confusion with respect to the 
accurate reporting of transactions. As the commenter noted, the 
practical issues for reporting block trades could be resolved in a 
variety of ways. The Commission will work with the industry during 
the implementation period to achieve the most appropriate 
resolution.
---------------------------------------------------------------------------

    In the Reproposing Release, the Commission stated that it 
preliminarily did not believe that ``stopped'' orders should be 
excepted from Rule 611,\251\ and requested comment on the extent to 
which the proposed rule language appropriately designated those 
transactions that should be excepted because they are consistent with 
the price protection objectives of Rule 611.\252\ Several commenters on 
the Reproposing Release recommended that the Commission except the 
execution of stopped orders from the operation of Rule 611.\253\ They 
believed that, because dealers executing stopped orders provide a 
source of liquidity that does not otherwise exist in the market at the 
time the order is stopped, the use of stopped orders represents a 
common and valuable form of capital commitment by dealers that inures 
to the benefit of investors. They were concerned that, in the absence 
of an exception for stopped orders, dealers may be unwilling to commit 
capital in this manner, or, at a minimum, may charge investors a 
greater risk premium for the capital commitment.
---------------------------------------------------------------------------

    \251\ For purposes of this discussion and Rule 611, a stopped 
order is an order for which a trading center has guaranteed, at the 
time of order receipt, an execution at a price no worse than a 
specified price (referred to in this discussion as the ``stop'' 
price).
    \252\ Reproposing Release, 69 FR at 77440 n. 149.
    \253\ See, e.g., Letter from Bruce Lisman, Bear, Stearns & Co., 
to Jonathan G. Katz, Secretary, Commission, dated January 27, 2005 
(``Bear Stearns Reproposal Letter'') at 2-3; Citigroup Reproposal 
Letter at 7-8; Morgan Stanley Reproposal Letter at 9-10; SIA 
Reproposal Letter at 16-18; UBS Reproposal Letter at 6. But see 
Goldman Sachs Letter at 7-8, n. 14; Letter from Mary Yeager, 
Assistant Secretary, New York Stock Exchange, Inc., to Jonathan G. 
Katz, Secretary, Commission, dated January 12, 2005 (``NYSE 
Reproposal Letter I''), Detailed Comments at 3 n. 13.
---------------------------------------------------------------------------

    The Commission agrees that stopped orders can provide a valuable 
tool for the execution of institutional orders, but is concerned that a 
broad exception for all stopped orders would undermine the price 
protection objectives of Rule 611. Several commenters recognized this 
concern and suggested criteria for a stopped order exception that would 
limit the possibility of abuse.\254\ For instance, UBS suggested 
limiting the applicability of the exception to instances where the stop 
price is ``in the

[[Page 37528]]

money'' when elected (i.e., below the current best bid for buy stops 
and above the current best offer for sell stops). In these 
circumstances, the dealer is required to commit capital at a 
disadvantageous price that would be exacerbated if the dealer also had 
to satisfy protected quotations at the time it executed the stopped 
order.\255\ The SIA also suggested that a stopped order guarantee 
subject to the exception only be available to a non-broker-dealer or a 
broker-dealer for the benefit of a non-broker-dealer customer and that 
the customer must agree to the stopped price on an order-by-order 
basis.\256\
---------------------------------------------------------------------------

    \254\ Bear Stearns Reproposal Letter at 3; Morgan Stanley 
Reproposal Letter at 10; SIA Reproposal Letter at 17-18; UBS 
Reproposal Letter at 6.
    \255\ UBS Reproposal Letter at 6. See also SIA Reproposal Letter 
at 17 (recommending that the exception only be available if the 
customer that received the stop guarantee is on the advantaged side 
and the dealer that gave the guarantee is on the disadvantaged 
side).
    \256\ SIA Reproposing Letter at 17.
---------------------------------------------------------------------------

    In response to these comments, the Commission has adopted a 
separate exception for the execution of stopped orders in Rule 
611(b)(9). The exception is narrowly drawn to prevent abuse, while also 
facilitating the continued use of stopped orders by institutional 
customers. As suggested by the commenters, the exception will apply to 
the execution of so-called ``underwater'' stops. Specifically, the 
exception applies to the execution by a trading center of a stopped 
order when the price of the execution of the order was, for a stopped 
buy order, lower than the national best bid in the stock at the time of 
execution or, for a stopped sell order, higher than the national best 
offer in the stock at the time of execution. To qualify for the 
exception, the stopped order must be for the account of a customer and 
the customer must have agreed to the stop price on an order-by-order 
basis.\257\
---------------------------------------------------------------------------

    \257\ Rule 611(b)(9)(i), (ii), and (iii). ``Customer'' is 
defined in Rule 600(b)(16) as any person that is not a broker or 
dealer.
---------------------------------------------------------------------------

    In addition, as proposed in the Reproposing Release, paragraph 
(b)(7) of Rule 611 sets forth an exception that would allow the 
execution of volume-weighted average price (``VWAP'') orders, as well 
as other types of orders that are not priced with reference to the 
quoted price of a stock at the time of execution and for which the 
material terms were not reasonably available at the time the commitment 
to execute the order was made. This exception will serve the interests 
of marketable orders and is consistent with the principle of protecting 
the best displayed quotations.
    Several commenters suggested that Rule 611 should include 
exceptions for additional types of transactions, such as those 
involving an equity security and a related derivative (for instance, a 
stock-option transaction), risk arbitrage strategies, and convertible 
or merger arbitrage.\258\ These commenters noted that the economics of 
these transactions are based on the relationship between the prices of 
a security and the related derivative (or between two related 
securities), and the execution of one trade is contingent upon the 
execution of the other trade. Thus, the parties to these transactions 
are less concerned with the price of the individual transactions than 
with the spread between the individual transaction prices. They 
believed that the economics of these transactions would be distorted, 
and additional risk would be introduced, if the dealer or an investor 
was forced to comply with the Order Protection Rule with respect to the 
execution of one or both sides of the transaction.\259\
---------------------------------------------------------------------------

    \258\ Bear Stearns Reproposal Letter at 3-4; Citigroup 
Reproposal Letter at 7; Morgan Stanley Reproposal Letter at 10; SIA 
Reproposal Letter at 16.
    \259\ See, e.g., Morgan Stanley Reproposal Letter at 10.
---------------------------------------------------------------------------

    The Commission has given a great deal of consideration to the 
comments favoring a general exception from Rule 611 for broad 
categories of transactions, variously described as ``contingency'' 
transactions, ``arbitrage'' transactions, ``spread'' transactions, and 
transactions priced with reference to derivatives. Any exception for 
such a broad category of transactions, however, potentially could 
unduly detract from the price protection objectives of the Rule. For 
example, one of the well-known benefits of arbitrage transactions in 
general is that they promote more efficient pricing of securities in 
the public markets. Excluding all such transactions from interacting 
with public quotations potentially could lessen the price discovery 
benefits of arbitrage. Accordingly, the Commission has determined that 
the most appropriate process to handle suggestions that specific types 
of transactions should be excluded from the coverage of Rule 611 is 
through its exemptive procedure set forth in paragraph (d) of the Rule. 
The extended implementation period for Regulation NMS will provide a 
full opportunity for the public to request specific exemptions that 
they believe are necessary or appropriate in the public interest and 
consistent with the protection of investors. Of course, the Commission 
also will consider exemptive requests once Regulation NMS has been 
implemented.
    Even given all the exceptions set forth in Rule 611, however, the 
Commission recognizes that the existence of intermarket price 
protection without an opt-out exception may interfere to some extent 
with the extremely short-term trading strategies of some market 
participants. Some of these strategies can be affected by a delay in 
order-routing or execution of as little as \3/10\ths of one second. 
Given the current NMS structure with multiple competing markets, any 
protection of displayed quotations in one market could affect the 
implementation of short-term trading strategies in another market. This 
conflict between protecting the best displayed prices and facilitating 
short-term trading strategies raises a fundamental policy question--
when such a conflict exists, should the overall efficiency of the NMS 
defer to the needs of short-term traders, many of whom rarely intend to 
hold a position overnight? Or should the NMS serve the needs of longer-
term investors, both large and small, that will benefit substantially 
from intermarket price protection?
    The Commission believes that two of the most important public 
policy functions of the secondary equity markets are to minimize 
trading costs for long-term investors and to reduce the cost of capital 
for listed companies. These functions are inherently connected, because 
the cost of capital of listed companies is influenced by the 
transaction costs of those who are willing to accept the investment 
risk of holding corporate stock for an extended period. To the extent 
that the interests of short-term traders and market intermediaries in a 
broad opt-out exception conflict with those of investors, the 
Commission believes that the interests of long-term investors are 
entitled to take precedence.\260\ In this way, the NMS will fulfill its 
Exchange Act objectives to promote fair and efficient equity markets 
for investors and to serve the public interest.
---------------------------------------------------------------------------

    \260\ See supra, section I.B.2.
---------------------------------------------------------------------------

5. Scope of Protected Quotations
    The original trade-through proposal would have protected all 
quotations disseminated by a Plan processor in the consolidated quote 
stream. Currently, the scope of these quotations depends on the 
regulatory status of an SRO. Under Exchange Act Rule 11Ac1-1 (``Quote 
Rule'') (redesignated as Rule 602), exchange SROs are required to 
provide only their best bids and offers (``BBOs'') in a stock. In 
contrast, a national securities association, which currently 
encompasses Nasdaq's trading facilities and the NASD's ADF, must 
provide BBOs of its individual members. Consequently, the original

[[Page 37529]]

proposal would have protected only a single BBO of an exchange and not 
any additional quotations in its depth of book (``DOB''). For Nasdaq 
facilities and the ADF, however, the proposal would have protected 
member BBOs at multiple price levels. The Proposing Release requested 
comment on whether only a single BBO for Nasdaq and the ADF should be 
protected.\261\
---------------------------------------------------------------------------

    \261\ Proposing Release, 69 FR at 11136.
---------------------------------------------------------------------------

    Commenters expressed concern that the proposed rule text would 
protect the BBOs of individual market makers and ATSs in Nasdaq's 
facilities and the ADF, but only a single BBO of exchange SROs.\262\ 
The Specialist Association, for example, believed that it would be 
unfair to offer greater protection to the quotations of members of an 
association SRO than to those of an exchange SRO.\263\ Morgan Stanley 
stated that to ``equalize the protections available to all market 
participants, we believe the Commission should treat SuperMontage as a 
single market for purposes of the trade-through rule, instead of 
treating each individual Nasdaq market maker as a separate quoting 
market participant.'' \264\
---------------------------------------------------------------------------

    \262\ See, e.g., Goldman Sachs Letter at 6; Morgan Stanley 
Letter at 8; NYSE Letter, Attachment at 4; Specialist Assoc. Letter 
at 3.
    \263\ Specialist Assoc. Letter at 3.
    \264\ Morgan Stanley Letter at 8.
---------------------------------------------------------------------------

    The Commission agrees with these commenters that Rule 611 should 
not mandate a regulatory disparity between the quotations displayed 
through exchange SROs and those displayed through Nasdaq facilities and 
the ADF. Potentially, Nasdaq and the ADF could attract a significant 
number of limit orders if they were able to offer order protection that 
was not available at exchange SROs. This result would not be consistent 
with the Exchange Act goals of fair competition among markets and the 
equal regulation of markets.\265\ The Commission therefore modified the 
definition of ``protected bid'' and ``protected offer'' in the 
reproposal to encompass the BBOs of an exchange, Nasdaq, and the ADF. 
In this way, exchange markets would be treated comparably with Nasdaq 
and the ADF.
---------------------------------------------------------------------------

    \265\ Exchange Act Sections 11A(a)(1)(C)(ii) and 11A(c)(1)(F).
---------------------------------------------------------------------------

    The Proposing Release also addressed the issue of extending trade-
through protection to DOB quotations, but questioned whether protecting 
all DOB quotations would be feasible at this time.\266\ Comment 
specifically was requested, however, on whether protection should be 
extended beyond the BBOs of SROs if individual markets voluntarily 
provided DOB quotations through the facilities of an effective national 
market system plan.\267\ At the subsequent NMS Hearing, a panelist 
specifically endorsed the policy and feasibility of extending trade-
through protection to DOB quotations, as long as such quotations were 
automated and accessible: ``Automatically executable quotes, whether 
they are on the top of the book or up and down the book, should be 
protected by the trade-through rule, and manual quotes should not be. 
This is a simple and technically easy idea to implement* * *.''\268\
---------------------------------------------------------------------------

    \266\ Proposing Release, 69 FR at 11136.
    \267\ Id.
    \268\ Hearing Tr. at 57 (testimony of Thomas Peterffy, Chairman, 
Interactive Brokers Group).
---------------------------------------------------------------------------

    Most of the subset of comment letters on the original proposal that 
specifically addressed the DOB issue supported the approach of 
extending trade-through protection to all limit orders displayed in the 
NMS, not merely the BBOs of the various markets.\269\ The Consumer 
Federation of America, for example, stated that ``such an approach 
would result in better price transparency and help to address 
complaints that decimal pricing has reduced price transparency because 
of the relatively thin volume of trading interest displayed in the best 
bid and offer.'' \270\ The ICI noted that protecting all displayed 
limit orders might not be feasible at this time, but urged the 
Commission to examine the issue further.\271\
---------------------------------------------------------------------------

    \269\ American Century Letter at 2; Ameritrade Letter I at 4; 
BNY Letter at 2; Capital Research Letter at 2; Consumer Federation 
Letter at 2; Goldman Sachs Letter at 6; ICI Letter at 8. See also 
ArcaEx Letter at 7 (supported trade-through protection for exchange-
listed stocks only, but for entire depth-of-book). But see Letter 
from Samuel F. Lek, Chief Executive Officer, Lek Securities 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated May 
24, 2004 (``Lek Securities Letter'') at 7; Letter from David 
Humphreville, President, the Specialist Association of the New York 
Stock Exchange, to Jonathan G. Katz, Secretary, Commission, dated 
June 30, 2004 (``Specialist Assoc. Letter'') at 3.
    \270\ Consumer Federation Letter at 2.
    \271\ ICI Letter at 8.
---------------------------------------------------------------------------

    The Commission recognized, however, that other commenters may have 
chosen not to address the alternative of protecting voluntary DOB 
quotations because it was not included in the proposed rule text. In 
the Reproposing Release, therefore, the Commission proposed rule text 
for two alternatives: (1) The Market BBO Alternative that would protect 
only the BBOs of the exchange SROs, Nasdaq, and the ADF; or (2) the 
Voluntary Depth Alternative that, in addition to protecting BBOs, would 
protect the DOB quotations that markets voluntarily disseminate in the 
consolidated quotations stream. The Commission requested comment on 
which of the two alternatives would most further the Exchange Act 
objectives for the NMS in a practical and workable manner. In 
particular, comment was requested on whether extending trade-through 
protection to DOB quotations would significantly increase the benefits 
of the Order Protection Rule, and on the effect that adoption of the 
Voluntary Depth Alternative would have on competition among markets. 
The Commission also requested comment on whether the Voluntary Depth 
Alternative could be implemented in a practical and cost-effective 
manner.\272\
---------------------------------------------------------------------------

    \272\ See Section II.A.5 in the Reproposing Release for a 
detailed discussion of the request for comment on the Market BBO 
Alternative and the Voluntary Depth Alternative.
---------------------------------------------------------------------------

    A large majority of commenters that supported the reproposed Order 
Protection Rule supported the Market BBO Alternative.\273\ Many 
commenters

[[Page 37530]]

believed that the Market BBO Alternative achieves the appropriate 
balance between the need to promote competition among orders and to 
preserve competition among markets,\274\ but that the Voluntary Depth 
Alternative, by focusing too exclusively on competition among orders, 
would unduly restrict competition among markets.\275\ Many commenters 
also believed that implementing the Voluntary Depth Alternative would 
be significantly more difficult and costly than implementing the Market 
BBO Alternative.\276\
---------------------------------------------------------------------------

    \273\ Approximately 1,556 commenters expressed support for the 
Market BBO Alternative, of which approximately 1,411 were form 
letters. See, e.g., Letter from Brendan R. Dowd and Zdrojeski, Co-
Presidents, Alliance of Floor Brokers, to Jonathan G. Katz, 
Secretary, Commission, dated January 20, 2005 (``Alliance of Floor 
Brokers Reproposal Letter'') at 1; Letter from Neal L. Wolkoff, 
Acting Chief Executive Officer, American Stock Exchange, LLC, to 
Jonathan G. Katz, Secretary, Commission, dated January 27, 2005 
(``Amex Reproposal Letter'') at 2; Bear Stearns Reproposal Letter at 
1 (if properly modified); Letter from Minder Cheng, Managing 
Director, CIO, US Active Equities, Global Head of Equity and 
Currency Trading, Barclays Global Investors, N.A., to Jonathan G. 
Katz, Secretary, Commission, dated January 26, 2005 (``BGI 
Reproposal Letter'') at 2; Letter from Joseph M. Velli, Senior 
Executive Vice President, The Bank of New York, to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``BNY Reproposal 
Letter'') at 2; BSE Reproposal Letter at 2; Letter from David A. 
Herron, Chief Executive Officer, The Chicago Stock Exchange, to 
Jonathan G. Katz, Secretary, Commission, dated January 26, 2005 
(``CHX Reproposal Letter'') at 2; Letter from Kimberly G. Walker, 
Chairman, Committee on Investment of Employee Benefit Assets, to 
Jonathan G. Katz, Secretary, Commission, dated January 25, 2005 
(``CIEBA Reproposal Letter'') at 2; Deutsche Bank Reproposal Letter 
at 2; Form Letters G, H, I, J, and K; Letter from D. Keith Ross, 
Jr., Chief Executive Officer, Getco, LLC, to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``Getco Reproposal 
Letter'') at 2; Letter from Thomas Peterffy, Chairman, and David M. 
Battan, Vice President, The Interactive Brokers Group, to Jonathan 
G. Katz, Secretary, Commission, dated January 24, 2005 
(``Interactive Brokers Group Reproposal Letter'') at 1; NAIC 
Reproposal Letter at 2; Letter from John M. Schaible, President, 
NexTrade Holdings, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated December 22, 2004 (``Nextrade Reproposal Letter'') at 3; NYSE 
Reproposal Letter I at 1-3; Letter from Kenneth J. Polcari, 
President, et al., Organization of Independent Floor Brokers, to 
Jonathan G. Katz, Secretary, Commission, dated January 12, 2005 
(``Organization of Independent Floor Brokers Reproposal Letter'') at 
2; Phlx Reproposal Letter at 1; Letter from Richard A. Rosenblatt, 
CEO, and Joseph C. Gawronski, COO, Rosenblatt Securities Inc., to 
Jonathan G. Katz, Secretary, Commission, dated January 26, 2005 
(``Rosenblatt Securities Reproposal Letter'') at 2; Specialist 
Association Reproposal Letter at 2; T. Rowe Price Reproposal Letter 
at 2.
    \274\ See, e.g., Amex Reproposal Letter at 3; BGI Reproposal 
Letter at 2; BNY Reproposal Letter at 2-3; Form Letter J; Specialist 
Association Reproposal Letter at 3.
    \275\ See, e.g., Alliance of Floor Brokers Reproposal Letter at 
2; Amex Reproposal Letter at 3; Bear Stearns Reproposal Letter at 2; 
BNY Reproposal Letter at 2-3; BSE Reproposal Letter at 6; CHX 
Reproposal Letter at 3; CIEBA Reproposal Letter at 2; Deutsche Bank 
Reproposal Letter at 2; Getco Reproposal Letter at 1-2; Interactive 
Brokers Reproposal Letter at 3; NAIC Reproposal Letter at 1-2; NYSE 
Reproposal Letter I at 2; Organization of Independent Floor Brokers 
Reproposal Letter at 2; Rosenblatt Securities Reproposal Letter at 
2; Specialist Association Reproposal Letter at 5.
    \276\ See, e.g., Amex Reproposal Letter at 3; BNY Reproposal 
Letter, at 3; BSE Reproposal Letter at 7; CHX Reproposal Letter at 
2; Letter from W. Leo McBlain, Chairman, and Thomas J. Jordan, 
Executive Director, Financial Information Forum, to Jonathan G. 
Katz, Secretary, Commission, dated January 26, 2005 (``FIF 
Reproposal Letter'') at 2-3; Getco Reproposal Letter at 1; 
Interactive Brokers Group Reproposal Letter at 1; Nextrade 
Reproposal Letter at 3; NYSE Reproposal Letter I, Detailed Comments 
at 8; Phlx Reproposal Letter at 2; Specialist Association Reproposal 
Letter at 4.
---------------------------------------------------------------------------

    The Commission has determined to adopt the Market BBO Alternative. 
The Commission believes that providing enhanced protection for the best 
bids and offers of each exchange, Nasdaq, and the ADF will represent a 
major step toward achieving the objectives of intermarket price 
protection, but with fewer of the costs and drawbacks associated with 
the Voluntary Depth Alternative. In particular, the Market BBO 
Alternative will promote best execution for retail investors on an 
order-by-order basis, given that most retail investors justifiably 
expect that their orders will be executed at the NBBO. In addition, 
implementation of the Market BBO Alternative will not require an 
expansion of the data disseminated through the Plans. The Plans 
currently disseminate the BBOs of each SRO, but do not disseminate the 
depth of book of all SROs.
    The Commission does not agree with commenters that the Voluntary 
Depth Alternative would be a CLOB, virtual or otherwise.\277\ The 
essential characteristic of a CLOB is strict price/time priority. To 
achieve time priority, all orders must be funneled through a single 
trading facility so that they can be ranked by time. Such a facility 
would greatly reduce the opportunity for markets to compete by offering 
a variety of different trading services. Price priority alone, however, 
would not cause nearly as significant an impact on competition among 
markets because it allows price-matching by competing markets. Thus, 
while a CLOB requires centralization of essentially all orders, price 
priority (whether the Market BBO Alternative or the Voluntary Depth 
Alternative) merely requires the routing of a much smaller subset of 
orders that otherwise would be executed at inferior prices.
---------------------------------------------------------------------------

    \277\ Many of these commenters expressed the view that 
implementation of the Voluntary Depth Alternative effectively would 
amount to a virtual CLOB. See, e.g., Alliance of Floor Brokers 
Reproposal Letter at 2; BGI Reproposal Letter at 3; BNY Reproposal 
Letter at 2-3; CHX Reproposal Letter at 2-3; Letter from Congressman 
Peter T. King et al., to Jonathan G. Katz, Secretary, Commission, 
dated January 25, 2005 (``Congressman King et al. Reproposal 
Letter'') at 1; Letter from Congressman Edward R. Royce and 
Congressman George Radanovich to Jonathan G. Katz, Secretary, 
Commission, dated January 25, 2005 (``Congressmen Royce & Radanovich 
Reproposal Letter''); Letter from Congresswoman Lydia M. 
Vel[aacute]zquez to Jonathan G. Katz, Secretary, Commission, dated 
January 25, 2005 (``Congresswoman Vel[aacute]zquez Letter'') at 1; 
NAIC Reproposal Letter at 1; NYC Comptroller Reproposal Letter; NYSE 
Reproposal Letter at 2; Organization of Independent Floor Brokers 
Reproposal Letter at 1; Form Letters G, H, I, J, K, and L.
---------------------------------------------------------------------------

    A number of commenters believed that enhanced order interaction 
with quotations beyond the best bids and offers of the various SROs 
would likely result even if the Commission adopted the Market BBO 
Alternative.\278\ Given the existence of highly sophisticated order 
routing technology and the requirement to route orders to access the 
best bids and offers under the Market BBO Alternative, these commenters 
asserted that competition and best execution responsibilities would 
lead market participants to voluntarily access depth-of-book quotations 
in addition to quotations at the top-of-book. The Commission believes 
that such a competition-driven outcome would benefit investors and the 
markets in general.
---------------------------------------------------------------------------

    \278\ See, e.g., Bear Stearns Reproposal Letter at 2; BNY 
Reproposal Letter at 2; Interactive Brokers Reproposal Letter at 4.
---------------------------------------------------------------------------

    Another group of commenters advocated protecting only the 
NBBO.\279\ They believed that NBBO protection would be a more measured 
first step forward that would strengthen existing price protection 
while helping to mitigate implementation problems and potential 
unintended consequences with either the Market BBO or Voluntary Depth 
Alternative.\280\
---------------------------------------------------------------------------

    \279\ CIBC Reproposal Letter at 1 (joining positions taken by 
SIA in its letter); Citigroup Reproposal Letter at 6 (arguing that 
to the extent a trade-through rule is necessary, it prefers 
protecting the NBBO, with an exception for most liquid securities 
preferred); FSR Reproposal Letter at 4; JP Morgan Reproposal Letter 
at 3 (stating that if Commission does not provide large order 
exception then NBBO preferred); Lava Reproposal Letter at 1,3 (not 
supporting or opposing the reproposed Order Protection Rule but 
indicating NBBO would facilitate adoption and ease implementation 
concerns); Merrill Lynch Reproposal Letter at 3; SIA Reproposal 
Letter at 5-12; STANY Reproposal Letter at 10.
    \280\ See, e.g., SIA Reproposal Letter at 5-12.
---------------------------------------------------------------------------

    The Commission does not support the NBBO approach. The marginal 
benefits to be gained from protecting only the NBBO would not justify 
the costs of implementing the approach. In addition, protecting only 
the NBBO would be a step backwards from the scope of the existing ITS 
trade-through rule, which covers the best bids and offers of each 
exchange and the NASD. The Commission also is concerned that an order 
protection rule that protected only the NBBO would be excessively 
vulnerable to gaming behavior, because a market participant could post 
a 100-share order improving the NBBO and then execute a much larger 
order away from the NBBO while protecting only the 100-share quotation. 
This result would not be consistent with the purposes of the Order 
Protection Rule.
6. Benefits and Implementation Costs of the Order Protection Rule
    Commenters were concerned about the cost of implementing the 
original trade-through proposal. Some argued that, in general, 
implementing the proposed rule would be too expensive and would 
outweigh any perceived benefits of the rule.\281\ Commenters also were 
concerned about the cost of specific requirements in the proposed rule, 
particularly the procedural requirements associated with the proposed 
opt-out exception (e.g., obtaining informed consent from customers and 
disclosing the NBBO to customers).\282\
---------------------------------------------------------------------------

    \281\ See, e.g., Bloomberg Tradebook Letter at 14; Fidelity 
Letter I at 12; Instinet Letter at 14, 15; Nasdaq Letter II at 2; 
Letter from Junius W. Peake, Monfort Distinguished Professor of 
Finance, Kenneth W. Monfort College of Business, University of 
Northern Colorado, dated April 23, 2004 (``Peake Letter I'') at 2; 
NMS Study Group Letter at 4; Letter from Richard A. Rosenblatt, 
Chief Executive Officer, & Joseph C. Gawronski, Chief Operating 
Officer, Rosenblatt Securities Inc., to William H. Donaldson, 
Chairman, Commission, dated June 23, 2004 (``Rosenblatt Securities 
Letter II'') at 4; STANY Letter at 3; UBS Letter at 8.
    \282\ See, e.g., Ameritrade Letter I at 8; Brut Letter at 12; 
Citigroup Letter at 8-9; E*TRADE Letter at 7; Letter from W. Leo 
McBlain, Chairman, & Thomas J. Jordan, Executive Director, Financial 
Information Forum, to Jonathan G. Katz, Secretary, Commission, dated 
July 9, 2004 (``Financial Information Forum Letter'') at 2; JP 
Morgan Letter at 4; SIA Letter at 12-14.

---------------------------------------------------------------------------

[[Page 37531]]

    Some of the commenters based their concerns about implementation 
costs on the estimated costs included in the Proposing Release for 
purposes of the Paperwork Reduction Act of 1995 (``PRA'').\283\ In the 
Reproposing Release, the Commission revised its estimate of the PRA 
costs associated with the proposed rule to reflect the streamlined 
requirements of Rule 611 as reproposed, and to reflect a further 
refinement of the estimated number of trading centers subject to the 
rule.\284\ In particular, Rule 611 as reproposed did not contain an 
opt-out exception, and thus costs associated with the proposed 
exception, which represented a large portion of the overall estimated 
costs described in the Proposing Release, were no longer 
applicable.\285\ In total, eliminating the opt-out procedural 
requirements alone reduced the estimate of costs in the Proposing 
Release by $294 million in start-up costs and $207 million in annual 
costs. In the Reproposing Release, the Commission also refined its 
estimate of the number of broker-dealers that would be required to 
establish, maintain, and enforce written policies and procedures 
designed to prevent trade-throughs pursuant to the reproposed Rule from 
6,788 registered broker-dealers to approximately 600 broker-
dealers.\286\
---------------------------------------------------------------------------

    \283\ 44 U.S.C. 3501 et seq.
    \284\ The PRA analysis is forth in section VIII.A below.
    \285\ Specifically, the estimated costs of providing investors 
with disclosure necessary to obtain informed consent to opt-outs and 
retaining records relating to such disclosures were $100 million in 
start-up costs and $59 million annually. Further, the estimated 
costs of the proposed requirement for broker-dealers to provide 
every customer that opted out with the NBBO at the time of execution 
were $194 million in start-up costs and almost $148 million 
annually.
    \286\ In the Proposing Release, the Commission estimated that 
potentially all of the 6,768 registered broker-dealers would be 
subject to this requirement, but acknowledged that it believed the 
figure was likely overly-inclusive because it might include 
registered broker-dealers that do not effect transactions in NMS 
stocks. As noted in the Reproposing Release, after further 
consideration, the Commission believes that this number indeed 
greatly overestimated the number of registered broker-dealers that 
would be subject to the rule, given that most of those broker-
dealers do not engage in the business of executing orders 
internally. The estimated number therefore was reduced to 
approximately 600 broker-dealers in the Reproposing Release. No 
comments were received on this estimate. The estimate is described 
further in section VIII.A below.
---------------------------------------------------------------------------

    Taken together, these changes substantially reduced the estimated 
costs associated with implementation of and ongoing compliance with 
reproposed Rule 611. As discussed further in section VIII.A below, the 
estimated PRA costs associated with reproposed Rule 611 were $17.8 
million in start-up costs and $3.5 million in annual costs. In 
addition, as discussed further in section IX.A.2 below, the estimated 
implementation costs in the Reproposing Release for necessary systems 
modifications were $126 million in start-up costs and $18.4 million in 
annual costs. Accordingly, the total estimated costs in the Reproposing 
Release were $143.8 million in start-up costs and $21.9 million in 
annual costs.
    Although a number of commenters generally expressed the view that 
there would be significant costs associated with implementing and 
complying with the reproposed Rule, they did not discuss the specific 
estimated cost figures included in the Reproposing Release or include 
their own estimates.\287\ Many commenters expressed concerns with the 
costs associated with implementing the Voluntary Depth Alternative, 
believing that the costs of implementing the Voluntary Depth 
Alternative would be substantially greater than the Market BBO 
Alternative.\288\ As discussed above in Section II.A.5, the Commission 
is adopting the Market BBO Alternative and not the Voluntary Depth 
Alternative. The Commission does not believe that the inclusion of a 
stopped order exception will materially impact the estimated costs 
included in the Reproposing Release.\289\ The Commission continues to 
estimate implementation costs for the Order Protection Rule as adopted 
of approximately $143.8 million and annual costs of approximately $21.9 
million.\290\
---------------------------------------------------------------------------

    \287\ See, e.g., CIBC Reproposal Letter at 4; Letter from Thomas 
M. Joyce, CEO & President, Knight Trading Group, Inc., to Jonathan 
G. Katz, Secretary, Commission, dated January 25, 2005 (``Knight 
Securities Reproposal Letter'' ``Knight Reproposal Letter'') at 5 
(expressing the view that the costs of either the Market BBO or 
Voluntary Depth Alternative outweigh the nominal benefits of the 
Rule); Merrill Lynch Reproposal Letter at 5; Nasdaq Reproposal 
Letter at 2; SIA Reproposal Letter at 11.
    \288\ Amex Reproposal Letter at 3; Letter from Steve Swanson, 
CEO & President, Automated Trading Desk, LLC, to Jonathan G. Katz, 
Secretary, Commission, dated January 26, 2005 (``ATD Reproposal 
Letter'') at 4; BNY Reproposal Letter at 3; CHX Reproposal Letter at 
2; NYSE Reproposal Letter I, Detailed Comments at 8; RBC Capital 
Markets Reproposal Letter at 6; STANY Reproposal Letter at 9.
    \289\ The estimated cost figures included the Reproposing 
Release did not include additional costs that would be associated 
with the Voluntary Depth Alternative. See section IX.A.2 of the 
Reproposing Release.
    \290\ See infra sections VIII.A and IX.A.2.
---------------------------------------------------------------------------

    In assessing the implementation costs of the Order Protection Rule, 
it is important to recognize that much, if not all, of the connectivity 
among trading centers necessary to implement intermarket price 
protection has already been put in place. Trading centers for exchange-
listed securities already are connected through the ITS. The Commission 
understands that, at least as an interim solution, ITS facilities and 
rules can be modified relatively easily and at low cost to provide the 
current ITS participants a means of complying with the provisions of 
Rule 611. With respect to Nasdaq stocks, connectivity among many 
trading centers already is established through private linkages. 
Routing out to other trading centers when necessary to obtain the best 
prices for Nasdaq stocks is an integral part of the business plan of 
many trading centers, even when not affirmatively required by best 
execution responsibilities or by Commission rule. Moreover, a variety 
of private vendors currently offer connectivity to NMS trading centers 
for both exchange-listed and Nasdaq stocks.
    The Commission believes that the benefits of strengthening price 
protection for exchange-listed stocks (e.g., by eliminating the gaps in 
ITS coverage of block positioners and 100-share quotes) and introducing 
price protection for Nasdaq stocks will be substantial, although the 
total amount is difficult to quantify. One objective, though quite 
conservative, estimate of benefits is the dollar amount of quotations 
that annually are traded through. The Commission staff's analysis of 
trade-through rates indicates that over 12 billion shares of displayed 
quotations in Nasdaq and NYSE stocks were traded through in 2003, by an 
average amount of 2.3 cents for Nasdaq stocks and 2.2 cents for NYSE 
stocks.\291\ These traded-through quotations represent approximately 
$209 million in Nasdaq stocks and $112 million in NYSE stocks, for a 
total of $321 million in bypassed limit orders and inferior prices for 
investors in 2003 that could have been addressed by strong trade-
through protection.\292\ The Commission believes that this $321 million 
estimated annual benefit, particularly when combined with the benefits 
of enhanced investor confidence in the fairness and orderliness of the 
equity markets, justifies the one-time costs of implementation and 
ongoing annual costs of the Order Protection Rule.
---------------------------------------------------------------------------

    \291\ Trade-Through Study at 3, 5.
    \292\ Id. at 3.
---------------------------------------------------------------------------

    Two commenters on the reproposal asserted that the dollar amount of 
traded-through quotations overstated the benefits of order protection 
because ``trading is for the most part a zero-sum

[[Page 37532]]

game.'' \293\ They believed that trades executed at inferior prices 
were random noise that sometimes benefited and sometimes disadvantaged 
a particular investor, stating that ``[i]t is only if one class of 
investors systematically loses out to another class as a result of 
trade-throughs that there is a problem.'' \294\
---------------------------------------------------------------------------

    \293\ Angel Reproposal Letter at 4; Fidelity Reproposal Letter 
at 8.
    \294\ Angel Reproposal Letter at 4.
---------------------------------------------------------------------------

    The Commission does not agree that trades executed at inferior 
prices should be considered merely a transfer of benefits from one 
group of investors to another equally-situated group of investors. 
There are at least three parties affected by every trade-through 
transaction: (1) The party that received an inferior price; (2) the 
party whose superior-priced limit order was traded-through; and (3) the 
contra party to the trade-through transaction that received an 
advantageous price. The redistributions of welfare resulting from 
trade-through transactions cannot reasonably be expected to occur 
randomly across these parties. Customers of brokers that are doing a 
poor job of routing orders are more likely to be harmed than customers 
of brokers that are doing a better job.\295\ Investors who generally 
submit limit orders at the best prices are more likely to be harmed 
than customers who generally submit less aggressively-priced limit 
orders.
---------------------------------------------------------------------------

    \295\ As discussed above, it can be difficult for retail 
investors in particular to monitor whether their orders in fact 
received the best available price at the time of order execution. 
See supra, note 53 and accompanying text.
---------------------------------------------------------------------------

    Thus, trade-through transactions can result in direct harm to two 
parties, as well as more general harm to the efficiency of the markets 
by dampening the incentive for aggressive quoting. Moreover, even when 
the party receiving an inferior price does so willingly (such as when 
an institution accepts a block trade at a price away from the inside 
quotation),\296\ the party whose quotation was traded through and the 
efficiency of the markets still are harmed. Finally, many trade-
throughs are dealer internalized trades, where the party receiving the 
advantageous price is not an investor but a market intermediary, and 
therefore such trades cannot be considered a transfer of benefits from 
one group of investors to another equally-situated group of investors. 
This transfer of benefits from investors to market intermediaries 
cannot be dismissed as mere ``random noise.''
---------------------------------------------------------------------------

    \296\ Fidelity and the Battalio/Jennings Paper asserted that the 
staff study should not have included block trades in its estimate of 
the benefits of strengthened trade-through protection. Fidelity 
Reproposal Letter II at 1; Battalio/Jennings Paper at 2. The 
Commission does not agree. First, the amount that block trades 
contributed to the $321 million estimate is very small. Block trades 
represented only 1.9% of total trade-throughs in Nasdaq stocks and 
1.1% of total trade-throughs in NYSE stocks. Trade-Through Study, 
Tables 6, 13. Most importantly, the staff study used the lesser of 
the size of the traded-through quotation and the size of the trade-
through transaction when calculating the $321 million. Id. at 3. 
Thus, if a 10,000 share transaction traded through a 100-share 
quotation, only 100 shares counted toward the estimation of 
benefits. The Battalio/Jennings Paper incorrectly asserted that the 
staff study did not use this conservative approach. Battalio/
Jennings Paper at 2. Finally, block trades are appropriately 
included in the estimation of benefits because their failure to 
interact with significant displayed quotations is one of the most 
serious problems with respect to the protection of limit orders that 
the Order Protection Rule is designed to address. See supra, section 
II.A.1.c.
---------------------------------------------------------------------------

    In addition, economic theory predicts that, in an auction market, 
buyers who place the highest value on a stock will bid most 
aggressively.\297\ If an incoming market order is allocated to an 
investor who is not bidding the best price, this re-allocation is 
neither zero-sum nor random. It systematically reallocates trades away 
from those investors for whom the welfare gains would be largest. The 
argument also can be framed in terms of an investor's preferences with 
respect to the tradeoff between price and execution speed. Among those 
investors who trade using limit orders, we would expect more aggressive 
limit orders to be submitted by those investors who place more value on 
speed or certainty of execution and relatively less value on price. 
Conversely, we would expect investors who place a lower value on speed 
and certainty of execution and a higher value on price to submit less 
aggressive limit orders. When an incoming market order is executed 
against a limit order with an inferior price, the result is: (1) A 
faster execution for an investor who does not place as much value on 
speed of execution; and (2) a lost execution or slower execution for 
the investor who places a higher value on prompt execution. This is not 
a zero-sum redistribution.
---------------------------------------------------------------------------

    \297\ See, e.g., B. Hollifield, R. Miller and P. Sandas, 
``Empirical Analysis of Limit Order Markets,'' 71 Review of Economic 
Studies 1027-1063 and n. 4 (2004).
---------------------------------------------------------------------------

    Moreover, the $321 million estimate is a conservative measure of 
the total benefits of the Order Protection Rule. It does not attempt to 
measure any gains from trading associated with investors' private 
values, beyond those expressed in their limit order prices. The Order 
Protection Rule can be expected to generate other categories of 
benefits that are not quantified in the $321 million estimate, such as 
the benefits that can be expected to result from increased use of limit 
orders, increased depth, and increased order interaction.
    Thus, the Commission believes that the $321 million estimate of 
benefits is conservative because it is based solely on the size of 
displayed quotations in the absence of strong price protection. In 
essence, it measures the problem--a shortage of quoted depth--that the 
Order Protection Rule is designed to address, rather than the benefits 
that it could achieve. Every trade-through transaction potentially 
sends a message to market participants that their displayed quotations 
can be and are ignored by other market participants. When the total 
share volume of trade-through transactions that do not interact with 
displayed quotations reaches 9% and above for hundreds of the most 
actively traded NMS stocks,\298\ this message is unlikely to be missed 
by those who watched their quotations being traded through. Certainly, 
the common practice of trading through displayed size is most unlikely 
to prompt market participants to display even greater size.
---------------------------------------------------------------------------

    \298\ See Trade-Through Study, Tables 4.
---------------------------------------------------------------------------

    A primary objective of the Order Protection Rule is to increase 
displayed depth and liquidity in the NMS and thereby reduce transaction 
costs for a wide spectrum of investors, particularly institutional 
investors that must trade in large sizes. Precisely estimating the 
extent to which strengthened price protection will improve market depth 
and liquidity, and thereby lower the transaction costs of investors, is 
very difficult. The difficulty of estimation should not hide from view, 
however, the enormous potential benefits for investors of improving the 
depth and efficiency of the NMS. Because of the huge dollar amount of 
trading volume in NMS stocks--more than $17 trillion in 2003 \299\--
even the most incremental improvement in market depth and liquidity 
could generate a dollar amount of benefits that annually would dwarf 
the one-time start-up costs of implementing trade-through protection.
---------------------------------------------------------------------------

    \299\ World Federation of Exchanges, Annual Report (2003), at 
86.
---------------------------------------------------------------------------

    One approach to evaluating the potential benefits of the Order 
Protection Rule is to examine a category of investors that stand to 
benefit a great deal from improved depth and liquidity for NMS stocks--
the shareholders in U.S. equity mutual funds. In 2003, the total assets 
of such funds were $3.68 trillion.\300\ The average portfolio turnover 
rate for equity funds was 55%,

[[Page 37533]]

meaning that their total purchases and sales of securities amounted to 
approximately $4.048 trillion.\301\ A leading authority on the trading 
costs of institutional investors has estimated that in the second 
quarter of 2003 the average price impact experienced by investment 
managers ranged from 17.4 basis points for giant-capitalization stocks, 
21.4 basis points for large-capitalization stocks, and up to 35.4 basis 
points for micro-capitalization stocks.\302\ In addition, it estimated 
the cost attributable to adverse price movements while searching for 
liquidity for institutional orders, which often are too large simply to 
be presented to the market. Its estimate of these liquidity search 
costs ranged from 13 basis points for giant capitalization stocks, 23 
basis points for large capitalization stocks, and up to 119 basis 
points for micro-capitalization stocks.
---------------------------------------------------------------------------

    \300\ Investment Company Institute, Mutual Fund Fact Book 
(2004), at 55.
    \301\ Id. at 64. Portfolio turnover is reported as the lesser of 
portfolio sales or purchases divided by average net assets. Because 
price impact occurs for both purchases and sales, the turnover rate 
must be doubled, then multiplied by total fund assets, to estimate 
the total value of trading that would be affected by an improvement 
in depth and liquidity.
    \302\ Plexus Group, Inc., Commentary 80, ``Trading Truths: How 
Mis-Measurement of Trading Costs Is Leading Investors Astray,'' 
(April 2004), at 2-3.
---------------------------------------------------------------------------

    To obtain a conservative estimate of price impact costs and 
liquidity search costs incurred across all stocks, the total market 
impact and liquidity search costs for giant capitalization stocks (30.4 
basis points) and the total market impact and liquidity search costs 
for large capitalization stocks (44.4 basis points) are averaged 
together to yield a figure of 37.4 basis points.\303\ The much higher 
market impact and liquidity search costs of midcap, smallcap, and 
microcap stocks are not included. Using this estimate of 37.4 basis 
points, the shareholders in U.S. equity mutual funds incurred implicit 
transaction costs of $15.1 billion in 2003. Based on a hypothetical 
assumption that, in light of the current share volume of trade-through 
transactions that does not interact with displayed liquidity, 
intermarket trade-through protection could improve depth and liquidity 
for NMS stocks by 5% (or an average reduction of 1.87 basis points in 
price impact and liquidity search costs for large investors), the 
savings in transaction costs for U.S equity funds alone, and the 
improved returns for their millions of individual shareholders, would 
have amounted to approximately $755 million in 2003.
---------------------------------------------------------------------------

    \303\ Cf. supra, note 146 and accompanying text (Plexus estimate 
of average transaction costs, including commissions, during the 
fourth quarter of 2003 for Nasdaq and NYSE stocks as, respectively, 
83 basis points and 55 basis points; commissions average 12 basis 
points for large capitalization stocks).
---------------------------------------------------------------------------

    Of course, the benefits of improved depth and liquidity for the 
equity holdings of other types of investors, including pension funds, 
insurance companies, and individuals, are not incorporated in the 
foregoing calculations. In 2003, these other types of investors held 
78% of the value of publicly traded U.S. equity outstanding, with 
equity mutual funds holding the remaining 22%.\304\ For example, 
pension funds alone held $9 trillion in assets in 2003, of which an 
estimated $4.9 trillion was held in equity investments other than 
mutual funds.\305\ Thus, the implicit transaction costs incurred by 
institutional investors each year is likely at least double the $15.1 
billion estimated for equity mutual funds, for a total of more than $30 
billion. Assuming that these other types of investors experienced a 
reduction in transaction costs that equaled the reduction of trading 
costs for equity mutual funds, the assumed 5% improvement in market 
depth and liquidity could yield total transaction cost savings for all 
investors of over $1.5 billion annually. Such savings would improve the 
investment returns of equity ownership, thereby promoting the 
retirement and other long-term financial interests of individual 
investors and reducing the cost of capital for listed companies.
---------------------------------------------------------------------------

    \304\ Mutual Fund Factbook, supra note 300, at 59.
    \305\ Id. at 91 (employer-sponsored pension market held 
estimated $9.0 trillion in assets in 2003, $7.7 trillion of which 
were not represented by mutual fund assets); Milliman, Inc., Pension 
Fund Survey (available at www.milliman.com) (consulting firm's 
survey of 2003 annual reports for 100 of largest U.S. corporations 
found that the median equity allocation for pension fund assets was 
65%).
---------------------------------------------------------------------------

B. Description of Adopted Rule

    Rule 611 can be divided into three elements: (1) The provisions 
that establish the scope of the Rule's coverage, most of which are set 
forth in the definitions of Rule 600(b); (2) the operative requirements 
of paragraph (a) of Rule 611, which, among other things, mandate the 
adoption and enforcement of written policies and procedures that are 
reasonably designed to prevent trade throughs on that trading center of 
protected quotations and, if relying on an exception, that are 
reasonably designed to assure compliance with the terms of the 
exception; and (3) the exceptions set forth in paragraph (b) of Rule 
611. These elements are discussed below, followed by a section 
emphasizing that a broker's duty of best execution is not lessened by 
the adoption of Rule 611.
1. Scope of Rule
    The scope of Rule 611 is largely determined by a series of 
definitions set forth in Rule 600(b). In general, the Rule addresses 
trade-throughs of protected quotations in NMS stocks by trading 
centers. A ``trading center'' is defined in Rule 600(b)(78) as a 
national securities exchange or national securities association that 
operates an SRO trading facility,\306\ an ATS,\307\ an exchange market 
maker,\308\ an OTC market maker,\309\ or any other broker or dealer 
that executes orders internally by trading as principal or crossing 
orders as agent. This last phrase is intended particularly to cover 
block positioners. An ``NMS stock'' is defined in paragraphs (b)(47) 
and (b)(46) of Rule 600 as a security, other than an option, for which 
transaction reports are collected, processed and made available 
pursuant to an effective national market system plan. This definition 
effectively covers stocks listed on a national securities exchange and 
stocks included in either the National Market or SmallCap tiers of 
Nasdaq. It does not include stocks quoted on the OTC Bulletin Board or 
elsewhere in the OTC market.
---------------------------------------------------------------------------

    \306\ An ``SRO trading facility'' is defined in Rule 600(b)(72) 
as a facility operated by or on behalf of an SRO that executes 
orders in a security or presents orders to members for execution.
    \307\ An ``alternative trading system'' is defined in Rule 
600(b)(2) with a cross reference to Regulation ATS.
    \308\ An ``exchange market maker'' is defined in Rule 
600(b)(24).
    \309\ An ``OTC market maker'' is defined in Rule 600(b)(52).
---------------------------------------------------------------------------

    The term ``trade-through'' is defined in Rule 600(b)(77) as the 
purchase or sale of an NMS stock during regular trading hours,\310\ 
either as principal or agent, at a price that is lower than a protected 
bid or higher than a protected offer. Rule 600(b)(57), which defines a 
``protected bid'' or ``protected offer,'' \311\ includes three main 
elements: (1) An automated quotation; (2) displayed by an automated 
trading center; and (3) that is the best bid or best offer of an 
exchange, The NASDAQ Stock Market, or an association other than The 
NASDAQ Stock Market (currently, the best bid or offer of the NASD's 
ADF).\312\
---------------------------------------------------------------------------

    \310\ The term ``regular trading hours'' is defined in Rule 
600(b)(64) as the time between 9:30 a.m. and 4:00 p.m. Eastern time, 
unless otherwise specified.
    \311\ Protected bid and protected offer are collectively defined 
as a ``protected quotation'' in Rule 600(b)(58).
    \312\ See section II.A.5 above for a discussion of the 
Commission's determination to adopt the Market BBO Alternative with 
respect to the scope of protected quotations.
---------------------------------------------------------------------------

    As discussed above, an ``automated quotation'' is defined in Rule 
600(b)(3) as a quotation displayed by a trading

[[Page 37534]]

center that: (1) Permits an incoming order to be marked as immediate-
or-cancel; (2) immediately and automatically executes an order marked 
as immediate-or-cancel against the displayed quotation up to its full 
size; \313\ (3) immediately and automatically cancels any unexecuted 
portion of an order marked as immediate-or-cancel without routing the 
order elsewhere; (4) immediately and automatically transmits a response 
to the sender of an order marked as immediate-or-cancel indicating the 
action taken with respect to such order; and (5) immediately and 
automatically displays information that updates the displayed quotation 
to reflect any change to its material terms.
---------------------------------------------------------------------------

    \313\ The requirement that an automated quotation be accessible 
up to its full size does not mean that a trading center must 
automate all of its available trading interest. For example, trading 
centers will be permitted to operate hybrid markets with different 
order types and rules for automated trading and manual trading. 
Rather, the ``full size'' term in the definition of automated 
quotation requires that, once a trading center offers an automated 
execution of a particular displayed quotation and thereby obtains 
protection under Rule 611, such quotation must be immediately and 
automatically accessible up to its full size, which will include 
both the displayed and reserve size of the quotation. Given that to 
comply with Rule 611, market participants need to be able to access 
the displayed size of protected quotations at all trading centers 
(even when the displayed size of the quotation may be less than the 
size of the market participant's total trading interest), the 
Commission believes trading centers must provide fair and efficient 
access to the full size available for the quotation. Cf. infra, 
sections III.B.1 and III.B.2 (access standard and fee limitation of 
Rule 610 apply to both displayed and reserve size of displayed 
quotations). This requirement, which is applicable to trading 
centers that display automated quotations, does not mean that market 
participants are required to route orders in an attempt to execute 
against the reserve size of a protected quotation. Rather, Rule 611 
operates as follows. In the first instance, the Rule protects 
prices--a trading center cannot execute a transaction at a price 
inferior to the price of a protected quotation, absent an exception. 
One of the most commonly used exceptions to the Rule is likely to be 
the intermarket sweep order exception, which applies to sweep orders 
that are routed to execute against the full displayed size of 
better-priced protected quotations. See infra, note 320 and 
accompanying text.
---------------------------------------------------------------------------

    Consequently, a quotation will not qualify as ``automated'' if any 
human intervention after the time an order is received is allowed to 
determine the action taken with respect to the quotation. The term 
``immediate'' precludes any coding of automated systems or other type 
of intentional device that would delay the action taken with respect to 
a quotation. Although a trading center must provide an IOC/no-routing 
functionality for incoming orders, it also can offer additional 
functionalities. Among the changes to material terms that require an 
immediate update to a quotation are price, displayed size, and 
automated/manual indicator. Any quotation that does not meet the 
requirements for an automated quotation is defined in Rule 600(b)(37) 
as a ``manual quotation.''
    As discussed above, an ``automated trading center'' is defined in 
Rule 600(b)(4) as a trading center that: (1) Has implemented such 
systems, procedures, and rules as are necessary to render it capable of 
displaying quotations that meet the requirements for an automated 
quotation set forth in paragraph (b)(3) of this section; (2) identifies 
all quotations other than automated quotations as manual quotations; 
(3) immediately identifies its quotations as manual quotations whenever 
it has reason to believe that it is not capable of displaying automated 
quotations; and (4) has adopted reasonable standards limiting when its 
quotations change from automated quotations to manual quotations, and 
vice versa, to specifically defined circumstances that promote fair and 
efficient access to its automated quotations and are consistent with 
the maintenance of fair and orderly markets. The requirement of 
reasonable standards for switching the automated/manual status of 
quotations is designed to preclude practices that would cause confusion 
among market participants concerning the status of a trading center's 
quotations or that would inappropriately advantage the members or 
customers of a trading center at the expense of the public.
    The third element of the definition of ``protected bid'' and 
``protected offer'' identifies which automated quotations are protected 
under the Order Protection Rule. Specifically, Rule 600(b)(57) provides 
that an automated quotation displayed by an automated trading center 
that is the BBO of an exchange SRO, the BBO of Nasdaq, or the BBO of 
the NASD (i.e., the ADF) qualifies as a protected quotation. Thus, only 
a single, accessible best bid and best offer for each of the exchange 
SROs, Nasdaq, and the NASD is protected under the Order Protection 
Rule. A best bid and best offer must be accessible by routing an order 
to a single market destination (i.e., currently, either to a single 
exchange execution system, a single Nasdaq execution system, or a 
single ADF participant).
2. Requirement of Reasonable Policies and Procedures
    Paragraph (a)(1) of Rule 611 requires a trading center to 
establish, maintain, and enforce written policies and procedures that 
are reasonably designed to prevent trade-throughs on that trading 
center of protected quotations in NMS stocks that do not fall within an 
exception set forth in paragraph (b) of Rule 611 and, if relying on 
such an exception, that are reasonably designed to assure compliance 
with the terms of the exception.\314\ In addition, paragraph (a)(2) of 
Rule 611 requires a trading center to regularly surveil to ascertain 
the effectiveness of the policies and procedures required by paragraph 
(a)(1) and to take prompt action to remedy deficiencies in such 
policies and procedures.
---------------------------------------------------------------------------

    \314\ The Commission has modified the language of Rule 611(a)(1) 
to make clear that a trading center's policies and procedures must 
only be reasonably designed to prevent trade-throughs on its own 
trading center of protected quotations in NMS stocks that do not 
fall within an exception set forth in paragraph (b) of Rule 611 and, 
if relying on such an exception, that are reasonably designed to 
assure compliance with the terms of the exception.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the Commission believes it 
would be inappropriate to implement a complete prohibition against any 
trade-throughs, particularly given the realities of intermarket trading 
and order-routing in many high-volume NMS stocks,\315\ and has not 
adopted such an approach. In this trading environment, despite 
reasonable attempts to prevent them, false positive or accidental 
trade-throughs may result from timing discrepancies resulting from 
technology limitations, latencies in the delivery and receipt of 
quotation updates, and data discrepancies. The requirement of written 
policies and procedures, as well as the responsibility assigned to 
trading centers to regularly surveil to ascertain the effectiveness of 
their procedures and take prompt remedial steps, is designed to achieve 
the objective of eliminating all trade-throughs that reasonably can be 
prevented, while also recognizing the inherent difficulties of 
eliminating trade-through transactions that, despite a trading center's 
reasonable efforts, may occur.
---------------------------------------------------------------------------

    \315\ Proposing Release, 69 FR at 11137 (noting the problem of 
``false positive'' trade-throughs caused by rapidly changing 
quotations, even when a trading center took reasonable precautions 
to prevent trade-throughs).
---------------------------------------------------------------------------

    In the Reproposing Release, the Commission requested comment on 
whether this approach would be sufficient to address enforceability 
concerns. Several commenters expressed a concern about the significant 
burden that would be placed on market participants to prove compliance 
and defend each execution that appears to be a trade-through (i.e., 
they could be presumed to have violated the Rule unless they can prove 
they did not), particularly in light of the significant number of false 
positives that are likely to result.\316\ The Commission

[[Page 37535]]

recognizes this concern and intends to work closely with industry 
participants during the implementation period for the Order Protection 
Rule to provide useful and practical guidance for trading centers on 
the policies and procedures needed to comply with the Rule.
---------------------------------------------------------------------------

    \316\ Morgan Stanley Reproposal Letter at 15; Letter from David 
Cummings, Chief Executive Officer, Tradebot Systems, Inc., to 
Jonathan G. Katz, Secretary, Commission, dated January 26, 2005 
(``Tradebot Reproposal Letter'') at 1; UBS Reproposal Letter at 5 
(expressing the view that the Rule would be unenforceable).
---------------------------------------------------------------------------

    At a minimum, a trading center's policies and procedures must 
enable the trading center (and persons responsible for transacting on 
its market, such as specialists) to monitor, on a real-time basis, the 
protected quotations displayed by other trading centers so as to 
determine the prices at which the trading center can and cannot execute 
trades. In addition, a trading center's policies and procedures must 
establish objective standards and parameters governing its use of the 
exceptions set forth in Rule 611(b). A trading center's automated 
order-handling and trading systems must be programmed in accordance 
with these policies and procedures. Finally, the trading center must 
take such steps as are necessary to enable it to enforce its policies 
and procedures effectively. For example, trading centers will need to 
establish procedures such as regular exception reports to evaluate 
their trading and order-routing practices. Such reports will need to be 
examined to affirm that a trading center's policies and procedures have 
been followed by its personnel and properly coded into its automated 
systems and, if not, to promptly identify the reasons and take remedial 
action.
    Of course, surveillance is an important component of a trading 
center's satisfaction of its legal obligations. In the context of Rule 
611, paragraph (a)(2) of the Rule reinforces the ongoing maintenance 
and enforcement requirements of paragraph (a)(1) of the Rule by 
explicitly assigning an affirmative responsibility to trading centers 
to surveil to ascertain the effectiveness of their policies and 
procedures. Trading centers cannot merely establish policies and 
procedures that may be reasonable when created and assume that such 
policies and procedures continue to satisfy the requirements of Rule 
611. Rather, trading centers must regularly assess the continuing 
effectiveness of their procedures and take prompt action when needed to 
remedy deficiencies. In particular, trading centers must engage in 
regular and periodic surveillance to determine whether trade-throughs 
are occurring without an applicable exception and whether they have 
failed to implement and maintain policies and procedures that would 
have reasonably prevented such trade-throughs.
    As a further means to bolster compliance with the Order Protection 
Rule, the Commission has instructed its staff to develop for our 
consideration and for notice and comment a rule proposal that would 
require trading centers to publicly disclose standardized and 
comparable statistics on the incidence of trade-through transactions 
that do not fall within an exception to the Rule. Such industry-wide 
statistics would promote greater public accountability by trading 
centers for the quality of their policies and procedures. The 
statistics also would be helpful for trading centers, as well as 
regulatory authorities, in assessing the reasonableness and 
effectiveness of the policies and procedures adopted by various trading 
centers. In particular, a trading center that generated a materially 
higher rate of trade-throughs than other comparable trading centers 
would need to closely evaluate the types of policies and procedures 
used by the other trading centers as a means to upgrade its own 
policies and procedures. On the other hand, the fact that many trading 
centers generated comparable rates of trade-throughs would not shield 
them from a violation of the Order Protection Rule if a material number 
of the trade-through transactions could reasonably have been prevented 
by the use of particular policies and procedures. In general, the 
Commission preliminarily believes that comparable, industry-wide 
statistics on trade-throughs would provide a valuable resource to 
identify the most effective policies and procedures and to promote 
their use by all relevant trading centers.
3. Exceptions
    Rule 611(b) sets forth a variety of exceptions addressing 
transactions that may fall within the definition of a trade-through, 
but which are not subject to the operative requirements of the Rule. 
The exceptions primarily are designed to achieve workable intermarket 
price protection and to facilitate certain trading strategies and order 
types that are useful to investors, but also are consistent with the 
principle of price protection.\317\
---------------------------------------------------------------------------

    \317\ Several commenters recommended that the consolidated tape 
should identify trades that were executed and reported pursuant to 
an exception to the Rule. See, e.g., Citigroup Reproposal Letter at 
7; SIA Reproposal Letter at 17. The Commission agrees that increased 
transparency would be greatly beneficial. Such identification would 
give market participants and investors timely notice that a trade 
qualified for an exception and was not a true trade-through. The 
Commission therefore intends to request that the market data Plans 
explore the feasibility of identifying trade-through exceptions. It 
also intends to initiate a discussion with the Plans on shortening 
the current 90-second time frame for reporting trades in light of 
current technology and trading practices. Reporting trades in 
substantially less than 90 seconds would reduce the number of trades 
that are reported out of sequence, thus improving the accuracy and 
reliability of the consolidated trade stream and helping to reduce 
the false appearance of trade-throughs.
---------------------------------------------------------------------------

    Paragraph (b)(1) excepts a transaction if the trading center 
displaying the protected quotation that was traded through was 
experiencing a failure, material delay, or malfunction of its systems 
or equipment when the trade-through occurred. As discussed in section 
II.A.3 above, the exception for a ``material delay'' gives trading 
centers a self-help remedy if another trading center repeatedly fails 
to provide an immediate response (within one second) to incoming orders 
attempting to access its quotes. The trading center receiving an order 
can only be held responsible for its own turnaround time (i.e., from 
the time it first received an order to the time it transmits a response 
to the order). Accordingly, the routing trading center will be required 
to develop policies and procedures that allow for any potential delays 
in transmission not attributable to the receiving trading center. The 
exception in paragraph (b)(1) also covers any failure or malfunction of 
a trading center's systems or equipment, as well as any material delay.
    Trading centers will need to establish specific objective 
parameters governing their use of the ``self-help'' exemption as part 
of their reasonable policies and procedures. For example, a single 
failure to respond within one second generally will not justify future 
bypassing of another trading center's quotations. Many failures to 
respond within one second in a short time period, in contrast, clearly 
will warrant use of the exception. A trading center making use of the 
exception must notify the non-responding trading center immediately 
after (or at the same time as) electing this exception pursuant to 
reasonable and objective standards contained in its policies and 
procedures.\318\
---------------------------------------------------------------------------

    \318\ For instance, a trading center may wish to use electronic 
mail to make this notification.
---------------------------------------------------------------------------

    Paragraph (b)(8) of Rule 611 sets forth an exception for flickering 
quotations. It excepts a transaction if the trading center displaying 
the protected quotation that was traded through had displayed, within 
one second prior to execution of the trade-through, a best bid or best 
offer, as applicable, for the

[[Page 37536]]

NMS stock with a price that was equal or inferior to the price of the 
trade-through transaction. This exception thereby provides a ``window'' 
to address false indications of trade-throughs that in actuality are 
attributable to rapidly moving quotations. It also potentially will 
reduce the number of instances in which a trading center must alter its 
normal trading procedures and route orders to other trading centers to 
comply with Rule 611. The exception is thereby intended to promote more 
workable intermarket price protection.
    Paragraphs (b)(5) and (b)(6) of Rule 611 set forth exceptions for 
intermarket sweep orders. An intermarket sweep order is defined in Rule 
600(b)(30) as a limit order \319\ that meets the following 
requirements: (1) When routed to a trading center, the limit order is 
identified as an intermarket sweep order; and (2) simultaneously with 
the routing of the limit order identified as an intermarket sweep 
order, one or more additional limit orders, as necessary, are routed to 
execute against the full displayed size of all protected quotations 
with a superior price. These additional limit orders must be marked as 
intermarket sweep orders to allow the receiving market center to 
execute the order immediately without regard to better-priced 
quotations displayed at other trading centers (by definition, each of 
the additional limit orders would meet the requirements for an 
intermarket sweep order).
---------------------------------------------------------------------------

    \319\ Such a limit order would be ``marketable'' because it 
would be immediately subject to execution at current displayed 
prices. Consequently, ``limit order'' is used differently in this 
context than elsewhere in this release, where it is used to refer to 
non-marketable orders that generally will be displayed, in contrast 
to marketable orders that generally will not be displayed. See 
supra, note 53 (description of marketable limit orders and non-
marketable limit orders).
---------------------------------------------------------------------------

    Paragraph (b)(5) allows a trading center immediately to execute any 
order identified as an intermarket sweep order. It therefore need not 
delay its execution for the updating of the better-priced quotations at 
other trading centers to which orders were routed simultaneously with 
the intermarket sweep order. Paragraph (b)(6) allows a trading center 
itself to route intermarket sweep orders and thereby clear the way for 
immediate internal executions at the trading center. This exception 
particularly will facilitate the immediate execution of block orders by 
dealers on behalf of their institutional clients. Specifically, if a 
dealer wishes to execute internally a customer order at a price that 
would trade through one or more protected quotations on other trading 
centers, the dealer will be able to do so if it simultaneously routes 
one or more intermarket sweep orders to execute against the full 
displayed size of each such better-priced protected quotations. If 
there is only one better-priced protected quotation, then the dealer is 
only required to route an intermarket sweep order to execute against 
that protected quotation.
    Paragraph (c) of Rule 611 requires that the trading center, broker, 
or dealer responsible for the routing of an intermarket sweep order 
take reasonable steps to establish that orders are properly routed in 
an attempt to execute against all applicable protected quotations. A 
trading center, broker, or dealer is required to satisfy this 
requirement regardless whether it routes the order through its own 
systems or sponsors a customer's access through a third-party vendor's 
systems.
    To illustrate the operation of the intermarket sweep order 
exception, assume that a broker-dealer's customer wished to sell a 
large amount of an NMS stock. Trading Center A is displaying the 
national best bid of 500 shares at $10.00, along with quotations in its 
proprietary depth-of-book data feed of 1500 shares at $9.99, and 5000 
shares at $9.97. The customer decides to sweep all liquidity on Trading 
Center A down to $9.97. Assume also that Trading Center B is displaying 
a protected bid of 2000 shares at $9.99, Trading Center C is displaying 
a protected bid of 400 shares at $9.98, and Trading Center D is 
displaying a protected bid of 200 shares at $9.97. The broker-dealer 
could execute this trade for its customer, subject to its best 
execution responsibilities, by simultaneously routing the following 
orders: (1) An intermarket sweep order to Trading Center A with a limit 
price of $9.97 and a size of 7000 shares; (2) an intermarket sweep 
order to Trading Center B with a limit price of $9.99 and a size of 
2000 shares; and (3) an intermarket sweep order to Trading Center C 
with a limit price of $9.98 and a size of 400 shares. All of these 
orders would meet the requirements of Rule 600(b)(30) because the 
necessary orders simultaneously were routed to execute against the 
displayed size of all better-priced protected quotations. Trading 
Centers A, B, and C all could execute their orders immediately without 
regard to the protected quotations displayed at other trading centers. 
No order would need to be routed to Trading Center D because the price 
of its bid was not superior to the most inferior limit price of the 
order routed to Trading Center A. Assuming the customer obtained a fill 
for each of its orders at the displayed prices and sizes,\320\ it would 
have been able to obtain an immediate execution of a 9400-share trade 
by sweeping through four price levels at Trading Center A, while also 
honoring the protected quotations at two other trading centers.\321\ 
The trade therefore would have both upheld the principle of price 
protection and served the customer's legitimate interest in obtaining 
an immediate execution of large size.
---------------------------------------------------------------------------

    \320\ An intermarket sweep order could go unfilled because the 
protected quotation at a trading center was accessed or withdrawn 
prior to the trading center's receipt of the intermarket sweep 
order. In addition, the existence of undisplayed orders or reserve 
size at some trading centers could result in an execution at better 
prices than may have been indicated by the displayed prices and 
sizes. The router of an intermarket sweep order would only be 
responsible, however, for routing orders in accordance with the 
displayed price and size of protected quotations. Whether the orders 
actually execute against the protected quotations, or go unfilled 
because the quotations have been previously executed or withdrawn, 
is not within the responsibility or control of the router of the 
intermarket sweep order.
    \321\ If a trading center has routed intermarket sweep orders to 
access the full displayed size of protected quotations under the 
Order Protection Rule, it will be allowed to continue trading 
without regard to a particular trading center's quotations until it 
has received a response from such trading center. See supra, note 
194.
---------------------------------------------------------------------------

    The exception in paragraph (b)(7) of Rule 611 will facilitate other 
types of orders that often are useful to investors--benchmark orders. 
It excepts the execution of an order at a price that was not based, 
directly or indirectly, on the quoted price of an NMS stock at the time 
of execution and for which the material terms were not reasonably 
determinable at the time the commitment to execute the order was made. 
A common example of a benchmark order is a VWAP order. Assume a broker-
dealer's customer decides to buy a stock at 9 a.m. before the markets 
open for normal trading. The customer submits, and the broker-dealer 
accepts, an order to buy 100,000 shares at the volume-weighted average 
price of the stock from opening until 1 p.m. At 1 p.m., the national 
best offer in the stock is $20.00, but the relevant volume-weighted 
average price (in a rising market) is $19.90. The broker-dealer would 
be able to rely on the benchmark order exception to execute the order 
at $19.90 at 1 p.m., without regard to better-priced protected 
quotations at other trading centers. Of course, any transactions 
effected by the broker-dealer during the course of the day to obtain 
sufficient stock to fill the benchmark order would remain subject to 
Rule 611. The benchmark exception also would encompass the execution of 
an order that is benchmarked to a market's single-priced opening, as 
the

[[Page 37537]]

Commission would not interpret such an opening price to be the ``quoted 
price'' of the NMS stock at the time of execution.
    Paragraph (b)(9) of Rule 611 provides an exception for the 
execution of certain stopped orders.\322\ Specifically, the exception 
applies to the execution by a trading center of a stopped order where 
the price of the execution of the order was, for a stopped buy order, 
lower than the national best bid at the time of execution or, for a 
stopped sell order, higher than the national best offer at the time of 
execution.\323\ To illustrate the operation of this requirement, assume 
that a dealer's customer wished to buy a large amount of an NMS stock. 
Assume further that the dealer has agreed to guarantee execution of the 
order at an average price no worse than $10.12 (the stop price), and 
that the national best bid and offer for the stock at the time was 
10.05 to 10.07. If the dealer buys on behalf of the customer until half 
of the order is completed and has averaged 10.10 to that point, but the 
national best bid and offer for the stock is then 10.15 to 10.17, the 
dealer would be obligated to execute the remainder of the order by 
selling to the customer at 10.14 to average 10.12 for the entire order. 
The exception in paragraph (b)(9) of Rule 611 permits the dealer to 
execute the remainder at 10.14 without being obligated to route to all 
protected bids at 10.15. In addition, to qualify for the exception, the 
stopped order must be for the account of a customer \324\ and the 
customer must have agreed to the ``stop'' price on an order-by-order 
basis.\325\ The Commission notes that any individual transactions 
executed by the dealer in the market for the customer must be executed 
in compliance with Rule 611.
---------------------------------------------------------------------------

    \322\ See section II.A.4.b and notes 251 to 257 and accompanying 
text above for a discussion of this exception.
    \323\ Rule 611(b)(9)(iii).
    \324\ Rule 611(b)(9)(i). Customer is defined in Rule 600(b)(16) 
as any person that is not a broker or dealer.
    \325\ Rule 611(b)(9)(ii).
---------------------------------------------------------------------------

    Finally, paragraph (b) of Rule 611 includes a variety of other 
exceptions: (1) Transactions other than ``regular way'' contracts; 
\326\ (2) single-price opening, reopening, or closing transactions; 
\327\ and (3) transactions executed at a time when protected quotations 
were crossed.\328\ The crossed quotation exception would not apply when 
a protected quotation crosses a non-protected (e.g., manual) 
quotation.\329\ The exception for single-priced reopenings will only 
apply to single-priced reopening transactions after a trading halt 
conducted pursuant to a trading center rule. To qualify, the reopening 
process must be transparent and provide for the queuing and ultimate 
execution of multiple orders at a single equilibrium price.\330\
---------------------------------------------------------------------------

    \326\ Rule 611(b)(2). ``Regular way'' refers to bids, offers, 
and transactions that embody the standard terms and conditions of a 
market. Thus, this exception applies to a transaction that was 
executed other than pursuant to standardized terms and conditions, 
for instance a transaction that has extended settlement terms.
    \327\ Rule 611(b)(3).
    \328\ Rule 611(b)(4).
    \329\ Id.
    \330\ See supra, section II.A.2.b for a discussion of this 
exception.
---------------------------------------------------------------------------

4. Duty of Best Execution
    Several commenters on the original proposal who supported excluding 
manual quotations from trade-through protection also suggested that 
manual quotations should be excluded from the NBBO that is calculated 
and disseminated by Plan processors.\331\ Under this approach, market 
participants could disregard manual quotations for purposes of 
assessing the best execution of customer orders and calculating 
execution quality statistics under Rule 11Ac1-5 (redesignated as Rule 
605 of Regulation NMS). The Reproposing Release did not propose to 
eliminate manual quotations from the NBBO and emphasized that adoption 
of Rule 611 would not lessen a broker-dealer's duty of best 
execution.\332\ Noting the common business practice of market makers to 
use the NBBO to price investors orders (particularly retail orders), 
the Reproposing Release expressed concern that eliminating manual 
quotations from the NBBO potentially would widen the spreads in many 
stocks, even though the quotations often may in fact represent the best 
indication of the current market price of the stock.
---------------------------------------------------------------------------

    \331\ See, e.g., Citigroup Letter at 3, 6; Goldman Sachs Letter 
at 5-6; Morgan Stanley Letter at 2-3, 7; SIA Letter at 13.
    \332\ Reproposing Release, 69 FR at 77447.
---------------------------------------------------------------------------

    In response to the Reproposing Release, some commenters continued 
to assert that manual quotations should be excluded from the NBBO.\333\ 
They believed that that it would be inconsistent and unreasonable to 
distinguish between automated and manual quotations for purposes of 
trade-through protection, market data revenue, access fees, and 
requirements regarding locked and crossed markets, but not to remove 
such quotations from the calculation of the NBBO.\334\ They argued that 
including manual quotations in the benchmark against which a broker-
dealer's best execution responsibility is judged provides an unfair 
standard of comparison, particularly to the extent manual quotations 
are not accessible.\335\ Several commenters requested that, at a 
minimum, the Commission clarify a broker-dealer's duty of best 
execution with respect to manual quotations.\336\ Another commenter 
suggested that manual quotations be removed from the NBBO when the 
manual market is not the primary market.\337\
---------------------------------------------------------------------------

    \333\ See, e.g., Ameritrade Reproposal Letter at 7; ATD 
Reproposal Letter at 7; Citigroup Reproposal Letter at 8; Knight 
Reproposal Letter at 6; Madoff Reproposal Letter at 2-3; Morgan 
Stanley Reproposal Letter at 12; SIA Reproposal Letter at 3, 14-15; 
STANY Reproposal Letter at 10-11; UBS Reproposal Letter at 6.
    \334\ See, e.g., ATD Reproposal Letter at 6; Citigroup 
Reproposal Letter at 8; Madoff Reproposal Letter at 4.
    \335\ See, e.g., Citigroup Reproposal Letter at 8; Knight 
Reproposal Letter at 6; STANY Reproposal Letter at 11.
    \336\ Ameritrade Reproposal Letter at 7-8; Merrill Lynch 
Reproposal Letter at 8; SIA Reproposal Letter at 15.
    \337\ ATD Reproposal Letter at 7.
---------------------------------------------------------------------------

    The Commission continues to be concerned that eliminating all 
manual quotations from the NBBO would exclude not only inaccessible 
manual quotations, but also manual quotations that truly establish the 
best available price for a stock, particularly for those stocks with 
relatively small trading volume in which a manual market has a dominant 
share of trading. Such a result could lead to decreased execution 
quality for investors in these stocks by allowing broker-dealers to 
ignore the best available quotations when executing customer orders. 
The Commission therefore is not at this time excluding manual 
quotations from the NBBO or from the benchmark used for calculating 
execution quality statistics under Rule 605.
    The Commission continues to emphasize that adoption of Rule 611 in 
no way lessens a broker-dealer's duty of best execution. A broker-
dealer has a legal duty to seek to obtain best execution of customer 
orders.\338\ According to the Report of the Special Study of Securities 
Markets, ``[t]he integrity of the industry can be maintained only if 
the fundamental principle that a customer should at all times get the 
best available price which

[[Page 37538]]

can reasonably be obtained for him is followed.'' \339\ A broker-
dealer's duty of best execution derives from common law agency 
principles and fiduciary obligations, and is incorporated in SRO rules 
and, through judicial and Commission decisions, the antifraud 
provisions of the federal securities laws.\340\
---------------------------------------------------------------------------

    \338\ See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & 
Smith, Inc., 135 F.3d 266, 269-70, 274 (3d Cir.), cert. denied, 525 
U.S. 811 (1998); Certain Market Making Activities on Nasdaq, 
Securities Exchange Act Release No. 40900 (Jan. 11, 1999) (settled 
case) (citing Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971); Arleen 
Hughes, 27 SEC 629, 636 (1948), aff'd sub nom. Hughes v. SEC, 174 
F.2d 969 (D.C. Cir. 1949)). See also Order Execution Obligations, 
Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 
48290 (Sept. 12, 1996) (``Order Handling Rules Release'').
    \339\ H.R. Doc. No. 95, 88th Cong., 1st Sess. Pt. II, 624 
(1963).
    \340\ Order Handling Rules Release, 61 FR at 48322. See also 
Newton, 135 F.3d at 270. Failure to satisfy the duty of best 
execution can constitute fraud because a broker-dealer, in agreeing 
to execute a customer's order, makes an implied representation that 
it will execute it in a manner that maximizes the customer's 
economic gain in the transaction. See Newton, 135 F.3d at 273 
(``[T]he basis for the duty of best execution is the mutual 
understanding that the client is engaging in the trade--and 
retaining the services of the broker as his agent--solely for the 
purpose of maximizing his own economic benefit, and that the broker 
receives her compensation because she assists the client in reaching 
that goal.''); Marc N. Geman, Securities Exchange Act Release No. 
43963 (Feb. 14, 2001) (citing Newton, but concluding that respondent 
fulfilled his duty of best execution). See also Payment for Order 
Flow, Securities Exchange Act Release No. 34902 (Oct. 27, 1994), 59 
FR 55006, 55009 (Nov. 2, 1994) (``Payment for Order Flow Final 
Rules''). If the broker-dealer intends not to act in a manner that 
maximizes the customer's benefit when he accepts the order and does 
not disclose this to the customer, the broker-dealer's implied 
representation is false. See Newton, 135 F.3d at 273-274.
---------------------------------------------------------------------------

    The duty of best execution requires broker-dealers to execute 
customers' trades at the most favorable terms reasonably available 
under the circumstances, i.e., at the best reasonably available 
price.\341\ The Commission has not viewed the duty of best execution as 
inconsistent with the automated routing of orders or requiring 
automated routing on an order-by-order basis to the market with the 
best quoted price at the time. Rather, the duty of best execution 
requires broker-dealers to periodically assess the quality of competing 
markets to assure that order flow is directed to the markets providing 
the most beneficial terms for their customer orders.\342\ Broker-
dealers must examine their procedures for seeking to obtain best 
execution in light of market and technology changes and modify those 
practices if necessary to enable their customers to obtain the best 
reasonably available prices.\343\ In doing so, broker-dealers must take 
into account price improvement opportunities, and whether different 
markets may be more suitable for different types of orders or 
particular securities.\344\
---------------------------------------------------------------------------

    \341\ Newton, 135 F.3d at 270. Newton also noted certain factors 
relevant to best execution--order size, trading characteristics of 
the security, speed of execution, clearing costs, and the cost and 
difficulty of executing an order in a particular market. Id. at 270 
n. 2 (citing Payment for Order Flow, Exchange Act Release No. 33026 
(Oct. 6, 1993), 58 FR 52934, 52937-38 (Oct. 13, 1993) (Proposed 
Rules)). See In re E.F. Hutton & Co. (``Manning''), Securities 
Exchange Act Release No. 25887 (July 6, 1988). See also Payment for 
Order Flow Final Rules, 59 FR at 55008-55009.
    \342\ Order Handling Rules Release, 61 FR at 48322-48333 (``In 
conducting the requisite evaluation of its internal order handling 
procedures, a broker-dealer must regularly and rigorously examine 
execution quality likely to be obtained from different markets or 
market makers trading a security.''). See also Newton, 135 F.3d at 
271; Market 2000: An Examination of Current Equity Market 
Developments V-4 (SEC Division of Market Regulation January 1994) 
(``Without specific instructions from a customer, however, a broker-
dealer should periodically assess the quality of competing markets 
to ensure that its order flow is directed to markets providing the 
most advantageous terms for the customer's order.''); Payment for 
Order Flow Final Rules, 59 FR at 55009.
    \343\ Order Handling Rules, 61 FR at 48323.
    \344\ Order Handling Rules, 61 FR at 48323. For example, in 
connection with orders that are to be executed at a market opening 
price, ``[b]roker-dealers are subject to a best execution duty in 
executing customer orders at the opening, and should take into 
account the alternative methods in determining how to obtain best 
execution for their customer orders.'' Disclosure of Order Execution 
and Routing Practices, Securities Exchange Act Release No. 43590 
(Nov.17, 2000), 65 FR 75414, 75422 (Dec. 1, 2000) (adopting new 
Exchange Act Rules 11Ac1-5 and 11Ac1-6 and noting that alternative 
methods offered by some Nasdaq market centers for pre-open orders 
included the mid-point of the spread or at the bid or offer).
---------------------------------------------------------------------------

    The protection against trade-throughs required of trading centers 
by Rule 611 undergirds the broker-dealer's duty of best execution, by 
helping ensure that customer orders are not executed at prices inferior 
to the best protected quotations. Nonetheless, the Order Protection 
Rule does not supplant or diminish the broker-dealer's responsibility 
for achieving best execution, including its duty to evaluate the 
execution quality of markets to which it routes customer orders, 
regardless of the exceptions set forth in the Rule.
    At the same time, however, the Commission recognizes the validity 
of concerns expressed by commenters with respect to the need for 
guidance concerning their best execution responsibilities after 
implementation of Regulation NMS. As they do today, broker-dealers will 
continue to be able to assess the level of accessibility and 
availability of manual quotations in making their best execution 
determinations. In particular, when the market for a stock is dominated 
by trading centers that display automated quotations, and a trading 
center that is not a dominant market for the stock displays manual 
quotations, a broker-dealer reasonably could determine, as part of its 
regular and rigorous review of execution quality, to bypass such a 
market with manual quotations in the particular stock if its prior 
experience demonstrated that attempting to access the market would not 
be in its customers' best interest. In making its assessment the 
broker-dealer would be entitled to consider both the likelihood of 
receiving an execution at displayed prices and the potential cost to 
its customers of failed attempts. The Commission also emphasizes that 
any trading center posting quotations, whether automated or manual, in 
the public quotation stream has a responsibility to be firm for its 
quotations pursuant to Rule 602.

III. Access Rule

    For the NMS to fulfill its statutory objectives, fair and efficient 
access to each of the individual markets that participate in the NMS is 
essential. One of the statutory NMS objectives, for example, is to 
assure the practicability of brokers executing investors' orders in the 
best market.\345\ Another is to assure the efficient execution of 
securities transactions.\346\ Clearly, neither of these objectives can 
be achieved if brokers cannot fairly and efficiently route orders to 
execute against the best quotations for a stock, wherever such 
quotations are displayed in the NMS. In 1975, Congress determined that 
the ``linking of all markets'' for NMS stocks through communications 
and data processing facilities would ``foster efficiency; enhance 
competition; increase the information available to brokers, dealers, 
and investors; facilitate the offsetting of investors' orders; and 
contribute to the best execution of investors' orders.'' \347\ Since 
1975, there have been dramatic improvements in communications and 
processing technologies. Rule 610 is intended to capitalize on these 
improvements and thereby enhance the ``linking of all markets'' for the 
future NMS.
---------------------------------------------------------------------------

    \345\ Section 11A(a)(1)(C)(iv) of the Exchange Act.
    \346\ Section 11A(a)(1)(C)(i) of the Exchange Act.
    \347\ Section 11A(a)(1)(D) of the Exchange Act.
---------------------------------------------------------------------------

    All SROs that trade exchange-listed stocks currently are linked 
through ITS, a collective intermarket linkage facility. ITS provides a 
means of access to exchanges and Nasdaq by permitting each market to 
send a ``commitment to trade'' through the system, with receiving 
markets generally having up to 30 seconds to respond.\348\ ITS also 
provides access to quotations of participants without fees and 
establishes uniform rules to govern quoting practices.\349\ Although 
ITS promotes access among participants that is uniform and free, it 
also is often slow

[[Page 37539]]

and limited. Moreover, it is governed by a unanimous vote requirement 
that has at times impeded innovation in the system or its set of rules.
---------------------------------------------------------------------------

    \348\ ITS Plan, Section 6(b)(i).
    \349\ ITS Plan, Sections 6(b), 8(d), and 11(b).
---------------------------------------------------------------------------

    In contrast, there is no collective intermarket linkage system for 
Nasdaq stocks. Instead, access is achieved primarily through private 
linkages among individual trading centers. This approach has 
demonstrated its benefits among electronic markets; it is flexible and 
can readily incorporate technological advances as they occur. There is 
no intermarket system, however, that offers free access to quotations 
in Nasdaq stocks. Nor are the trading centers for Nasdaq stocks subject 
to uniform intermarket standards governing their quoting and trading 
practices. The fees for access to ECN quotations in Nasdaq stocks, as 
well as the absence of standards for quotations that lock and cross 
markets, have been the source of disputes among participants in the 
market for Nasdaq stocks for many years. Moreover, access problems have 
arisen with respect to small market centers operating outside of an SRO 
trading facility and markets like the Amex that engage in manual 
trading of Nasdaq stocks. Access problems also have arisen with respect 
to intentional barriers to access, especially involving fees.
    Rule 610 reflects the Commission's determination that fair and 
efficient access to markets can be achieved without a collective 
intermarket linkage facility such as ITS, if baseline intermarket 
access rules are established.\350\ The rule adopts a private linkage 
approach for all NMS stocks with modifications to address the most 
serious problems that have arisen with this approach in the trading of 
Nasdaq stocks. Rule 610 addresses three subject areas: (1) Means of 
access to quotations; (2) fees for access to protected quotations and 
any other quotations that are the best bid or best offer of an 
exchange, The NASDAQ Market Center, or the NASD's ADF; and (3) locking 
and crossing quotations.\351\ In response to comments on the 
reproposal, the Commission is modifying the fee limitation to apply to 
any quotation at the best bid or offer as well as protected 
quotations.\352\ In addition, the Commission is modifying the fair 
access requirements of Regulation ATS to extend their application to 
ATSs with 5% of trading volume in a security.\353\
---------------------------------------------------------------------------

    \350\ With the implementation of Rule 610, the Commission 
believes that SROs can withdraw from the ITS Plan, assuming they 
have otherwise arranged to meet their access responsibilities.
    \351\ The Commission has modified the language of Rule 610(d) to 
require that an exchange or association ``establish, maintain, and 
enforce'' rules relating to certain locking and crossing activity, 
and to clarify that such rules must be written, to conform the 
language to the operative language of Rule 611(a)(1). See infra note 
455 and accompanying text.
    \352\ See infra, section III.A.2.
    \353\ The modification of Regulation ATS is discussed in section 
III.B.4 below.
---------------------------------------------------------------------------

A. Response to Comments and Basis for Adopted Rule

1. Means of Access to Quotations
    Paragraphs (a) and (b) of Rule 610 address means of access to 
quotations. Among the variety of services offered by equity markets, 
access to displayed quotations, particularly the best quotations of a 
trading center, is vital for the smooth functioning of intermarket 
trading. Brokers responsible for routing their customers' orders, as 
well as investors that make their own order-routing decisions, clearly 
must have fair and efficient access to the best displayed quotations of 
all trading centers to achieve best execution of those orders. In 
addition, trading centers themselves must have the ability to execute 
orders against the displayed quotations of other trading centers. 
Indeed, the very concept of intermarket protection against trade-
throughs is premised on the ability of trading centers to trade with, 
rather than trade through, the protected quotations displayed by other 
trading centers.
    Access to quotations, sometimes referred to as ``order execution 
access,'' \354\ should be distinguished from broader access to all of 
the different types of services offered by markets, such as the right 
to display limit orders or to submit complex order types. To obtain the 
full range of their services, markets generally require that an 
individual or firm become a member or subscriber of the market. This 
type of access, or ``membership access,'' subsumes access to quotations 
and is governed by particular regulatory requirements. Sections 6(b)(2) 
and 15A(b)(3) of the Exchange Act, for example, provide for fair access 
to membership in SROs. Similarly, Rule 301(b)(5) of Regulation ATS 
prohibits certain high volume ATSs from denying fair access to their 
services.\355\ Rules 610(a) and (b), in contrast, only address the 
responsibilities of trading centers to provide order execution access 
to their quotations.
---------------------------------------------------------------------------

    \354\ See Rule 301(b)(3) of Regulation ATS (order display and 
execution access requirements).
    \355\ As discussed in section III.B.4 below, the Commission is 
amending the fair access requirements of Regulation ATS to extend 
their application to ATSs with 5% of trading volume in a security.
---------------------------------------------------------------------------

    Rules 610(a) and (b) further the goal of fair and efficient access 
to quotations primarily by prohibiting trading centers from unfairly 
discriminating against non-members or non-subscribers that attempt to 
access their quotations through a member or subscriber of the trading 
center. Market participants can either become members or subscribers of 
a trading center to obtain direct access to its quotations, or they can 
obtain indirect access by ``piggybacking'' on the direct access of 
members or subscribers. These forms of access are widely used today in 
the market for Nasdaq stocks (as well as to a lesser extent in the 
market for exchange-listed stocks). Instead of every market participant 
establishing separate linkages with every trading center, many 
different private firms have entered the business of linking with a 
wide range of trading centers and then offering their customers access 
to those trading centers through the private firms' linkages. 
Competitive forces determine the types and costs of these private 
linkages.
    Most commenters supported this private linkage approach for access 
to quotations.\356\ They noted the success of private linkages among 
electronic markets for Nasdaq stocks and contrasted the speed and 
usefulness of those linkages with the ITS linkage for exchange-listed 
stocks. Morgan Stanley stated that ``[p]rivate linkages are much easier 
to establish and operate and can be constructed directly between [order 
execution facilities] or through market intermediaries. The smooth 
operation of the market for Nasdaq stocks today clearly demonstrates 
the power of private linkages.'' \357\ The NYSE concluded that ``[i]n 
the market for listed stocks, we believe that proposed Regulation NMS 
will provide the framework for alternatives to ITS for intermarket 
access.'' \358\ The SIA stated that ``[p]rivate linkages, as opposed to 
ITS-type linkages, will provide the flexibility--technologically and 
otherwise--that is vital to the continued development of the 
markets.\359\ Bloomberg expressed the belief that private linkages have 
proven to be effective in the market for Nasdaq securities and ``can 
readily, quickly and

[[Page 37540]]

inexpensively be adapted for use in exchange-listed securities,'' and 
even believed that ITS can be abandoned.\360\
---------------------------------------------------------------------------

    \356\ See, e.g., Citigroup Letter at 12; Consumer Federation 
Letter at 4; Goldman Sachs Letter at 4; ICI Letter at 16-17; Morgan 
Stanley Letter at 17; Nasdaq Letter II at 20; NYSE Letter, 
Attachment at 6; Letter from Carrie E. Dwyer, General Counsel & 
Executive Vice President, Charles Schwab & Co., Inc., to Jonathan G. 
Katz, Secretary, Commission, dated June 30, 2004 (``Schwab Letter'') 
at 17; SIA Letter at 16; UBS Letter at 8.
    \357\ Morgan Stanley Letter at 17.
    \358\ NYSE Letter, Attachment at 7.
    \359\ SIA Reproposal Letter at 21.
    \360\ Bloomberg Reproposal Letter at 7-8.
---------------------------------------------------------------------------

    A few commenters opposed the proposed private linkages 
approach.\361\ Some questioned whether multiple private linkages could 
match the efficiency of a single, uniform intermarket linkage, although 
they generally emphasized that the current ITS linkage needed to be 
enhanced. The Alliance of Floor Brokers, for example, suggested that 
problems with the ITS linkage, such as its slow speed and lack of 
structural flexibility, ``should be addressed before it is determined 
to replace it with some, as yet unspecified, routing methodology or 
mechanism.'' \362\ While agreeing that private linkages could promote 
access if they were not the sole means of communications between 
trading facilities and trading centers, and that ITS' ``archaic 
technology and restrictive membership provisions actively limit 
access,'' NexTrade contended that private linkages, if used to replace 
existing and universal industry links, could reduce total access.\363\ 
STANY believed that the Commission vastly underestimated the access 
issues represented by the proposal, and raised a number of concerns 
regarding the costs and feasibility of implementing the private linkage 
approach, including issues relating to software, hardware, maintenance, 
and protocols.\364\
---------------------------------------------------------------------------

    \361\ See, e.g., Letter from Brendan R. Dowd, Daniel W. Tandy & 
Ronald Zdrojeski, Alliance of Floor Brokers, to Jonathan G. Katz, 
Secretary, Commission, dated June 24, 2004 (``Alliance of Floor 
Brokers Letter'') at 2; Ameritrade Letter I, Appendix at 11; BSE 
Letter at 7; CHX Letter at 13; E*Trade Letter at 9.
    \362\ Alliance of Floor Brokers Letter at 2.
    \363\ NexTrade Reproposal Letter at 4.
    \364\ STANY Reproposal Letter at 3.
---------------------------------------------------------------------------

    The Commission has carefully considered the views of all the 
commenters. The Commission agrees with the commenters that stated that 
private linkages currently work well in the market for Nasdaq 
securities.\365\ The Commission believes that the benefits of private 
linkages, including their flexibility to meet the needs of different 
market participants and the scope they allow for competitive forces to 
determine linkages, justifies reliance on this model rather than a 
single intermarket linkage. Recognizing, however, that the adoption of 
the Order Protection Rule increases the importance of efficient access 
to each trading center, particularly with respect to access to ADF 
participants, the requirements in the Rule are designed to mitigate 
concerns about the cost of access to ADF participants, as discussed 
below. In addition, the Commission believes, given the significant 
number and variety of entities that currently provide access services 
and the competitive nature of the market for these services, that 
competition will be sufficient to provide routing services for any 
trading center that chooses to utilize an outside vendor rather than 
incur costs associated with building its own linkages. One ECN, for 
example, can be accessed through five extranets and at least 21 other 
access providers, as well as through direct connections.\366\
---------------------------------------------------------------------------

    \365\ See, e.g., Bloomberg Reproposal Letter at 7-8; Brut Letter 
at 18; Letter from Richard M. Whiting, Executive Director and 
General Counsel, Financial Services Roundtable, to Jonathan G. Katz, 
Secretary, Commission, dated June 30, 2004 (``FSR Letter'') at 4; 
Merrill Lynch Reproposal Letter at 8; Nasdaq Letter II at 20.
    \366\ See www.nasdaqtrader.com/trader/ebrut/ourofferings/connectivity.shtm.
---------------------------------------------------------------------------

    Several commenters, including some that otherwise supported the 
proposal, expressed concern about particular problems that might arise 
under a private linkage approach.\367\ Some were concerned that 
requiring non-discriminatory access to markets might undermine the 
value of SRO membership. CHX stated that ``[b]y requiring the Exchange 
to grant non-members access to the full capabilities of its order 
execution systems, the Commission's fair access proposal would 
inappropriately require the Exchange's members to help fund the costs 
of operating a market that could be routinely used by non-members. It 
would severely undercut the value of membership and enable non-members 
to free-ride on the fees paid by members.'' \368\ Amex stated that ``to 
the extent that the proposed rule undermines our right to differentiate 
between members (who pay fees and have duties and responsibilities to 
the Exchange) and non-members in our charges, it could effectively 
remove any incentive for Amex membership.'' \369\
---------------------------------------------------------------------------

    \367\ Alliance of Floor Brokers Letter at 10; Amex Letter, 
Exhibit A at 25-26; BSE Letter at 12; CHX Letter at 14; Citigroup 
Letter at 12; Letter from Edith H. Hallahan, First Vice President, 
Deputy General Counsel, Philadelphia Stock Exchange, to Jonathan G. 
Katz, Secretary, Commission, dated August 10, 2004 (``Phlx Letter'') 
at 2; STANY Letter at 9.
    \368\ CHX Letter at 14.
    \369\ Amex Letter, Exhibit A at 26.
---------------------------------------------------------------------------

    The Commission does not believe that the private linkage approach 
adopted today will seriously undermine the value of membership in SROs 
that offer valuable services to their members. First, the fact that 
markets will not be allowed to impose unfairly discriminatory terms on 
non-members who obtain indirect access to quotations through members 
does not mean that non-members will obtain free access to quotations. 
Members who provide piggyback access to non-members will be providing a 
useful service and presumably will charge a fee for such service. The 
fee will be subject to competitive forces and likely will reflect the 
costs of SRO membership, plus some element of profit to the SRO's 
members. As a result, non-members that frequently make use of indirect 
access are likely to contribute indirectly to the costs of membership 
in the SRO market. Moreover, the unfair discrimination standard of Rule 
610(a) will apply only to access to quotations, not to the full panoply 
of services that markets generally provide only to their members. These 
other services will be subject to the more general fair access 
provisions applicable to SROs and large ECNs, as well as the statutory 
provisions that govern SRO rules.
    On the other hand, any attempt by an SRO to charge differential 
fees based on the non-member status of the person obtaining indirect 
access to quotations, such as whether it is a competing market maker, 
would violate the anti-discrimination standard of Rule 610. As noted 
above, fair and efficient access to quotes is essential to the 
functioning of the NMS. To comply with the Order Protection Rule and 
their duty of best execution, trading centers often may be required to 
access the quotations of other trading centers. If a trading center 
charged discriminatory fees to non-members, including competitors, 
accessing its quotations, this would interfere with the functioning of 
the private linkage approach and detract from its usefulness to trading 
centers in meeting their regulatory responsibilities.
    Other types of differential fees, however, would not violate the 
anti-discrimination standard of Rule 610. Fees with volume-based 
discounts or fees that are reasonably based on the cost of providing a 
particular service will be permitted, so long as they do not vary based 
on the non-member status of a person obtaining indirect access to 
quotations. For example, a member providing indirect access could be 
given a volume discount on the full amount of its volume, including the 
volume accounted for by persons obtaining indirect access to 
quotations.
    Another specific concern expressed by commenters about the private 
linkage approach was the cost and difficulty of building efficient 
linkages to trading centers with a small amount of trading volume that 
do not make their quotations accessible through an SRO

[[Page 37541]]

trading facility.\370\ Such concerns arise at present with respect to 
the ADF, a display-only quotation facility operated by the NASD, 
because quotations displayed by ADF participants can only be reached by 
obtaining direct access to that trading center. As a result, the 
greater the number of ADF participants, the greater the number of 
separate connectivity points that market participants will need to 
access to comply with the Order Protection Rule and to meet their best 
execution responsibilities. The Commission's original proposal would 
have required such trading centers to provide access only to SROs and 
other ADF participants. At the NMS Hearing, several panelists expressed 
concern that this requirement would be inadequate to assure sufficient 
access, which prompted the Commission to request comment on the matter 
in its Supplemental Release.\371\ It noted that panelists at the NMS 
Hearing had suggested that relatively inactive ATSs and market makers 
should be required to publish their quotations in an SRO trading 
facility, at least until their share of trading reached a point where 
the cost of direct connections to those markets would not be out of 
proportion to their volume of trading. Alternatively, the Supplemental 
Release requested comment on whether an SRO without a trading facility, 
of which the NASD is currently the only one, should be required to 
ensure that any ATS or market maker is directly connected to most 
market participants before publishing its quotations in a display-only 
facility.
---------------------------------------------------------------------------

    \370\ Amex Letter at 8; Brut Letter at 19; Citigroup Letter at 
13; E*Trade Letter at 9; Nasdaq Letter II at 22; SIA Letter at 16; 
Specialist Assoc. Letter at 12; STA Letter at 4; STANY Letter at 10; 
UBS Letter at 9.
    \371\ Hearing Tr. at 135, 138-140; Supplemental Release, 69 FR 
at 30146.
---------------------------------------------------------------------------

    Several commenters on the original proposal supported the approach 
of requiring low-volume trading centers to make their quotations 
available through an SRO trading center.\372\ Brut, for example, stated 
that the presence of such low-volume trading centers ``requires vast 
industry investments to establish private connectivity (or utilize 
vendors) to access these markets--no matter how small or potentially 
how fleeting--to satisfy best execution obligations and avoid market 
disruption. The effort and investment to establish such connectivity is 
disproportionate to the liquidity on such market.'' \373\ Brut further 
noted that it had sought to avoid such ADF trading centers in the past, 
but that the extension of trade-through protection to Nasdaq stocks 
would eliminate this option.
---------------------------------------------------------------------------

    \372\ See, e.g., Brut Letter at 13; Citigroup Letter at 13; SIA 
Letter at 17 (some firms).
    \373\ Brut Letter at 13.
---------------------------------------------------------------------------

    The SIA also believed that ``reliance solely on the SEC's proposed 
market access rules would fail to address access issues related to 
smaller markets * * *. If the SEC obligates market participants to 
trade with [a smaller ADF market maker or ATS] by promulgating a trade-
through rule, we are concerned about the firms' burden of creating many 
private linkages to many small ATSs that may charge exorbitant fees for 
the necessary access.'' \374\ SIA members were divided, however, on the 
best means to resolve the issue. Some favored requiring smaller trading 
centers to make their quotes accessible through an SRO trading 
facility. Other SIA members, as well as other commenters, recommended 
requiring all trading centers to make their best quotations available 
through a public intermarket linkage facility.\375\
---------------------------------------------------------------------------

    \374\ SIA Letter at 16.
    \375\ See, e.g., Ameritrade Letter I, Appendix at 11; E*Trade 
Letter at 9; SIA Letter at 17.
---------------------------------------------------------------------------

    One commenter, in contrast, believed that access to trading centers 
quoting on the ADF should be addressed by requiring the NASD to add an 
order execution functionality to ADF. NexTrade stated that the ADF was 
created to make participation in Nasdaq's SuperMontage facility 
voluntary. It believed that ``the Commission should re-evaluate whether 
or not `private sector' solutions for SROs without an execution 
mechanism are sufficient for the investment community to satisfy its 
various obligations under the Act.'' \376\
---------------------------------------------------------------------------

    \376\ Letter from John M. Schaible, President, NexTrade 
Holdings, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
July 29, 2004 (``NexTrade Letter'') at 14.
---------------------------------------------------------------------------

    After considering the various views of commenters on the original 
proposal, in the Reproposing Release the Commission proposed to require 
ADF participants to bear the costs of providing the necessary 
connectivity that would facilitate efficient access to their 
quotations.\377\ Specifically, under reproposed Rule 610(b)(1) those 
ATSs and market makers that choose to display quotations in the ADF 
would bear the responsibility of providing a level and cost of access 
to their quotations that is substantially equivalent to the level and 
cost of access to quotations displayed by SRO trading facilities.
---------------------------------------------------------------------------

    \377\ See Section III.A.1 of the Reproposing Release for a 
discussion of the comments.
---------------------------------------------------------------------------

    A large number of commenters on the reproposal supported the 
proposed requirements in Rule 610(b)(1).\378\ The SIA, for example, 
stated that this requirement would likely address most of its 
previously stated concerns about ATSs and market makers that choose to 
make their quotations accessible only through the ADF.\379\ One 
commenter noted that it thought the approach was fair and 
appropriate.\380\
---------------------------------------------------------------------------

    \378\ See, e.g., CIBC Reproposal Letter at 1; JP Morgan 
Reproposal Letter at 2; Letter from Paul W. Lerro to Jonathan G. 
Katz, Secretary, Commission, dated January 22, 2005 (``Lerro 
Reproposal Letter'') at 14; Merrill Lynch Reproposal Letter at 9; 
Nasdaq Reproposal Letter at 18 (although advocating requiring 
trading facilities with less than a five percent share volume to 
make their quotations available through an SRO trading facility, 
thought that the Commission's proposal was the ``next best 
approach''); SIA Reproposal Letter at 3, 21; UBS Reproposal Letter 
at 1; Vanguard Reproposal Letter at 5.
    \379\ SIA Reproposal Letter at 3.
    \380\ Citigroup Reproposal Letter at 4.
---------------------------------------------------------------------------

    At the same time, some commenters (both those supporting and those 
opposing the reproposed access standards) continued to voice their 
concerns about the potential need to develop, and the costs of 
developing, connections to numerous small trading centers in the 
ADF.\381\ For instance, one commenter, noting that the ADF is not a 
single market and that the expense of access increases proportionally 
by the number of markets that must be accessed, stated that the cost of 
accessing more than one or two additional markets would be prohibitive 
for most of its members.\382\ Several commenters believed that non-SRO 
trading centers should make their quotations available through the 
automatic execution facilities of an SRO, thereby requiring other 
market participants to only have to maintain access to six or seven 
markets, rather than potentially dozens.\383\ In contrast, one 
commenter that is an ADF participant continued to express its concerns 
with the proposed access requirements, stating its belief that the 
proposal to require ADF participants to establish the necessary 
connectivity that would facilitate efficient access to their quotations 
would create a cost barrier that discriminates against smaller firms in 
the ADF.\384\
---------------------------------------------------------------------------

    \381\ See, e.g., Merrill Lynch Reproposal Letter at 9; SIA 
Reproposal Letter at 21; STANY Reproposal Letter at 3-4.
    \382\ STANY Reproposal Letter at 3.
    \383\ See, e.g., Knight Reproposal Letter at 5; Nasdaq 
Reproposal Letter at 17-18 (expressing the view that trading 
facilities with less than a five percent volume shares should be 
required to make their quotations available through an SRO trading 
facility); STA Reproposal Letter at 6; Type N Reproposal Letter at 
1.
    \384\ NexTrade Reproposal Letter at 4-6.

---------------------------------------------------------------------------

[[Page 37542]]

    The Commission has decided to adopt Rule 610(b)(1) as reproposed, 
but does not believe that its adopted access approach discriminates 
against smaller firms or creates a barrier to access for innovative new 
market entrants. Rather, smaller firms and new entrants have a range of 
alternatives from which to choose that will allow them to avoid 
incurring any costs to meet the connectivity requirements of Rule 
610(b)(1) if they wish to do so. This approach is fully consistent with 
Congressional policy set forth in the Regulatory Flexibility Act, which 
directs the Commission to consider significant alternatives to 
regulations that accomplish the stated objectives of the Exchange Act 
and minimize the economic impact on small entities.\385\
---------------------------------------------------------------------------

    \385\ 5 U.S.C. 603(c). In the Reproposing Release, the 
Commission noted that only two of the approximately 600 broker-
dealers (including ATSs) that would be subject to Rule 610 are 
considered small (total capital of less than $500,000) for purposes 
of the Regulatory Flexibility Act. 69 FR at 77492. The adopted 
access approach provides alternatives that will benefit a wider 
range of smaller ATSs than the two that are considered small 
entities.
---------------------------------------------------------------------------

    Small ATSs are exempt from participation in the consolidated 
quotation system and, therefore, from the connectivity requirements of 
Rule 610. Under Rule 301(b)(3) of Regulation ATS, an ATS is required to 
display its quotations in the consolidated quotation stream only in 
those securities for which its trading volume reaches 5% of total 
trading volume. Consequently, smaller ATSs are not required to provide 
their quotations to any SRO (whether an SRO trading facility or the 
NASD's ADF) and thereby trigger the access requirements of Rule 610. 
Moreover, potential new entrants with innovative trading mechanisms can 
commence business without having to incur any costs associated with 
participation in the consolidated quotation system.
    Some smaller ATSs, however, may wish to participate voluntarily in 
the consolidated quotation system. Such participation can benefit 
smaller firms and promote competition among markets by enabling smaller 
firms to obtain wide distribution of their quotations among all market 
participants.\386\ Here, too, such firms will have alternatives that 
would not obligate them to comply with the connectivity requirements of 
Rule 610(b)(1). ATSs and market makers that wish to trade NMS stocks 
can choose from a number of options for quoting and trading. They can 
become a member of a national securities exchange and quote and trade 
through the exchange's trading facilities. They can participate in The 
NASDAQ Market Center and quote and trade through that facility. By 
choosing either of these options, an ATS or market maker would not 
create a new connectivity point that all other market participants must 
reach and would not be subject to Rule 610(b)(1). Some firms, however, 
may not want to participate in an SRO trading facility. These ATSs and 
market makers can quote and trade in the OTC market. The existence of 
the NASD's ADF makes this third choice possible by providing a facility 
for displaying quotations and reporting transactions in the 
consolidated data stream.
---------------------------------------------------------------------------

    \386\ See infra, note 566 (the Commission's Advisory Committee 
on Market Information recommended retention of the consolidated 
display requirement because, among other things, it ``may promote 
market competition by assuring that information from newer or 
smaller exchanges is widely distributed.'').
---------------------------------------------------------------------------

    The NASD is not, however, statutorily required to provide an order 
execution functionality in the ADF. As a national securities 
association, the NASD is subject to different regulatory requirements 
than a national securities exchange. It is responsible for regulating 
the OTC market (i.e., trading by broker-dealers otherwise than on a 
national securities exchange). Section 15A(b)(11) of the Exchange Act 
requires an association to have rules governing the form and content of 
quotations relating to securities sold otherwise than on a national 
securities exchange that are published by a member of the association. 
Such rules must be designed to produce fair and informative quotations 
and to promote orderly procedures for collecting, distributing, and 
publishing quotations. The Exchange Act does not expressly require an 
association to establish a facility for executing orders against the 
quotations of its members, although it could choose to do so.
    The Commission believes that market makers and ECNs should continue 
to have the option of operating in the OTC market, rather than on an 
exchange or The NASDAQ Market Center. As noted in the Commission's 
order approving Nasdaq's SuperMontage trading facility, this ability to 
operate in the ADF is an important competitive alternative to Nasdaq or 
exchange affiliation.\387\ Therefore, the Commission has determined not 
to require small trading centers to make their quotations accessible 
through an SRO trading facility.
---------------------------------------------------------------------------

    \387\ See Securities Exchange Act Release No. 43863 (Jan. 19, 
2001), 66 FR 8020 (Jan. 26, 2001).
---------------------------------------------------------------------------

    Instead, Rule 610(b)(1) requires all trading centers that choose to 
display quotations in an SRO display-only quotation facility to provide 
a level and cost of access to such quotations that is substantially 
equivalent to the level and cost of access to quotations displayed by 
SRO trading facilities. Rule 610(b) therefore may cause trading centers 
that display quotations in the ADF to incur additional costs to enhance 
the level of access to their quotations and to lower the cost of 
connectivity for market participants seeking to access their 
quotations. The extent to which these trading centers in fact incur 
additional costs to comply with the adopted access standards will be 
largely within the control of the trading center itself. As noted 
above, ATSs and market makers that wish to trade NMS stocks can choose 
from a number of options for quoting and trading, including quoting and 
trading in the OTC market. As a result, the additional connectivity 
requirements of Rule 610(b) will be triggered only by a trading center 
that displays its quotations in the consolidated data stream and 
chooses not to provide access to those quotations through an SRO 
trading facility.
    Currently, nine SROs operate trading facilities in NMS stocks. 
Market participants throughout the securities industry generally have 
established connectivity to these nine points of access to quotations 
in NMS stocks. By choosing to display quotations in the ADF, a trading 
center effectively could require the entire industry to establish 
connectivity to an additional point of access. Potentially, many 
trading centers could choose to display quotations in the ADF, thereby 
significantly increasing the overall costs of connectivity in the NMS. 
Such an inefficient outcome would become much more likely if an ADF 
trading center were not required to assume responsibility for the 
additional costs associated with its decision to display quotations 
outside of an established SRO trading facility.
    Although the Exchange Act envisions an individual broker-dealer 
having the option of trading in the OTC market,\388\ it does not 
mandate that the securities industry in general must subsidize the 
costs of accessing a broker-dealer's quotations in the OTC market if 
the NASD chooses not to provide connectivity. The Commission believes 
that it is reasonable and appropriate to require those ATSs and market 
makers that choose to display quotations in the ADF to bear the 
responsibility of providing a level and cost of access to their 
quotations that is substantially equivalent to the level and cost of 
access

[[Page 37543]]

to quotations displayed by SRO trading facilities. Under Rule 
610(b)(1), therefore, ADF participants will be required to bear the 
costs of the necessary connectivity to facilitate efficient access to 
their quotations. This standard will help ensure that additional 
connectivity burdens are not imposed on the securities industry each 
time that an additional ADF participant necessitates a new connectivity 
point by choosing to begin displaying quotations in the consolidated 
quotation stream.
---------------------------------------------------------------------------

    \388\ See Sections 11A(c)(3)(A) and (4) of the Exchange Act, 15 
U.S.C 78k-1(c)(3)(A) and (4).
---------------------------------------------------------------------------

    To clarify the intent of this requirement, the Commission 
emphasizes that a ``substantially equivalent'' cost of access will not 
be evaluated in terms of absolute dollar costs of access and therefore 
does not necessarily allow an ATS or market maker quoting in the ADF to 
charge the same fees or impose the same costs that an SRO trading 
facility charges or imposes. Rather, the standard in Rule 610(b)(1) 
compares the costs to an ADF participant's relative degree of trading 
volume.\389\ Consequently, the cost of access to an ADF participant 
must be substantially equivalent to the cost of access to SRO trading 
facilities on a per transaction basis. For example, a $1000 port fee 
charged by an ECN participating in the ADF that trades one million 
shares a day would not be substantially equivalent to a $1000 port fee 
charged by an SRO trading facility trading 100 million shares a day.
---------------------------------------------------------------------------

    \389\ Cf. NexTrade Reproposal Letter at 6. See Section III.A.1 
of the Reproposing Release and supra notes 370 to 375 discussing the 
concerns of commenters and panelists at the NMS Hearings regarding 
access to relatively inactive ATSs and market makers with a small 
amount of trading volume.
---------------------------------------------------------------------------

    As discussed above, the Commission recognizes that trading centers 
subject to Rule 610(b)(1) may incur costs associated with providing 
access to their quotations in compliance with the Rule, although the 
costs will vary depending upon the manner in which each trading center 
determines to provide such access. As noted in the Commission's order 
approving the pilot program for the ADF, the reduction in 
communications line costs in recent years and the advent of competing 
access providers offer the potential for multiple competitive means of 
access to the various trading centers that trade NMS stocks.\390\ To 
meet their regulatory requirements, ADF participants will have the 
option of establishing and, when necessary, paying for connections to 
industry access providers that have extensive connections to a wide 
array of market participants through a variety of direct access options 
and private networks. The option of participation in existing market 
infrastructure and systems should reduce a trading center's cost of 
compliance.
---------------------------------------------------------------------------

    \390\ Securities Exchange Act Release No. 46249 (July 24, 2002), 
67 FR 49822 (July 31, 2002).
---------------------------------------------------------------------------

    Two commenters raised concerns about reliance on third party 
private vendors to provide access, since they may not be regulated by 
the Commission and thus could deny access to a trading center they 
viewed as a competitor, or because utilizing their services to link to 
other trading centers is outside the control of a trading center.\391\ 
The Commission believes that the requirement in Rule 610(b)(1) that ADF 
participants provide a substantially equivalent level of access will 
preclude the ADF participant from providing access only through a 
narrow range of private access providers. The range of access providers 
must be sufficient to provide access substantially equivalent to SRO 
trading facilities. In these circumstances, and given the significant 
number and variety of entities that currently provide access services 
and the competitive nature of the market for these services, the 
Commission believes that competition will be sufficient to provide 
services for any trading center choosing to utilize an outside 
vendor.\392\
---------------------------------------------------------------------------

    \391\ NexTrade Reproposal Letter at 6; STANY Reproposal Letter 
at 4.
    \392\ For example, as noted above, one ECN can be accessed 
through five extranets and at least 21 other access providers, as 
well as through direct connections.
---------------------------------------------------------------------------

    One commenter emphasized the importance of the NASD carefully 
assessing and monitoring the extent to which ADF participants meet the 
access standards of Rule 610(b).\393\ The Commission agrees that 
effective NASD oversight of ADF participants' compliance with the Rule 
is critical to the viability of the access standards adopted today, 
given that these participants are not accessible through an SRO trading 
facility. As the self-regulatory authority responsible for the OTC 
market, the NASD must act as the ``gatekeeper'' for the ADF, and, as 
such, will need to closely assess the extent to which ADF participants 
meet the access standards of Rule 610. Prior to implementation of Rule 
610, the NASD will need to make an affirmative determination that 
existing ADF participants are in compliance with the requirements of 
the Rule.\394\ If an ADF participant is not complying with these access 
standards, the NASD would have a responsibility to stop publishing the 
participant's quotations until the participant comes into 
compliance.\395\ The Commission also believes that, in light of these 
new access standards, the addition of a new ADF participant would 
constitute a change in a material aspect of the operation of the NASD's 
facilities, and thus require the filing of a proposed rule change 
pursuant to Section 19(b) of the Exchange Act that would be subject to 
public notice and comment.\396\ Alternatively, the NASD could choose to 
provide a communications facility that would link all of the ADF 
participants to each other and that would provide a single point of 
access to market participants attempting to access an ADF 
participant.\397\
---------------------------------------------------------------------------

    \393\ SIA Reproposal Letter at 21.
    \394\ See Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
    \395\ Id.
    \396\ See Rule 19b-4(b)(1) under the Exchange Act, 17 CFR 
240.19b-4(b)(1).
    \397\ The Commission does not believe that NASD, solely by 
providing such a communications facility, would fall within the 
definition of SRO trading facility, which applies to an SRO that 
operates a facility that executes orders in a security or presents 
orders to members for execution.
---------------------------------------------------------------------------

2. Limitation on Access Fees
    A number of ECN trading centers charge fees to incoming orders that 
execute against their displayed quotations.\398\ These ECNs typically 
pass a substantial portion of the access fee on to limit order 
customers as rebates for supplying the accessed liquidity (i.e., 
submitting non-marketable limit orders). For Nasdaq stocks, ECNs have 
charged access fees directly to their subscribers, but also have 
charged access fees to non-subscribers when their quotations have been 
displayed and executed through Nasdaq facilities. Market makers have 
not been permitted to charge any fee for counterparties accessing their 
quotations under the Quote Rule. Other types of trading centers, 
including exchange SROs, may charge fees that are triggered when 
incoming orders access their displayed quotations. These fees have only 
been charged to their members, because only members have the right to 
route orders to an exchange other than through ITS. For exchange-listed 
stocks, however, the ITS has provided free intermarket access to 
quotations in other markets for its participants.
---------------------------------------------------------------------------

    \398\ A full description of the current framework for access 
fees is provided in the Proposing Release. 69 FR at 11156.
---------------------------------------------------------------------------

    The trade-through protection and linkage requirements adopted today 
will significantly alter the conditions that have shaped access fee 
practices in the past. For exchange-listed stocks, Rule 610 adopts a 
private linkage approach that relies on access through members and 
subscribers rather than through a public intermarket linkage system. 
For

[[Page 37544]]

access outside of ITS, markets will pay, directly or indirectly, the 
fees charged by other markets to their members and subscribers. For 
Nasdaq stocks, the Order Protection Rule will, for the first time, 
establish price protection, so market participants will no longer have 
the option of bypassing the quotations of trading centers with access 
fees that they view as too high.
    The benefits of strengthened price protection and more efficient 
linkages could be compromised if trading centers are able to charge 
substantial fees for accessing their quotations. Moreover, the wider 
the disparity in the level of access fees among different market 
centers, the less useful and accurate are the prices of quotations 
displayed for NMS stocks. For example, if two trading centers displayed 
quotations to sell an NMS stock for $10.00 per share, one offer could 
be accessible for a total price of $10.00 plus a $0.009 fee, while the 
second trading center might not charge any access fee. What appeared in 
the consolidated data stream to be identical quotations would in fact 
be far from identical.
    To address the potential distortions caused by substantial, 
disparate fees, the original access proposal included a limitation on 
fees. Trading centers would have been limited to a fee of no more than 
$0.001 per share. Liquidity providers also would have been limited to a 
fee of no more than $0.001 per share for attributable quotations, but 
could not have charged any fee for non-attributable quotations. In 
addition, the proposal established an accumulated fee limitation of no 
more than $0.002 per share for any transaction. At the NMS Hearing, 
panelists sharply disagreed about access fees, with some panelists 
arguing that agency markets must be allowed to charge access fees for 
their services, and other panelists arguing that access fees distort 
quotation prices and should be banned.\399\ In the Supplemental 
Release, therefore, the Commission requested comment on all aspects of 
the proposed fee limitations, including whether it should adopt a 
single accumulated fee limitation that would apply to all types of 
market centers, and, if so, whether the proposed $0.002 per share was 
an appropriate amount, or whether the amount should be higher or 
lower.\400\
---------------------------------------------------------------------------

    \399\ See, e.g., Hearing Tr. at 166, 168.
    \400\ Supplemental Release, 69 FR at 30147.
---------------------------------------------------------------------------

    Commenters on the original proposal were splintered on the issue of 
access fees. A number supported the Commission's proposal as a 
worthwhile compromise resolution on an extremely difficult issue.\401\ 
They believed that the proposal would level the playing field in terms 
of who could charge fees, and provide some measure of certainty to 
market participants that the quoted price will be, essentially, the 
price they will pay. Other commenters were strongly opposed to any 
limitation on fees, believing that competition alone would sufficiently 
address the high fees that distort quoted prices.\402\ One asserted 
that ``[c]ompetitive forces have satisfactorily dealt with the issue of 
outlier ECNs * * * [M]arket participants have put them at the bottom of 
their order routing tables, which means that orders placed on these 
ECNs would be the last to be executed at any price level, a position 
that no market participant wants to be in.'' \403\ In contrast, some 
commenters argued that all access fees charged to non-members and non-
subscribers should be prohibited, but believed that the proposed fee 
limitations should not apply to SRO transaction fees, particularly 
those that are filed with the Commission for approval.\404\ Finally, a 
few commenters questioned the Commission's authority to set limitations 
on access fees.\405\
---------------------------------------------------------------------------

    \401\ See, e.g., BNY Letter at 4; Letter from Kenneth Griffin, 
President & Chief Executive Officer, Citadel Investment Group, 
L.L.C., to Jonathan G. Katz, Secretary, Commission, dated July 9, 
2004 (``Citadel Letter'') at 9; Citigroup Letter at 14; E*Trade 
Letter at 10; Nasdaq Letter II at 3; SIA Letter (some members) at 
18.
    \402\ See, e.g., Brut Letter at 12; Instinet Letter at 24; SIA 
Letter (some firms) at 18.
    \403\ Instinet Letter at 27.
    \404\ See, e.g., Amex Letter at 7-8; Goldman Sachs Letter at 5; 
Knight Letter II at 2; NYSE Letter at 5; STA Letter at 6.
    \405\ See, e.g., Instinet Letter at 24; Letter from Roderick 
Covlin, Executive Vice President, TrackECN, to William H. Donaldson, 
Chairman, Commission, dated May 10, 2004 (``TrackECN Letter'') at 1.
---------------------------------------------------------------------------

    After considering the many divergent views of the commenters on the 
original proposal, the Commission reproposed a flat $0.003 per share 
access fee cap.\406\ Commenters on the reproposal also held varying 
views with regard to the proposal to limit access fees to $0.003 per 
share. One group of commenters supported the reproposal's simplified 
approach to access fees.\407\ For example, one commenter stated that 
the reproposal is a reasonable alternative to either banning access 
fees outright or permitting access fees with relatively high price 
caps.\408\
---------------------------------------------------------------------------

    \406\ For the relatively small number of NMS stocks priced under 
$1.00, fees will be limited to 0.3% of the quotation price per share 
to prevent fees from constituting an excessive percentage of share 
price.
    \407\ See, e.g., BNY Reproposal Letter at 1,3; Deutsche Bank 
Reproposal Letter at 3; FSR Reproposal Letter at 4 (some members 
supported the proposal, which they believed would provide certainty 
for all market participants, while other members believed that 
access fees should be banned entirely); JP Morgan Reproposal Letter 
at 2; SIA Reproposal Letter at 3 (members were split). Nasdaq, 
although questioning the inflexibility of the fee limitation, stated 
that the fee limits were an inevitable consequence of the trade-
through proposal, needed because markets and market participants 
could otherwise take advantage of the power granted to them. Nasdaq 
Reproposal Letter at 19.
    \408\ Deutsche Bank Reproposal Letter at 3.
---------------------------------------------------------------------------

    Another group of commenters opposed the Commission's access fee 
limitation,\409\ with some opposing any effort to limit fees through 
regulatory means \410\ and others believing that all access fees should 
be prohibited.\411\ Many of those against imposing any fee limitation 
believed that competition was the best means for determining 
prices,\412\ although at least one commenter acknowledged a trade-
through rule could change this competitive dynamic.\413\ One commenter 
questioned the Commission's statutory authority to impose an access fee 
cap.\414\
---------------------------------------------------------------------------

    \409\ See Ameritrade Reproposal Letter at 10; ArcaEx Reproposal 
Letter at 9-10; BGI Reproposal Letter at 3; Bloomberg Reproposal 
Letter at 1, 8; BSE Reproposal Letter at 2; CHX Reproposal Letter at 
4; Letter from Lawrence E. Harris, Fred V. Keenan Chair in Finance, 
Department of Finance and Business Economics, Marshall School of 
Business, University of Southern California, to Jonathan G. Katz, 
Secretary, Commission, dated February 5, 2005 (``Harris Reproposal 
Letter'') at 4-5; Instinet Reproposal Letter at 10; Merrill Lynch 
Reproposal Letter at 3, 9; Morgan Stanley Reproposal Letter at 12-
13; NexTrade Reproposal Letter at 7-8; Phlx Reproposal Letter at 4-
5.
    \410\ See, e.g., ArcaEx Reproposal Letter at 10; BGI Reproposal 
Letter at 3; BSE Reproposal Letter at 2; CHX Reproposal Letter at 4; 
Phlx Reproposal Letter at 4-5.
    \411\ See, e.g., Bloomberg Reproposal Letter at 8; Harris 
Reproposal Letter at 4-5; Merrill Lynch Reproposal Letter at 3.
    \412\ Ameritrade Reproposal Letter at 10; ArcaEx Reproposal 
Letter at 10; CHX Reproposal Letter at 4; Instinet Reproposal Letter 
at 10.
    \413\ Nasdaq Reproposal Letter at 19.
    \414\ Instinet Reproposal Letter at 10.
---------------------------------------------------------------------------

    Some of the commenters that supported a total ban on access fees 
nonetheless supported the Commission's efforts to limit fees, if the 
Commission were to permit access fees.\415\ Some commenters, although 
opposed to a fee limitation, thought that the reproposal improved on 
the original proposal.\416\ One commenter stated that

[[Page 37545]]

the reproposal improved on the original fee limitation proposal by 
eliminating the attribution requirement, reducing the potential for 
unintended consequences, and simplifying its administration.\417\
---------------------------------------------------------------------------

    \415\ See, e.g., Citigroup Reproposal Letter at 4 (although 
advocating that the access fee limitation should be set at $0.001, 
or the original proposal's tiered cap of $0.002); Knight Trading 
Group Reproposal Letter at 6; STA Reproposal Letter at 4 (supporting 
the $0.003 per share cap in the absence of complete prohibition on 
fees); STANY Reproposal Letter at 5 (supporting the $0.003 per share 
cap in the absence of complete elimination of non-subscriber fees).
    \416\ Bloomberg Reproposal Letter at 8 (supporting abolishment 
of all access fees, but praising the Reproposal's simplified 
approach); Instinet Reproposal Letter at 3, 10-11.
    \417\ Instinet Reproposal Letter at 3, 10-11.
---------------------------------------------------------------------------

    Although acknowledging the many difficult issues associated with 
access fees, the Commission remains concerned that these issues must be 
resolved to promote a fair and efficient NMS, particularly under the 
regulatory structure adopted today. As the SIA noted in its discussion 
of access fees, its members continue to be united in their desire for a 
market-wide resolution of the access fee issue, although divided on the 
optimum solution.\418\
---------------------------------------------------------------------------

    \418\ SIA Reproposal Letter at 3.
---------------------------------------------------------------------------

    After considering the continuing divergent views of commenters, the 
Commission believes that a flat limitation on access fees to $0.003 per 
share is the fairest and most appropriate solution to what has been a 
longstanding and contentious issue.\419\ The limitation is intended to 
achieve several objectives. First, Rule 610(c) promotes the NMS 
objective of equal regulation of markets and broker-dealers by applying 
equally to all types of trading centers and all types of market 
participants.\420\ As noted above, although ECNs and other types of 
trading centers, including SROs, may currently charge access fees, 
market makers have not been permitted to charge any fee for 
counterparties accessing their quotations. The Commission believes, 
however, that it is consistent with the Quote Rule for market makers to 
charge fees for access to their quotations, so long as such fees meet 
the requirements of Rule 610(c). In particular, market makers will be 
permitted to charge fees for executions of orders against their 
quotations, irrespective of whether the order executions are effected 
on an SRO trading facility or directly by the market maker.
---------------------------------------------------------------------------

    \419\ For the relatively small number of NMS stocks priced under 
$1.00, fees will be limited to 0.3% of the quotation price per share 
to prevent fees from constituting an excessive percentage of share 
price.
    \420\ Section 11A(c)(1)(F) of the Exchange Act.
---------------------------------------------------------------------------

    Second, the adopted fee limitation is designed to preclude 
individual trading centers from raising their fees substantially in an 
attempt to take improper advantage of strengthened protection against 
trade-throughs and the adoption of a private linkage regime. In 
particular, the fee limitation is necessary to address ``outlier'' 
trading centers that otherwise might charge high fees to other market 
participants required to access their quotations by the Order 
Protection Rule. It also precludes a trading center from charging high 
fees selectively to competitors, practices that have occurred in the 
market for Nasdaq stocks. In the absence of a fee limitation, the 
adoption of the Order Protection Rule and private linkages could 
significantly boost the viability of the outlier business model. 
Outlier markets might well try to take advantage of intermarket price 
protection by acting essentially as a toll booth between price levels. 
The high fee market likely will be the last market to which orders 
would be routed, but prices could not move to the next level until 
someone routed an order to take out the displayed price at the outlier 
market. Therefore, the outlier market might see little downside to 
charging exceptionally high fees, such as $0.009, even if it is last in 
priority. While markets would have significant incentives to compete to 
be near the top in order-routing priority,\421\ there might be little 
incentive to avoid being the least-preferred market if fees were not 
limited.
---------------------------------------------------------------------------

    \421\ See supra, section II.A.4.a (discussion of competitive 
implications of trade-through protection).
---------------------------------------------------------------------------

    The $0.003 cap will limit the outlier business model. It will place 
all markets on a level playing field in terms of the fees they can 
charge and the rebates they can pass on to liquidity providers. Some 
markets might choose to charge lower fees, thereby increasing their 
ranking in the preferences of order routers. Others might charge the 
full $0.003 and rebate a substantial proportion to liquidity providers. 
Competition will determine which strategy is most successful.
    Moreover, the fee limitation is necessary to achieve the purposes 
of the Exchange Act. Access fees tend to be highest when markets use 
them to fund substantial rebates to liquidity providers, rather than 
merely to compensate for agency services. If outlier markets are 
allowed to charge high fees and pass most of them through as rebates, 
the published quotations of such markets would not reliably indicate 
the true price that is actually available to investors or that would be 
realized by liquidity providers. Section 11A(c)(1)(B) of the Exchange 
Act authorizes the Commission to adopt rules assuring the fairness and 
usefulness of quotation information. For quotations to be fair and 
useful, there must be some limit on the extent to which the true price 
for those who access quotations can vary from the displayed price. 
Consequently, the $0.003 fee limitation will further the statutory 
purposes of the NMS by harmonizing quotation practices and precluding 
the distortive effects of exorbitant fees. Moreover, the fee limitation 
is necessary to further the statutory purpose of enabling broker-
dealers to route orders in a manner consistent with the operation of 
the NMS.\422\ To protect limit orders, orders must be routed to those 
markets displaying the best-priced quotations. This purpose would be 
thwarted if market participants were allowed to charge exorbitant fees 
that distort quoted prices.
---------------------------------------------------------------------------

    \422\ Section 11A(c)(1)(E) of the Exchange Act authorizes the 
Commission to adopt rules assuring that broker-dealers transmit 
orders for NMS stocks in a manner consistent with the establishment 
and operation of a national market system.
---------------------------------------------------------------------------

    The Commission notes the $0.003 fee limitation is consistent with 
current business practices, as very few trading centers currently 
charge fees that exceed this amount.\423\ It appears that only two ECNs 
currently charges fees that exceed $0.003, charging $0.005 for access 
through the ADF. These ECNs currently do not account for a large 
percentage of trading volume. In addition, while a few SROs have large 
fees on their books for transactions in ETFs that exceed a certain size 
(e.g., 2100 shares), it is unlikely that these fees generate a large 
amount of revenues.
---------------------------------------------------------------------------

    \423\ Cf. Instinet Letter at 38 (``there is no basis for 
adopting any limitation other than at the prevailing $0.003 per 
share level, which was arrived at through open competition among 
ATSs, ECNs, and SRO markets in the Nasdaq market'') and Instinet 
Reproposal Letter at 11 (``as for an appropriate amount for such an 
accumulated fee limitation, the Reproposal sets the cap at the 
prevailing $0.003 per share level for stocks priced above $1.00, 
which was arrived at through open competition among marketplaces'').
---------------------------------------------------------------------------

    Accordingly, the adopted fee limitation will not impair the agency 
market business model. The Commission recognizes that agency trading 
centers perform valuable agency services in bringing buyers and sellers 
together, and that their business model historically has relied, at 
least in part, on charging fees for execution of orders against their 
displayed quotations. Under current conditions, the Commission believes 
that prohibiting access fees entirely would unduly harm this business 
model.
    Several commenters believed that, because best execution 
responsibilities may require a broker-dealer to access non-protected 
quotations, the Commission should extend the access fee cap to all 
quotations, not just protected quotations.\424\ One commenter

[[Page 37546]]

argued that the potential contribution of manual quotations to a market 
center's execution quality could require market participants to access 
those quotations to fulfill their duty of best execution, even though 
they are not protected by Rule 611.\425\ Thus, the commenter suggested 
that the access fee limitation should apply to all quotations, 
including manual quotations, so as not to disincent market participants 
from attempting to access those quotations.\426\
---------------------------------------------------------------------------

    \424\ Ameritrade Reproposal Letter at 10 (only if fee limitation 
is adopted); Citigroup Reproposal Letter at 4; Madoff Reproposal 
Letter at 5 (also stating that extending the fee limitation to all 
quotations will ensure that all quotations are treated fairly); 
Merrill Lynch Reproposal Letter at 9; SIA Reproposal Letter at 22; 
STANY Reproposal Letter at 2, 5.
    \425\ Madoff Reproposal Letter at 5.
    \426\ Id.
---------------------------------------------------------------------------

    The Commission agrees that the access fee limitation should apply 
to manual quotations that are best bids and offers to the same extent 
it applies to protected quotations, to preclude any incentive for 
trading centers to display manual quotations as a means to charge a 
higher access fee. In addition, the Commission recognizes that at 
present a trading center's execution quality statistics will be 
evaluated against the NBBO, whether that quotation is a manual or 
automated quotation. The Commission therefore has modified the proposed 
fee limitation in Rule 610(c) to apply to any quotation that is the 
best bid or best offer of an exchange, the ADF, or The NASDAQ Market 
Center, in addition to any protected quotations as defined in Rule 
600(b)(57).\427\
---------------------------------------------------------------------------

    \427\ In addition, the Commission notes that the access 
standards in Rule 610(a) and (b) apply to all quotations, not just 
automated quotations.
---------------------------------------------------------------------------

    The Commission is not, however, extending the fee cap to all 
quotations displayed by a trading center. Thus, the fee cap will not 
apply to depth-of-book quotations, or to any other services offered by 
markets. By applying only to the best bid and offer of an exchange, the 
ADF, or The NASDAQ Market Center, the limitation is narrowly drafted to 
have minimal impact on competition and individual business models while 
furthering the objectives of the Exchange Act by preserving the 
fairness and usefulness of quotations, as discussed above. It will 
provide the necessary support for proper functioning of the Order 
Protection Rule and private linkages, while leaving trading centers 
otherwise free to set fees subject only to other applicable standards 
(e.g., prohibiting unfair discrimination).
    Two commenters expressed a concern with the ability to determine 
after-the-fact whether a quotation against which an incoming order 
executed was subject to an access fee cap, given that under the Rule a 
market participant could be charged different fees based on whether or 
not a quotation was protected.\428\ In particular, one commenter raised 
the issue in the context of a sweep order that could hit non-protected 
quotations, and advocated applying the access fee limit to all sweep 
orders.\429\ The Commission acknowledges these concerns, but notes that 
market participants will be able to control the extent to which their 
orders interact with protected and non-protected quotations. First, 
under the Order Protection Rule, the definition of intermarket sweep 
order requires market participants to route orders to interact only 
with protected quotations. The objective can be achieved by routing an 
IOC, marketable limit order with a limit price that equals the price of 
the protected quotation. The extent to which they route to non-
protected quotations will be subject to the full range of competitive 
forces, including the fees that trading centers choose to charge for 
access to non-protected quotations.
---------------------------------------------------------------------------

    \428\ Bloomberg Reproposal Letter at 8, n. 6; SIA Reproposal 
Letter at 22.
    \429\ Bloomberg Reproposal Letter at 8, n. 6.
---------------------------------------------------------------------------

    The Commission recognizes, however, the concern that a market 
participant could intend to interact only with a protected quotation 
but in fact execute against a non-protected quotation. For example, at 
the time a market participant routes an order to a trading center, it 
may be attempting to execute against only that trading center's best 
bid or offer, which will be subject to the fee cap under adopted Rule 
610(c) (for instance, by sending an intermarket sweep order with a 
limit price equal to the price of the protected quotation). By the time 
the order arrives at the trading center, the incoming order may, if a 
better priced bid or offer has been displayed at the trading center for 
a size smaller than the size of the incoming order, execute against 
both the new best bid or offer and the quotation that previously was 
the trading center's best bid or offer. To meet the requirements of 
Rule 610(c), however, a trading center must ensure that it never 
charges a fee in excess of the cap for executions of an order against 
its quotations that are subject to the fee cap. The operation of this 
limitation will be based on quotations as they are displayed in the 
consolidated quotation stream. Thus, the trading center is responsible 
for ensuring that any time lag between prices in its internal systems 
and its quotations in the consolidated quotation system do not cause 
fees to be charged that violate the limitation of Rule 610(c). 
Compliance with this requirement obviously will not be a problem for 
trading centers that do not charge any fees in excess of the cap. Given 
the often rapid updating of quotations in NMS stocks, however, the 
Commission does not believe a trading center that charges fees above 
the cap for quotations that are not subject to the fee cap could comply 
with the Rule unless it provides a functionality that enables market 
participants to assure that they will never inadvertently be charged a 
fee in excess of the cap. For example, such a trading center could 
provide a ``top-of-book only'' or ``limited-fee only'' order 
functionality. By using this functionality, market participants 
themselves could assure that they were never required to pay a fee in 
excess of the levels set forth in Rule 610(c).
    In restricting the fee cap to the top-of-book, we are attempting to 
reduce the regulatory impact to the minimum extent necessary to effect 
the statutory purposes. We intend to monitor the operation of these 
rules to assess whether in practice, distinguishing which quotations 
are subject to the cap is so difficult, and accessing non-protected 
quotations is so essential, that broader coverage of the rule is 
necessary.
3. Locking or Crossing Quotations
    The original access proposal provided that the SROs must establish 
and enforce rules: (1) Requiring their members reasonably to avoid 
posting quotations that lock or cross the quotations of other markets; 
(2) enabling the reconciliation of locked or crossed markets; and (3) 
prohibiting their members from engaging in a pattern or practice of 
locking or crossing quotations. In light of the discussion at the NMS 
Hearing concerning automated quotations and automated markets,\430\ the 
Supplemental Release requested comment on whether market participants 
should be allowed to submit automated quotations that lock or cross 
manual quotations.\431\ In the Reproposing Release, the Commission 
reproposed restrictions on the practice of displaying locking or 
crossing quotations, but, consistent with its approach in the 
reproposed Order Protection Rule, modified the proposal to allow 
automated quotations to lock or cross manual quotations. Rule 610(d) as 
reproposed thereby addressed the concern that manual quotations may not 
be fully accessible and recognized that allowing automated quotations 
to lock

[[Page 37547]]

or cross manual quotations may provide useful market information.
---------------------------------------------------------------------------

    \430\ See supra, section II.A.2.
    \431\ Supplemental Release, 69 FR at 30147.
---------------------------------------------------------------------------

    Most of the commenters who addressed the issue supported the 
proposed restrictions on locking and crossing quotations.\432\ They 
generally agreed that the practice of displaying quotations that lock 
or cross previously displayed quotations is inconsistent with fair and 
orderly markets and detracts from market efficiency. One noted, for 
example, that locked and crossed markets ``can be a sign of an 
inefficient market structure'' and ``may create confusion for 
investors, as it is unclear under such circumstances what is the true 
trading interest in a stock.'' \433\ Another commenter stated that 
``[p]ricing rationality is disrupted by locked and crossed markets, and 
efforts should be taken to reduce the incidence of such disruptions.'' 
\434\ Some commenters asserted that locked markets often occur when a 
market participant deliberately posts a locking quotation to avoid 
paying a fee to access the quotation of another market and to receive a 
liquidity rebate for an execution against its own displayed 
quotation.\435\ Nasdaq submitted data regarding the frequency of locked 
and crossed markets. During a one-week period in March 2004, it found 
that markets for Nasdaq stocks were locked or crossed an average of 
509,018 times each day, with an average of 194,638 of the locks and 
crosses lasting more than 1 second and an average duration of all locks 
and crosses of 3.1 seconds.\436\ Nasdaq stocks currently are not 
subject to provisions discouraging intermarket locking or crossing 
quotations such as those contained in the ITS Plan.
---------------------------------------------------------------------------

    \432\ Amex Letter, Exhibit A at 27-28; Letter from Steve 
Swanson, Chief Executive Officer & President, Automated Trading 
Desk, LLC, to Jonathan G. Katz, Secretary, Commission, dated June 
30, 2004 (``ATD Letter'') at 3; Brut Letter at 17; BSE Letter at 13; 
Citigroup Letter at 14; E*Trade Letter at 10; ICI Letter at 18; JP 
Morgan Letter at 6; Nasdaq Letter II at 23-24; NYSE Letter, 
Attachment at 9; SIA Letter at 19-20; STA Letter at 6; STANY Letter 
at 8; UBS Letter at 9-10.
    \433\ ICI Letter at 18.
    \434\ Deutsche Bank Reproposal Letter at 3.
    \435\ Amex Letter, Exhibit A at 27-28; ATD Reproposal Letter at 
5; ICI Letter at 18; Nasdaq Letter II at 23.
    \436\ Nasdaq Letter II at 23. One commenter pointed to this data 
as support for not prohibiting locked and crossed markets, since 
314,380 of the 509,018 locks or crosses lasted less than one second, 
even without a rule. Letter from Edward J. Joyce, President and 
Chief Operating Officer, Chicago Board Options Exchange, 
Incorporated, to Jonathan G. Katz, Secretary, Commission, dated 
February 14, 2005 (``CBOE Reproposal Letter'') at 7.
---------------------------------------------------------------------------

    Several commenters specifically supported the modification to allow 
automated quotations to lock or cross manual quotations.\437\ One 
commenter stated that market participants should not be forced to seek 
out slow, uncertain executions before being permitted to offer 
liquidity at prices they find acceptable.\438\
---------------------------------------------------------------------------

    \437\ Citigroup Reproposal Letter at 4; Nasdaq Reproposal Letter 
at 18; SIA Reproposal Letter at 23.
    \438\ Nasdaq Reproposal Letter at 18.
---------------------------------------------------------------------------

    A few comments opposed restricting the practice of locking or 
crossing quotations.\439\ They generally believed that the proposal 
would impair market transparency and efficiency, such as by prohibiting 
the display of information as to the true level of trading interest or 
information that a particular market's quotations may be inaccessible. 
One commenter identified a number of causes, apart from access fees and 
liquidity rebates, which could lead to locked and crossed markets.\440\ 
These included determinations by market participants that quotations 
displayed by a locked or crossed market are not truly accessible, 
decisions by market participants that the potential disadvantages of 
routing away outweigh the potential advantages (e.g., loss of execution 
priority on the market place currently displaying the order), and 
decisions by market participants to exclusively use a particular market 
to run a trading strategy, even at the risk of missing some trading 
opportunities. One commenter stated that providing an exception from 
the restrictions for manual quotations would do little to mitigate the 
negative impact of the restrictions on market transparency and 
efficiency.\441\
---------------------------------------------------------------------------

    \439\ CBOE Reproposal Letter at 1-4; Letter from Linda Lerner, 
General Counsel, Domestic Securities, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated September 9, 2004 (``Domestic 
Securities Letter'') at 2-3; Hudson River Trading Letter at 5-6; 
Instinet Reproposal Letter at 3,11; Letter from Michael J. Simon, 
Senior Vice President & Secretary, International Securities 
Exchange, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
June 30, 2004 (``ISE Letter'') at 7-8; Tower Research Letter at 6-8; 
Tradebot Reproposal Letter at 1.
    \440\ Instinet Letter at 39.
    \441\ Instinet Reproposal Letter at 3.
---------------------------------------------------------------------------

    The Commission recognizes that Rule 610(d), by restricting locked 
markets with respect to automated quotations, can prohibit the display 
of an order that would otherwise have been displayed and reduced the 
quoted spread to zero. However, although locked markets do occur a 
certain percentage of the time, they do not occur all the time, even in 
extremely active stocks, and thus the average effective spread in these 
stocks typically is between one-half cent and one cent (one cent being 
the minimum price increment for all but a very few stocks). Thus, the 
Commission believes that any widening of average effective spreads 
caused solely by the adopted rule will be limited to the difference 
between a sub-penny and penny spread. In addition, a locked market 
currently may not actually represent two market participants willing to 
buy and sell at the same price. Often, the locking market participant 
is not truly willing to trade at the displayed locking price, but 
instead chooses to lock rather than execute against the already-
displayed quotation to receive a liquidity rebate.\442\
---------------------------------------------------------------------------

    \442\ See supra, note 435. See also AFB Comment Letter at 9; 
Schwab Comment Letter at 17.
---------------------------------------------------------------------------

    The Commission agrees with commenters supporting the proposal that 
an automated quotation is entitled to protection from locking or 
crossing quotations. When two market participants are willing to trade 
at the same quoted price, giving priority to the first-displayed 
automated quotation will encourage posting of quotations and contribute 
to fair and orderly markets. The basic principle underlying the NMS is 
to promote fair competition among markets, but within a system that 
also promotes interaction between all of the buyers and sellers in a 
particular NMS stock. Allowing market participants simply to ignore 
accessible quotations in other markets and routinely display locking 
and crossing quotations is inconsistent with this principle. The Rule 
will, however, not prohibit automated quotations from locking or 
crossing manual quotations, thereby permitting market participants to 
reflect information regarding the inaccessibility of a particular 
trading center's quotations.
    Two commenters requested that the Commission include an exception 
to the locked and crossed requirements for system malfunctions and 
material delays, and one commenter requested that the Commission 
include an exception for flickering quotations, similar to the 
exceptions proposed for the Order Protection Rule.\443\ The SIA also 
requested that the Commission further clarify the operation of the 
``ship and post'' procedures.\444\ The Commission believes that it 
would be reasonable for the SROs to include in their rules implemented 
pursuant to Rule 610(d) exceptions equivalent to those included in the 
Order Protection Rule.\445\ The Commission intends to

[[Page 37548]]

work closely with the SROs and other industry participants during the 
implementation period for Regulation NMS to achieve reasonable 
industry-wide standards for SRO rules relating to locked and crossed 
markets. In addition, such rules must be filed for Commission approval, 
thereby providing an opportunity for public notice and comment.
---------------------------------------------------------------------------

    \443\ Nasdaq Reproposal Letter at 18; SIA Reproposal Letter at 
23.
    \444\ SIA Reproposal Letter at 23.
    \445\ Specifically, such exceptions would be included within SRO 
rules adopted pursuant to Rule 610(d) that require their members to 
reasonably avoid displaying quotations that lock or cross a 
protected quotation or displaying manual quotations that lock or 
cross any quotation in an NMS stock. The Commission notes that it 
has modified the language of Rule 610(d)(3) from the reproposal to 
clarify that, if an SRO's rules (as approved by the Commission) 
provide for reasonable exceptions to the locking and crossing 
requirements of Rule 610(d), the prohibition on its members engaging 
in a pattern or practice of displaying quotations that lock or cross 
any protected quotation in an NMS stock, or of displaying manual 
quotations that lock or cross any quotation in an NMS stock 
disseminated pursuant to an effective national market system plan, 
will not apply to the display of quotations that lock or cross any 
protected or other quotation as permitted by an applicable 
exception.
---------------------------------------------------------------------------

B. Description of Adopted Rule

    Paragraphs (a) and (b) of Rule 610 address access to all quotations 
displayed by an SRO trading facility or by an SRO display-only 
facility. Paragraph (c) addresses the fees charged for access to 
protected quotations, and paragraph (d) addresses locking and crossing 
quotations. The Commission also is extending the scope of the fair 
access requirements of Regulation ATS as proposed and reproposed.
1. Access to Quotations
a. Quotations of SRO Trading Facilities
    Paragraph (a) of Rule 610 applies to quotations of an SRO trading 
facility. In Rule 600(b)(72), an SRO trading facility is defined as a 
facility operated by or on behalf of a national securities exchange or 
a national securities association that executes orders in securities or 
presents orders to members for execution.\446\ This definition 
therefore encompasses the trading facilities of each of the exchanges, 
as well as The NASDAQ Market Center. The term ``quotation'' is defined 
in Rule 600(b)(62) as a bid or an offer, and ``bid'' or ``offer'' is 
defined in Rule 600(b)(8) as the bid price or the offer price 
communicated by a member of a national securities exchange or national 
securities association to any broker or dealer or to any customer. Rule 
610(a) therefore applies to the entire depth of book of displayed 
orders of an SRO trading facility, including reserve size as well as 
displayed size at each price.
---------------------------------------------------------------------------

    \446\ The Commission has modified the definition of SRO trading 
facility in Rule 600(b)(72) to include the phrase ``or on behalf 
of'' after ``operated by'' to make clear that the term includes an 
SRO trading facility for which an exchange or association has 
contracted out the operation to a third party.
---------------------------------------------------------------------------

    Rule 610(a) prohibits an SRO from imposing unfairly discriminatory 
terms that prevent or inhibit any person from obtaining efficient 
access through a member of the SRO to the quotations in an NMS stock 
displayed by the SRO trading facility. This anti-discrimination 
standard is designed to give non-members indirect access to quotations 
through members. It is premised on fair and efficient access of SRO 
members themselves to the quotations of the SRO's trading facility. SRO 
member access currently is addressed by a series of provisions of the 
Exchange Act. Sections (6)(b)(4) and 15A(b)(5) provide that the rules 
of an exchange or association provide for the equitable allocation of 
reasonable dues, fees, and other charges among its members and other 
persons using its facilities, while Sections 6(b)(5) and 15A(b)(6) 
provide in part that its rules not be designed to permit unfair 
discrimination between customers, brokers, or dealers. In addition, 
Sections 6(b)(1) and 15A(b)(2) of the Exchange Act require that an 
exchange or association must have the capacity to be able to carry out 
the purposes of the Exchange Act. Sections 6(b)(5) and 15A(b)(6) also 
require an exchange or association to have rules designed to remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system. Section 11A(a)(1)(C) provides that two of the 
objectives of a national market system are to assure the economically 
efficient execution of securities transactions and the practicability 
of brokers executing investors' orders in the best market. To achieve 
these objectives, an SRO's members--broker-dealers that have the right 
to trade directly on an SRO facility--must themselves have fair and 
efficient access to the quotations displayed on such facility.
    Rule 610(a) builds on this existing access structure by prohibiting 
unfair discrimination that prevents or inhibits non-members from 
piggybacking on the access of members. In the absence of mandatory 
public linkages directly between markets, the ability to obtain 
indirect access is necessary to assure that non-members can readily 
access quotations to meet the requirements of the Order Protection Rule 
and to fulfill their duty of best execution. In general, any SRO rule 
or practice that treats orders less favorably based on the identity of 
the ultimate party submitting the order through an SRO member could 
violate Rule 610(a). Thus, for example, charging differential fees or 
reducing an order's priority based on the identity of a member's 
customer would be inconsistent with Rule 610(a).
    Given the critical importance of indirect access to the private 
linkage approach incorporated in Rule 610(a), the Commission intends to 
review the current extent to which SRO members have fair and efficient 
access to quotations in NMS stocks that are displayed on an SRO trading 
facility (which term does not include the NASD's ADF, as discussed 
below). In this regard, we emphasize that the SROs with trading 
facilities cannot meet the access requirements of the Exchange Act 
simply by assuming direct access is available to trading centers that 
participate in the SRO trading facilities. Thus, if a trading center 
displays quotations on an SRO trading facility, but also provides 
direct access to such quotations, that SRO could not rely on the level 
of direct access to the non-SRO trading center to meet its Exchange Act 
responsibilities. An SRO trading facility must itself provide fair and 
efficient access to the quotations that are displayed as quotations of 
such SRO. Stated another way, an SRO trading facility cannot be used 
simply as a conduit for the display of quotations that cannot be 
accessed fairly and efficiently through the SRO trading facility 
itself. Accordingly, each SRO's facilities will be reviewed to 
determine whether they are able to meet the enhanced need for access 
under the adopted regulatory structure.
b. Quotations of SRO Display-Only Facility
    Paragraph (b) of Rule 610 applies to all quotations displayed by an 
SRO display-only facility. The term ``SRO display-only facility'' is 
defined in Rule 600(b)(71) as a facility operated by or on behalf of a 
national securities exchange or national securities association that 
displays quotations in securities, but does not execute orders against 
such quotations or present orders to members for execution.\447\ For 
quotations in NMS

[[Page 37549]]

stocks, this definition currently encompasses only the NASD's ADF.\448\
---------------------------------------------------------------------------

    \447\ The term ``SRO trading facility'' is defined in Rule 
600(b)(72) to mean a facility operated by or on behalf of a national 
securities exchange or a national securities association that 
executes orders in a security or presents orders to members for 
execution. The Commission has included the phrase ``to members'' 
after the phrase ``or present orders'' in the definition of ``SRO 
display-only facility'' in Rule 600(b)(71) as adopted to conform it 
to the definition of SRO trading facility. The Commission also has 
modified the definition of SRO display-only facility to include the 
phrase ``or on behalf of'' after ``operated by'' to make clear that 
the term includes an SRO trading facility for which an exchange or 
association has contracted out the operation to a third party.
    \448\ The Commission notes that Rule 610(b)(1) applies to all 
quotations displayed on an SRO display-only facility, even if the 
trading center also displays quotations in an SRO trading facility. 
To preclude the consolidated data stream from giving a misleading 
indication of available liquidity, separate quotations displayed on 
an SRO trading facility and an SRO display-only facility must each 
be fully accessible.
---------------------------------------------------------------------------

    Paragraph (b)(1) of Rule 610 requires any trading center that 
displays quotations in NMS stocks through an SRO display-only facility 
to provide a level and cost of access to such quotations that is 
substantially equivalent to the level and cost of access to quotations 
displayed by SRO trading facilities. The phrase ``level and cost of 
access'' would encompass both (1) the policies, procedures, and 
standards that govern access to quotations of the trading center, and 
(2) the connectivity through which market participants can obtain 
access and the cost of such connectivity. As discussed in section 
III.A.1 above, trading centers that choose to display quotations in an 
SRO display-only facility will be required to bear the responsibility 
of establishing the necessary connections to afford fair and efficient 
access to their quotations. The nature and cost of these connections 
for market participants seeking to access the trading center's 
quotations would need to be substantially equivalent to the nature and 
cost of connections to SRO trading facilities.\449\ In recent years, a 
variety of different types of entities have entered the business of 
providing connections for brokers and market participants to different 
trading centers. The Commission anticipates that ADF participants will 
take advantage of linking to these service providers to establish the 
necessary connectivity.
---------------------------------------------------------------------------

    \449\ As stated above in section III.A.1, this requirement does 
not apply on an absolute basis, but instead applies on a per-
transaction basis to reflect the costs relative to the ADF 
participant's trading volume.
---------------------------------------------------------------------------

    The NASD, as the self-regulatory authority responsible for 
enforcing compliance by ADF participants with the requirements of the 
Exchange Act, will need to evaluate the connectivity of ADF 
participants to determine whether it meets the requirements of Rule 
610(b)(1). Prior to implementation of Rule 610, the NASD will need to 
make an affirmative determination that existing ADF participants are in 
compliance with the requirements of the Rule.\450\ If an ADF 
participant is not complying with these access standards, the NASD 
would have a responsibility to stop publishing the participant's 
quotations until the participant comes into compliance.\451\ The 
Commission also believes that the addition of a new ADF participant 
would constitute a material aspect of the operation of the NASD's 
facilities, and thus require the filing of a proposed rule change 
pursuant to Section 19(b) of the Exchange Act that would be subject to 
public notice and comment.\452\
---------------------------------------------------------------------------

    \450\ See Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
    \451\ Id.
    \452\ See Rule 19b-4(b)(1) under the Exchange Act, 17 CFR 
240.19b-4(b)(1).
---------------------------------------------------------------------------

    Paragraph (b)(2) of Rule 610 prohibits any trading center that 
displays quotations through an SRO display-only facility from imposing 
unfairly discriminatory terms that prevent or inhibit any person from 
obtaining efficient access to such quotations through a member, 
subscriber, or customer of the trading center. This prohibition 
parallels the prohibition in Rule 610(a) that applies to the quotations 
of SRO trading facilities.\453\ Thus, a trading center's differential 
treatment of orders based on the identity of the party ultimately 
submitting an order through a member, subscriber, or customer of such 
trading center generally is inconsistent with this Rule.
---------------------------------------------------------------------------

    \453\ Moreover, as with paragraph (a) of Rule 610, paragraph (b) 
applies to both the displayed and reserve size of the displayed 
quotations of an SRO display-only facility.
---------------------------------------------------------------------------

2. Limitation on Access Fees
    Rule 610(c) limits the fees that can be charged for access to 
protected quotations and manual quotations at the best bid and offer. 
It provides that a trading center shall not impose, nor permit to be 
imposed, any fee or fees for the execution of an order against a 
protected quotation of the trading center or against any other 
quotation of the trading center that is the best bid or best offer of a 
national securities exchange, the best bid or best offer of The Nasdaq 
Stock Market, Inc., or the best bid or best offer of a national 
securities association other than the best bid or best offer of The 
Nasdaq Stock Market, Inc. in an NMS stock (``BBO quotations'') that 
exceed or accumulate to more than $0.003 per share or, for its 
protected quotations and BBO quotations with a price of less than 
$1.00, that exceed or accumulate to more than 0.3% of the quotation 
price per share. Thus, the scope of Rule 610(c) is limited to the price 
of the best bid and offer, whether automated or manual, of each 
exchange, The NASDAQ Market Center, and the ADF. When triggered, the 
fee limitation of Rule 610(c) will apply to any order execution at the 
displayed price of the protected quotation or the BBO quotation. It 
therefore would encompass executions against both the displayed size 
and any reserve size at the price of those quotations.
    Rule 610(c) encompasses a wide variety of fees currently charged by 
trading centers, including both the fees commonly known as access fees 
charged by ECNs and the transaction fees charged by SROs. So long as 
the fees are based on the execution of an order against a protected 
quotation or a BBO quotation, the restriction of Rule 610(c) will 
apply. Conversely, fees not triggered by the execution of orders 
against protected quotations or BBO quotations (e.g., certain periodic 
fees such as monthly or annual fees) generally will not be included.
    In addition, Rule 610(c) encompasses any fee charged directly by a 
trading center, as well as any fee charged by market participants that 
display quotations through the trading center's facilities. Nothing in 
Rule 610(c) will preclude an SRO or other trading center from taking 
action to limit fees beyond what is required by the Rule, and trading 
centers will have flexibility in establishing their fee schedules to 
comply with Rule 610(c). In particular, trading centers could impose a 
limit on the fees that market participants are permitted to charge for 
quotations that are accessed through a trading center's facilities. For 
example, Nasdaq has adopted such a limit for quotations displayed by 
The NASDAQ Market Center.\454\
---------------------------------------------------------------------------

    \454\ NASD Rule 4623(b)(6).
---------------------------------------------------------------------------

    The Commission believes that it is consistent with the Quote Rule 
for market makers to charge fees for access to their quotations, so 
long as such fees meet the requirements of Rule 610(c). In particular, 
market makers will be permitted to charge fees for executions of orders 
against their quotations irrespective of whether the order executions 
are effected on an SRO trading facility or directly by the market 
maker.
3. Locking or Crossing Quotations
    Rule 610(d) restricts locking or crossing quotations, but 
recognizes that locked and crossed markets can occur accidentally, 
especially given the differing speeds with which trading centers update 
their quotations. It requires that each national securities exchange 
and national securities association establish, maintain, and enforce 
written rules that: \455\ (1) Require

[[Page 37550]]

its members to reasonably avoid displaying quotations that lock or 
cross any protected quotation in an NMS stock, or of displaying manual 
quotations that lock or cross any quotation in an NMS stock 
disseminated pursuant to an effective national market system plan; (2) 
are reasonably designed to assure the reconciliation of locked or 
crossed quotations in an NMS stock; and (3) prohibit its members from 
engaging in a pattern or practice of displaying quotations that lock or 
cross any protected quotation in an NMS stock, or of displaying manual 
quotations that lock or cross any quotation in an NMS stock 
disseminated pursuant to an effective national market system plan, 
other than displaying quotations that lock or cross any protected or 
other quotation as permitted by an exception contained in the SRO's 
rules established pursuant to (1). Of course, the SRO's locking and 
crossing rules should apply only to its own quoting facility.
---------------------------------------------------------------------------

    \455\ The Commission has modified the language of adopted Rule 
610(d) to require that an exchange or association ``establish, 
maintain, and enforce'' such rules, and to clarify that such rules 
must be written, to conform the language to the operative language 
of Rule 611(a)(1).
---------------------------------------------------------------------------

    Rule 610(d) distinguishes between protected (and therefore 
automated) \456\ quotations and manual quotations. Protected quotations 
can not be intentionally crossed or locked by any other quotations. 
Manual quotations, in contrast, can be locked or crossed by automated 
quotations, but can not themselves intentionally lock or cross any 
other quotations included in the consolidated data stream, whether 
automated or manual. Recognizing that quotations may on occasion 
accidentally lock or cross other quotations, Rule 610(d) requires 
members to ``reasonably avoid'' locking and crossing and prohibits a 
``pattern or practice'' of locking or crossing quotations where this 
can reasonably be avoided. SRO rules can include so-called ``ship and 
post'' procedures that require a market participant to attempt to 
execute against a relevant displayed quotation while posting a 
quotation that could lock or cross such a quotation. Finally, Rule 
610(d)(2) requires that each SRO's rules be reasonably designed to 
enable the reconciliation of locked or crossed quotations in an NMS 
stock. Such rules must require the market participant responsible for 
displaying the locking or crossing quotation to take reasonable action 
to resolve the locked or crossed market.\457\
---------------------------------------------------------------------------

    \456\ Under Rule 600(b)(57), only automated quotations can 
qualify as protected quotations.
    \457\ The Commission notes that the requirement in Rule 
610(d)(1) that an SRO establish, maintain, and enforce rules that 
require its members reasonably to avoid engaging in certain activity 
relating to locking and crossing of displayed quotations may appear 
to be similar to the language contained in Section 8(d)(i) of the 
existing ITS Plan that ``[t]he Participants also agree that ``locked 
markets'' in System securities should be avoided.'' The Commission 
emphasizes, however, that the intent and meaning of Rule 610(d) is 
more strict and comprehensive than the ITS Plan provision. In 
particular, as noted above, Rule 610(d) requires SROs to restrict 
their members' ability to engage in locking and crossing activity. 
The Commission therefore believes that most existing SRO rules 
established to implement the locked and crossed provision of the ITS 
Plan likely would not be sufficient to comply with Rule 610(d).
---------------------------------------------------------------------------

4. Regulation ATS Fair Access
    The ``fair access'' standards of Rule 301(b)(5) of Regulation ATS 
\458\ require a covered ATS, among other things, to: (1) Establish 
written standards for granting access on its system; and (2) not 
unreasonably prohibit or limit any person in respect to services 
offered by the ATS by applying its access standards in an unfair or 
discriminatory manner. As originally proposed and reproposed, the 
Commission is amending this section of Regulation ATS to lower the 
threshold that triggers the Regulation ATS fair access requirements 
from 20% of the average daily volume in a security to 5%.\459\ Under 
the access approach adopted today, the fairness and efficiency of 
private linkages will assume heightened importance. A critical 
component of private linkages is the ability of interested market 
participants to become members or subscribers of a trading center, 
particularly those trading centers with significant trading volume. As 
discussed in section III.A.1 above, market participants then may use 
their membership or subscribership access as a means for others to 
obtain indirect access by piggybacking on the direct access of members 
or subscribers. The Commission therefore believes that it is 
appropriate to lower the fair access threshold of Regulation ATS.\460\ 
Lowering the threshold for paragraph (b)(5) of Rule 301 also makes its 
coverage consistent with the 5% threshold triggering the order display 
and execution access requirements of Rule 301(b)(3). As a result, each 
ATS required to disseminate its quotations in the consolidated data 
stream also will be prohibited from unreasonably limiting market 
participants from becoming a subscriber or customer. Aside from 
lowering the threshold, the substantive requirements of Rule 301(b)(5) 
are left unchanged.
---------------------------------------------------------------------------

    \458\ 17 CFR 242.301(b)(5).
    \459\ The Regulation ATS fair access requirements are triggered 
on a security-by-security basis for equity securities. See 
Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 63 FR 
70844, 70873 (Dec. 22, 1998).
    \460\ One commenter opposed the proposal to lower the threshold 
for Regulation ATS fair access, primarily because it largely acts as 
an agency broker that routes orders to other venues. Bloomberg 
Tradebook Letter at 7. The Commission believes that ATSs, which by 
definition have chosen to offer market functions beyond mere agency 
routing, would appropriately be subject to regulatory requirements 
that reflect such functions. Commenters on the Proposing and 
Reproposing Releases supported the proposal to lower the fair access 
threshold. See, e.g., Amex Letter at 28-29; Citigroup Reproposal 
Letter at 3; E*TRADE Letter at 10; ICI Letter at 4; Instinet 
Reproposal Letter at 3,12; Morgan Stanley Letter at 17-18; Merrill 
Lynch Reproposal Letter at 9; Nasdaq Reproposal Letter at 17; 
Specialist Assoc. Letter at 11; UBS Letter at 9.
---------------------------------------------------------------------------

    One commenter, Liquidnet, argued that the fair access standards of 
Regulation ATS should not apply to systems that display orders only to 
one other system subscriber, such as through a negotiation 
feature.\461\ Among other things, Liquidnet maintained that the fair 
access requirement should not apply to it because, in essence, it is an 
institutional block trading desk that does not publish quotations.\462\ 
By its terms, Rule 301(b)(5) of Regulation ATS will apply to Liquidnet. 
However, the Commission believes that some form of exemptive relief 
under Section 36 of the Exchange Act may be appropriate to maintain the 
fair access threshold at 20% for an ATS, such as Liquidnet, that, among 
other things, limits its business to institutional block trading and 
does not disseminate quotations. The Commission intends to consider 
this matter further during the implementation period for Regulation 
NMS.
---------------------------------------------------------------------------

    \461\ See letter to Jonathan G. Katz, Secretary, Commission, 
from Seth Merrin, Chief Executive Officer, Liquidnet Inc., dated 
January 26, 2005 (``Liquidnet Reproposal Letter'') at 3.
    \462\ See id.
---------------------------------------------------------------------------

IV. Sub-Penny Rule

    The Commission today is adopting Rule 612 under the Exchange Act 
\463\ which will govern sub-penny quoting of NMS stocks. Rule 612 
imposes new requirements on any bid, offer, order, or indication of 
interest that is displayed, ranked, or accepted by a national 
securities exchange, national securities association, ATS, vendor, or 
broker-dealer. The Commission is adopting Rule 612 as it was reproposed 
in December 2004 with only a few minor amendments for clarity.
---------------------------------------------------------------------------

    \463\ 17 CFR 242.612.
---------------------------------------------------------------------------

A. Background

    In June 2000, the Commission issued an order directing NASD and the 
national securities exchanges to act jointly in developing a plan to 
convert their quotations in equity securities and options from 
fractions to decimals.\464\

[[Page 37551]]

The June 2000 Order stated that the plan could fix the minimum price 
variation (``MPV'') during the phase-in period, provided the MPV was no 
greater than $0.05 and no less than $0.01 for any equity security.\465\ 
The June 2000 Order also required NASD and the exchanges to provide the 
Commission with studies analyzing how decimal conversion had affected 
systems capacity, liquidity, and trading behavior, including an 
analysis of whether there should be a uniform MPV.\466\ The Commission 
stated that, if NASD or an exchange wished to move to quoting stocks in 
an increment less than $0.01, its study should include a full analysis 
of the potential impact on the market requesting the change and on the 
markets as a whole.\467\ Furthermore, the Commission required each SRO 
to propose a rule change under Section 19(b) of the Exchange Act \468\ 
to establish its individual choice of MPV for securities traded on its 
market.\469\ NASD and the exchanges complied with these requirements, 
and in August 2002 the Commission approved rule changes from all of 
these SROs to establish an MPV of $0.01 for equity securities.\470\
---------------------------------------------------------------------------

    \464\ See Securities Exchange Act Release No. 42194 (June 8, 
2000), 65 FR 38010 (June 19, 2000) (``June 2000 Order''). On January 
28, 2000, the Commission had ordered NASD and the exchanges to 
facilitate an orderly transition to decimal pricing in the 
securities markets. See Securities Exchange Act Release No. 42360 
(Jan. 28, 2000), 65 FR 5003 (Feb. 2, 2000) (``January 2000 Order''). 
In that order, the Commission set a timetable for NASD and the 
exchanges to begin trading some equity securities, and options on 
those securities, in decimals by July 3, 2000, and to begin trading 
all equities and options by January 3, 2001. See January 2000 Order, 
65 FR at 5005. In April 2000, the Commission issued another order 
staying the original deadlines for decimalization. See Securities 
Exchange Act Release No. 42685 (Apr. 13, 2000), 65 FR 21046 (Apr. 
19, 2000).
    \465\ See June 2000 Order, 65 FR at 38013. The June 2000 Order 
also required that at least some equity securities be quoted in 
minimum increments of $0.01. See Id.
    \466\ See Id.
    \467\ See Id.
    \468\ 15 U.S.C. 78s(b).
    \469\ See June 2000 Order, 65 FR at 38013.
    \470\ See Securities Exchange Act Release No. 46280 (July 29, 
2002), 67 FR 50739 (Aug. 5, 2002) (``August 2002 Order'') (approving 
SR-Amex-2002-02, SR-BSE-2002-02, SR-CBOE-2002-02, SR-CHX-2002-06, 
SR-CSE-2002-02, SR-ISE-2002-06, SR-NASD-2002-08, SR-NYSE-2002-12, 
SR-PCX-2002-04, and SR-Phlx-2002-05).
---------------------------------------------------------------------------

    Between the June 2000 Order and the August 2002 Order, the 
Commission issued a Concept Release seeking public comment on the 
potential impact of sub-penny pricing,\471\ including its effect on: 
(1) Price clarity (e.g., the potential to cause ephemeral or 
``flickering'' quotations); (2) market depth (i.e., the number of 
shares available at a given price); (3) compliance with the Order 
Handling Rules and other price-dependent rules; and (4) the operations 
and capacity of automated systems.\472\ The Commission received 33 
comments on the Concept Release.\473\ The majority of commenters 
opposed sub-penny pricing. Some stated that the negative effects of 
decimal trading would be exacerbated by further reducing the MPV, 
without meaningfully reducing spreads or securing other benefits for 
the markets or investors.\474\ These commenters recommended that all 
securities have an MPV of at least a penny.\475\ A smaller number of 
commenters believed that the forces of competition, rather than 
regulation by the Commission or Congress, should determine the 
MPV.\476\ These commenters suggested that a smaller MPV could improve 
market efficiency and provide investors with greater opportunity for 
price improvement. They argued generally that the problems accompanying 
decimals could be resolved through technology enhancements, rather than 
through regulation.
---------------------------------------------------------------------------

    \471\ Securities Exchange Act Release No. 44568 (July 18, 2001), 
66 FR 38390 (July 24, 2001) (``Concept Release'').
    \472\ See 66 FR at 38391-95.
    \473\ For a list of the commenters, see Proposing Release, 69 FR 
at 11165.
    \474\ See Id.
    \475\ However, some commenters that opposed sub-penny quoting 
thought that trading in sub-pennies should be permitted. See Id.
    \476\ See Id. at 11165-66.
---------------------------------------------------------------------------

    In August 2003, Nasdaq submitted a proposed rule change to the 
Commission to adopt an MPV of $0.001 for Nasdaq-listed securities.\477\ 
Nasdaq stated that, unless and until a uniform MPV were established, it 
felt compelled to implement an MPV of $0.001 to remain competitive with 
ECNs that permit their subscribers to quote in sub-pennies. At the same 
time, Nasdaq filed a petition for Commission action urging the 
Commission ``to adopt a uniform rule requiring market participants to 
quote and trade Nasdaq securities in a consistent monetary increment * 
* * with the exception of average price trades.'' \478\
---------------------------------------------------------------------------

    \477\ See SR-NASD-2003-121. Nasdaq has since withdrawn this 
proposal.
    \478\ Letter to Jonathan G. Katz, Secretary, Commission, from 
Edward S. Knight, Executive Vice President, Nasdaq, dated August 4, 
2003 (``Nasdaq Petition'').
---------------------------------------------------------------------------

B. Commission Proposal and Reproposal on Sub-Penny Quoting

    In February 2004, the Commission proposed new Rule 612 that would 
govern sub-penny quoting as part of the overall Regulation NMS 
proposal. In the initial Proposing Release, the Commission summarized 
the conversion of the U.S. securities markets from fractional to 
decimalized trading and stated its view that, on balance, the benefits 
of decimalization have justified the costs. The Commission cautioned, 
however, that if the MPV were to decrease beyond a certain level, the 
potential costs to investors and the markets could at some point 
surpass any potential benefits.\479\ To address this concern, Rule 612 
as proposed would have prohibited any national securities exchange, 
national securities association, ATS, vendor, or broker-dealer from 
displaying, ranking, or accepting from any person a bid, offer, order, 
or indication of interest in an NMS stock priced in an increment less 
than $0.01 per share. This restriction would not have applied to any 
NMS stock the share price of which is below $1.00.
---------------------------------------------------------------------------

    \479\ See Proposing Release, 69 FR at 11165.
---------------------------------------------------------------------------

    The proposed rule was designed to limit the ability of a market 
participant to gain execution priority over a competing limit order by 
stepping ahead by an economically insignificant amount. In issuing the 
sub-penny proposal, the Commission cited research performed by OEA 
showing a high incidence of sub-penny trades that cluster around the 
$0.001 and $0.009 price points. The OEA study concluded that this 
phenomenon resulted from market participants attempting to step ahead 
of competing limit orders for the smallest economic increment 
possible.\480\
---------------------------------------------------------------------------

    \480\ See 69 FR at 11169-70.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission pointed to a variety of 
additional problems caused by sub-penny quoting, including the 
following:
     If investors' limit orders lose execution priority for a 
nominal amount, investors may over time decline to use them, thus 
depriving the markets of liquidity.
     When market participants can gain execution priority for 
an infinitesimally small amount, important customer protection rules 
such as exchange priority rules and NASD's Manning rule \481\ could be 
rendered meaningless.

[[Page 37552]]

Without these protections, professional traders would have more 
opportunity to take advantage of non-professionals, which could result 
in the latter either losing executions or receiving executions at 
inferior prices.
---------------------------------------------------------------------------

    \481\ See NASD IM-2110-2 (generally requiring that a member firm 
that accepts and holds an unexecuted limit order from its customer 
in a Nasdaq security and that continues to trade the subject 
security for its own market-making account at prices that would 
satisfy the customer's limit order, without executing that limit 
order, shall be deemed to have acted in a manner inconsistent with 
just and equitable principles of trade). The impetus for this rule 
was a case brought by a customer of an NASD member firm, William 
Manning, who alleged that the firm had accepted his limit order, 
failed to execute it, and violated its fiduciary duty to him by 
trading ahead of the order. In the Manning decision, In re E.F. 
Hutton & Co., Exchange Act Release No. 25887 (July 6, 1988), the 
Commission affirmed NASD's finding that a member firm, upon 
acceptance of a customer's limit order, undertakes a fiduciary duty 
to its customer and cannot trade for its own account at prices more 
favorable than the customer's order.
---------------------------------------------------------------------------

     Flickering quotations that can result from widespread sub-
penny pricing could make it more difficult for broker-dealers to 
satisfy their best execution obligations and other regulatory 
responsibilities. The best execution obligation requires a broker-
dealer to seek for its customer's transaction the most favorable terms 
reasonably available under the circumstances.\482\ This standard is 
premised on the practical ability of the broker-dealer to determine 
whether a displayed price is reasonably obtainable under the 
circumstances.
---------------------------------------------------------------------------

    \482\ See Securities Exchange Act Release No. 37619A (Sept. 6, 
1996), 61 FR 48290, 48322 (Sept. 12, 1996) (adopting the 
Commission's Order Handling Rules). A broker-dealer's duty of best 
execution derives from common law agency principles and fiduciary 
obligations and is incorporated in SRO rules and, through judicial 
and Commission decisions, the antifraud provisions of the federal 
securities laws. See id.
---------------------------------------------------------------------------

     Widespread sub-penny quoting could decrease market depth 
(i.e., the number of shares available at the NBBO) and lead to higher 
transaction costs, particularly for institutional investors (such as 
pension funds and mutual funds) that are more likely to place large 
orders. These higher transaction costs would likely be passed on to 
retail investors whose assets are managed by the institutions.
     Decreasing depth at the inside also could cause such 
institutions to rely more on execution alternatives away from the 
exchanges and Nasdaq that are designed to help larger investors find 
matches for large blocks of securities. Such a trend could increase 
fragmentation of the securities markets.
    In the Reproposing Release, the sub-penny rule was fundamentally 
unchanged although the Commission made certain minor modifications in 
response to the comments received on the Proposing Release. These 
modifications in reproposed Rule 612 would have: (1) Based the sub-
penny restriction on the price of the quotation rather than the price 
of the NMS stock itself; and (2) limited a quotation priced less than 
$1.00 per share to four decimal places.

C. Comments Received

    The Commission sought comment on all aspects of reproposed Rule 
612. Of the total comments that the Commission received in response to 
the Reproposing Release, approximately 33 commenters addressed the sub-
penny rule. The majority of these commenters supported a restriction on 
sub-penny quoting.\483\ One commenter argued that sub-penny quoting 
would too easily permit market professionals to step ahead of competing 
limit orders by an economically insignificant amount.\484\ Another 
commenter stated that ``[t]oday, SROs are held to minimum quoting 
increments, while other market centers are not, and this arbitrage 
should be eliminated.'' \485\ A third commenter offered a similar 
perspective, stating that the sub-penny prohibition ``will prevent 
renegade systems from allowing a minority of traders to exploit the 
majority'' that do not offer sub-penny quoting.\486\
---------------------------------------------------------------------------

    \483\ See Ameritrade Reproposal Letter at 10; Angel Reproposal 
Letter at 6; Archipelago Reproposal Letter at 15; ATD Letter at 4; 
Barclays Global Investors Reproposal Letter at 4; Bennett Letter at 
1; BSE Reproposal Letter at 2; Citigroup Reproposal Letter at 8-9; 
DBSI Reproposal Letter at 3; Financial Information Forum Reproposal 
Letter at 3; Financial Services Roundtable Reproposal Letter at 5; 
GETCO Reproposal Letter at 1; Harris Letter at 3-4; JPMSI Reproposal 
Letter at 2; Knight Reproposal Letter at 6; Lerro Reproposal Letter, 
Appendix A, at 1; Merrill Lynch Reproposal Letter at 9-10; Nasdaq 
Reproposal Letter at 20; e-mail from Chris Sexton to William H. 
Donaldson, Chairman, Commission, dated January 31, 2005; SIIA/FISD 
Reproposal Letter at 4-5; STA Reproposal Letter at 7-8; STANY 
Reproposal Letter at 2; T. Rowe Price Reproposal Letter at 3; UBS 
Reproposal Letter at 1. See also Morgan Stanley Reproposal Letter at 
13 (suggesting that ``a reasonable compromise'' would be to allow 
sub-penny quotations for the sole purpose of reflecting an access 
fee but to prohibit them in all other circumstances); SIA Reproposal 
Letter at 23 (supporting reproposed Rule 612 while noting that a 
minority of SIA members believe that Commission rulemaking in this 
area is not necessary).
    \484\ See Knight Reproposal Letter at 6. This comment echoed 
similar comments in response to the initial Proposing Release. See, 
e.g., Ameritrade Letter at 10; Archipelago Letter at 14; ATD Letter 
at 3; Bloomberg Tradebook Letter at 2; Citadel Letter at 9; 
Citigroup Letter at 14; ICI Letter at 7-8; Tullo Letter at 8.
    \485\ Archipelago Reproposal Letter at 15.
    \486\ Harris Letter at 4.
---------------------------------------------------------------------------

    Three commenters argued that, in the absence of a general 
prohibition on sub-penny quoting, market data systems would be severely 
taxed.\487\ One commenter--a trade organization that addresses issues 
relating to market data and securities processing automation--doubted 
``whether the impact of sub-penny quoting and trading on rising 
infrastructure costs is adequately offset by market quality benefits to 
investors and market participants.'' \488\ A second commenter stated 
that an industry-wide shift to sub-penny quoting would ``forc[e] the 
industry into another round of substantial capital investments to 
accommodate the quote traffic.'' \489\ A third commenter echoed that 
view, stating that the new rule ``will protect industry systems from 
significant data traffic that has little benefit to investors or to the 
industry.'' \490\
---------------------------------------------------------------------------

    \487\ See Financial Information Forum Reproposal Letter at 3; 
Knight Reproposal Letter at 6; SIIA/FISD Reproposal Letter at 5. 
These comments echoed similar comments on the initial Proposing 
Release. See Financial Information Forum Letter at 2-3; Financial 
Services Roundtable Letter at 6; Knight Letter at 7; Lehman Brothers 
Letter at 5; Reuters Letter at 4.
    \488\ SIIA/FISD Reproposal Letter at 5.
    \489\ Knight Reproposal Letter at 6.
    \490\ Financial Information Forum Reproposal Letter at 3.
---------------------------------------------------------------------------

    A few commenters on the Reproposing Release opposed Rule 612,\491\ 
as did a minority of commenters on the initial Proposing Release.\492\ 
Some commenters argued that quoting in sub-pennies should be permitted 
because it increases liquidity, lowers trading costs, and promotes 
efficient pricing in the equity markets.\493\ Two commenters believed 
that government intervention was not appropriate, as market forces 
should address this issue.\494\ Alternatively, one commenter who 
objected to reproposed Rule 612 argued that ``[t]he appropriate MPV in 
the equities market is at least [a] nickel or some reasonable, tiered 
alternative.'' \495\
---------------------------------------------------------------------------

    \491\ See letter from Alex Goor, President, INET ATS, Inc. to 
Jonathan G. Katz, Secretary, Commission, dated January 26, 2005 
(``INET Reproposal Letter''); Instinet Reproposal Letter at 17-18; 
Malureanu E-mail (no page numbers); NexTrade Reproposal Letter at 
12.
    \492\ See Brut Letter at 24; Domestic Securities Summary of 
Intended Testimony (no page numbers); GETCO Letter (no page 
numbers); memorandum to File No. S7-10-04 from Susan M Ameel, 
Counsel to Commissioner Atkins, dated August 20, 2004 (meeting with 
Hudson River Trading) (no page numbers); Instinet Letter at 50; King 
Letter at 1; Mercatus Center Letter at 7; NexTrade Letter at 9-10; 
Reg NMS Study Group Letter at 9; Tower Research Letter at 8; Vie 
Securities Letter at 3. In addition, one commenter submitted a study 
on sub-penny pricing shortly before the Commission approved the 
Reproposing Release for publication. See also e-mail from Dr. 
Bidisha Chakrabarty, Assistant Professor, John Cook School of 
Business, Saint Louis University, to [email protected], dated 
December 1, 2004, enclosing two articles, ``Can sub-penny pricing 
reduce trading costs?'' (``Chakrabarty and Chung Study'') and ``One 
tick fits all? A study of the Island and Instinet ECN merger'' 
(``Chakrabarty and Tripathi Study''). While not explicitly opposing 
the sub-penny proposal, the studies argued that a general 
prohibition on sub-penny quoting would keep spreads artificially 
high for many securities.
    \493\ See Hudson River Trading Testimony (no page numbers); 
GETCO Letter (no page numbers).
    \494\ See Instinet Letter at 50; Tower Research Summary of 
Intended Testimony (no page numbers).
    \495\ NexTrade Reproposal Letter at 12.
---------------------------------------------------------------------------

    One commenter on the Reproposing Release--INET, an ECN that 
currently offers its users the ability to quote certain NMS stocks in 
sub-pennies--argued generally that ``the various marketplaces * * * are 
better positioned than regulators to evaluate

[[Page 37553]]

the most appropriate trading increment.'' \496\ In addition, INET 
maintained that the existing penny MPV exacerbates larger market 
structure problems, such as internalization and payment for order 
flow,\497\ stating that ``the convention of only quoting in pennies 
creates what is in effect an underground market where better prices are 
remitted back to certain firms through payment for order flow 
relationships but not reflected in any quotation.'' \498\ Furthermore, 
INET presented specific examples where, it claimed, moving from penny 
to sub-penny quoting reduced spreads.\499\
---------------------------------------------------------------------------

    \496\ See INET Reproposal Letter at 1.
    \497\ INET observed, for example, that NYSE has less than a 50% 
market share in Lucent Technologies and Nortel Networks, two NMS 
stocks trading below $5 per share, even though NYSE's overall market 
share is approximately 80%. INET attributed this phenomenon to the 
internalization of orders by other market centers that can readily 
match the BBO set by NYSE, because vigorous price competition--in 
the form of sub-penny quotations--does not exist. See id. at 6.
    \498\ Id. at 7.
    \499\ For example, INET observed that, with a penny MPV, JD 
Uniphase (ticker: JDSU) regularly traded at a penny spread with 
large size quoted on both the bid and the ask. INET claimed that, 
immediately after reducing the MPV to $0.001 on its system recently, 
the average spread in JDSU fell to a tenth of a penny and trades 
occurred ``almost uniformly across each sub-penny increment'' and 
were not clustered around the $0.001 and $0.009 price points. Id. at 
5.
---------------------------------------------------------------------------

    After careful consideration of all comments received, the 
Commission is adopting Rule 612 as reproposed, with only a few minor 
amendments for clarity. The Commission notes that a large majority of 
commenters on both the Reproposing Release \500\ and the initial 
Proposing Release \501\ supported a sub-penny quoting prohibition. The 
comments received have reinforced the Commission's preliminary view 
that there are substantial drawbacks to sub-penny quoting, and the 
Commission believes that a uniform rule banning this practice (except 
for quotations priced less than $1.00 per share) is appropriate. 
Several commenters agreed with the Commission's view that sub-penny 
quotations can increase the incidence of quote flickering, which in 
turn may have adverse effects such as confusing investors or impeding a 
broker-dealer's ability to fulfill its duty of best execution.\502\
---------------------------------------------------------------------------

    \500\ See supra, note 483.
    \501\ See, e.g., Alliance of Floor Brokers Letter at 12; ACIM 
Letter at 2; Ameritrade Letter at 10; Archipelago Letter at 14; ATD 
Letter at 3-4; Bloomberg Tradebook Letter at 2; BNY Letter at 4; BSE 
Letter at 13-14; CBOE Letter at 7; Citadel Letter at 9; Citigroup 
Letter at 14-15; CSE Letter at 23; Denizkurt Letter (no page 
numbers); E*Trade Letter at 11; Financial Information Forum Letter 
at 2-3; Financial Services Roundtable Letter at 5-6; Goldman Sachs 
Letter at 10; ICI Letter at 19-20; ISE Letter at 8; JPMSI Letter at 
6-7; Knight Letter at 7-8; Lava Letter at 5; Lehman Brothers Letter 
at 5; Liquidnet Letter at 8; LSC Letter at 11; Morgan Stanley Letter 
at 3; Nasdaq Letter at 1-2; NYSE Letter at 9-10; NSX Letter at 9; 
Peake Letter I at 13; Reuters Letter at 4; SBA Letter at 2; Schwab 
Letter at 17; SIA Letter at 20-21; Specialist Association Letter at 
13-15; STA Letter at 7; STANY Letter at 13-14; UBS Letter at 10; 
Vanguard Letter at 6.
    \502\ See, e.g., Citadel Letter at 9; ICI Letter at 7; Knight 
Letter at 7; Reuters Letter at 4; SIA Letter at 20-21.
---------------------------------------------------------------------------

    Moreover, the Commission agrees with the many commenters who 
believe that Rule 612 will deter the practice of stepping ahead of 
exposed trading interest by an economically insignificant amount. Limit 
orders provide liquidity to the market and perform an important price-
setting function. The Commission is concerned that, if orders lose 
execution priority because competing orders step ahead for an 
economically insignificant amount, liquidity could diminish. As one 
commenter, the Investment Company Institute, stated, ``[t]his potential 
for the increased stepping-ahead of limit orders would create a 
significant disincentive for market participants to enter any sizeable 
volume into the markets and would reduce further the value of 
displaying limit orders.'' \503\
---------------------------------------------------------------------------

    \503\ ICI Letter at 20.
---------------------------------------------------------------------------

    Some commenters argued, however, that investors would suffer harm 
from the artificially wide spreads resulting from a prohibition on sub-
penny quoting.\504\ One commenter stated, for example, that ``the 
primary result of eliminating subpenny trading would be to preserve a 
minimum profit for market makers, and would result in significantly 
worse realized prices for the vast majority of market participants not 
in the business of making markets.'' \505\ These commenters offered 
various estimates of the costs of prohibiting sub-penny quoting.\506\
    Even assuming that quoting in sub-penny increments would reduce 
spreads, the Commission continues to believe, on balance, that the 
costs of sub-penny quoting are not justified by the benefits.\507\ The 
Commission instead agrees with the commenters who believe that the 
substantial costs associated with sub-penny quoting--among others, 
disincentives to liquidity providers whose limit orders are jumped by 
an economically insignificant amount and the increased incidence of 
flickering quotes and the resulting regulatory compliance and capacity 
burdens--make the adoption of Rule 612 appropriate at this time.
---------------------------------------------------------------------------

    \504\ See Chakrabarty and Chung Study at 24; INET Reproposal 
Letter at 3; Instinet Letter at 51; Mercatus Center Letter at 9; 
Tower Research Letter at 8.
    \505\ Tower Research Letter at 8. Tower Research also criticized 
the Nasdaq and OEA studies on which the Commission relied in issuing 
the sub-penny proposal. Tower Research argued, for example, that the 
studies did not differentiate between sub-penny trades and sub-penny 
quotations, and that clustering of sub-penny trades around the 
$0.001 and $0.009 price points could result from sub-penny price 
improvement rather than quotation activity. In response to this 
comment, OEA reviewed the sources of data used in the original study 
and found that sub-penny trades cluster at these two price points in 
markets where trades necessarily result from quotations, such as 
ECNs, not only in markets where that is not necessarily the case. 
See Memorandum from Office of Economic Analysis, dated December 15, 
2004 (available in Public File No. S7-10-04 and on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed/s71004.shtml)) 
(``OEA December 2004 Sub-Penny Analysis''). Accordingly, the 
Commission continues to believe that market participants frequently 
used their ability to quote in sub-pennies to step ahead of 
competing limit orders by the smallest possible amount.
    \506\ See Chakrabarty and Chung Study at 24 (stating that, for 
high volume stocks, ``the spread reduction in the absence of binding 
constraints * * * translates into savings of millions of dollars''); 
INET Reproposal Letter at 3 (arguing that allowing sub-penny quoting 
in ``23 of the most appropriate securities'' would generate annual 
savings of anywhere between $342 million and $1.9 billion); Instinet 
Letter at 50 (arguing that, if all markets traded QQQQ solely in 
sub-pennies, the savings would be approximately $150 million per 
year); Tower Research Letter at 9 (arguing that, just in six high-
volume securities, the proposed rule would have would have costs of 
over $400 million due to wider spreads).
    \507\ The Commission notes that the few commenters who provided 
detailed, quantitative criticisms of the proposed sub-penny rule 
relied on a very small number of NMS stocks as examples. These cost 
estimates appear to assume that all trading in the securities they 
discuss would occur at narrower quoted spreads if Rule 612 did not 
exist. The Commission does not believe that the commenters provided 
any evidence to justify that assumption. Currently, Nasdaq and the 
national securities exchanges generally do not permit quoting in 
sub-pennies; this practice exists only a small number of ATSs, and 
only for a small number of securities. Because spreads on Nasdaq and 
the exchanges already cannot be smaller than $0.01, Rule 612 will 
not require these markets to take any action that would cause their 
spreads to widen. Therefore, the Commission believes that the cost 
to these markets of not having sub-penny spreads should not be 
considered costs of the rule. Furthermore, the INET methodology for 
computing the potential savings to investors from quoting in sub-
pennies appears to be based on the unjustified assumption that all 
of selected stocks in their sample would trade with the same price-
point distribution as the average of JDSU, SIRI, and QQQQ. With 
respect to the ATSs that currently do permit some NMS stocks to be 
quoted in sub-pennies, the Commission staff has estimated that the 
gross costs of widened spreads in these securities will be 
approximately $48 million annually (or approximately $33 million if 
the Commission were to exempt QQQQ from Rule 612). See OEA December 
2004 Sub-Penny Analysis.
---------------------------------------------------------------------------

    Nevertheless, the Commission acknowledges the possibility that the 
balance of costs and benefits could shift in a limited number of cases 
or as the markets continue to evolve. Therefore, Rule 612--as proposed 
and as adopted--includes a provision setting forth procedures for the 
Commission, by order, to exempt any person, security, or

[[Page 37554]]

quotation (or any class or classes or persons, securities, or 
quotations) from the sub-penny quoting restriction if it determines 
that such exemption is necessary or appropriate in the public interest, 
and is consistent with the protection of investors. The Commission 
could grant such exemption either unconditionally or on specified terms 
and conditions.
    In the Proposing Release, the Commission requested comment on 
whether certain securities should be exempted from Rule 612.\508\ In 
particular, the Commission asked whether sub-penny quoting of exchange-
traded fund shares (``ETFs''), which are derivatively priced, raised 
the same concerns as with other NMS stocks.\509\ Some commenters that 
addressed this issue argued that the sub-penny prohibition should apply 
to all NMS stocks, including ETFs.\510\ These commenters generally 
believed that sub-penny quoting raises the same type of concerns for 
ETFs as for other types of securities.\511\ Other commenters provided 
arguments that exemptions for at least certain securities would be 
appropriate. One commenter that opposed Rule 612 argued that, if the 
Commission nevertheless did approve the rule, it should provide an 
exemption for QQQQ and other ETFs.\512\ This commenter argued that 
these securities ``uniquely lend[] themselves to subpenny quoting and 
trading'' because ``the[ir] derivative nature * * * enables investors 
to determine their true value at any point in time by calculating the 
aggregate price of the securities constituting a particular ETF.'' 
\513\ Other commenters, while not explicitly recommending that the 
Commission grant particular exemptions, argued that sub-penny quoting 
was reasonable for certain securities.\514\
---------------------------------------------------------------------------

    \508\ See Proposing Release, 69 FR at 11172.
    \509\ See id.
    \510\ See Ameritrade Reproposal Letter at 10; Amex Letter, 
Exhibit A, at 29; Citigroup Reproposal Letter at 9; ICI Letter at 
20; Knight Letter at 8; Morgan Stanley Letter at 21; NYSE Letter at 
10; SIA Letter at 21; Specialist Association Letter at 14.
    \511\ See, e.g., Amex Letter, Exhibit A, at 29; ICI Letter at 
20.
    \512\ See Instinet Letter at 51; Instinet Reproposal Letter at 
18.
    \513\ Id.
    \514\ See Brut Letter at 25; Mercatus Center Letter at 9-10; 
Tower Research Letter at 9, 14-15.
---------------------------------------------------------------------------

    As the Commission stated in the Reproposing Release,\515\ a basis 
may exist to exempt QQQQ and perhaps other actively traded ETFs from 
Rule 612. The Commission will continue to study this matter during the 
implementation period for Regulation NMS.
    One commenter, although not clearly advocating that the Commission 
use its authority to exempt certain securities from Rule 612, stated 
that ``the Commission may want to employ objective criteria in 
determining when it is appropriate to trade in sub-pennies.'' \516\ In 
this regard, another commenter stated: ``If the Commission wanted to 
permit only certain stocks to be quoted and traded in sub-penny 
increments, the main factor that should be considered is the average 
spread and the quoted size. If a security always trades with a penny 
spread and there is tremendous liquidity available on both sides of the 
market, this is a strong indication that the minimum increment is too 
wide.'' \517\ The Commission believes that this would be a reasonable 
consideration in analyzing whether it would be in the public interest 
and consistent with the protection of investors to grant an exemption 
pursuant to Rule 612(c). Other factors that the Commission might 
consider are:
---------------------------------------------------------------------------

    \515\ See 69 FR at 77459.
    \516\ Archipelago Reproposal Letter at 15.
    \517\ INET Reproposal Letter at 5.
---------------------------------------------------------------------------

     Whether the NMS stock is an ETF or other derivative that 
can readily be converted into its underlying securities or vice versa, 
in which case the true value of the security as derived from its 
underlying components might be at a sub-penny increment;
     Large volume of sub-penny executions in that security due 
to price improvement; and
     Low price of the security.
    This list is illustrative, not exclusive. The Commission may 
consider other factors--noted by a petitioner or in its own analysis--
if and when it considers whether to issue an exemption.
    The Commission wishes to highlight certain aspects of Rule 612, as 
adopted, that were raised by commenters on both the Proposing Release 
and the Reproposing Release.
1. Restriction Based on Price of the Quotation Not Price of the Stock
    As initially proposed, the restriction on sub-penny quoting would 
have been triggered if the price of the NMS stock itself were above 
$1.00. One commenter sought clarification of when an NMS stock would 
become sub-penny eligible, suggesting a threshold of trading below 
$1.00 for 30 consecutive business days.\518\ A second commenter 
suggested instead that the prohibition should derive from the price of 
the order, rather than the price of the stock; in other words, the rule 
should permit any sub-penny quotation below $1.00 and prohibit any sub-
penny quotation above $1.00, regardless of the price where the stock 
was in fact trading.\519\ The second commenter argued that this 
approach ``does not require countless re-classifications of stocks as 
`sub-penny eligible' based on fluctuations in their valuation, stock 
splits, or other price movements.'' \520\
---------------------------------------------------------------------------

    \518\ See Citigroup Letter at 15.
    \519\ See Brut Letter at 25.
    \520\ Id.
---------------------------------------------------------------------------

    The Commission agreed with the second commenter and, therefore, 
revised paragraph (a) of reproposed Rule 612 to prohibit any bid, 
offer, order, or indication of interest priced equal to or greater than 
$1.00 in an increment smaller than $0.01. As the Commission stated in 
the Reproposing Release,\521\ basing the restrictions on the price of 
the quotation or order rather than the price of the NMS stock itself 
would spare market participants the need to track the eligibility of 
stocks priced near the $1.00 threshold.
---------------------------------------------------------------------------

    \521\ See 69 FR at 77457-58.
---------------------------------------------------------------------------

    Three commenters on the Reproposing Release noted their approval of 
basing the sub-penny quoting restriction on the price of the quotation 
rather than the price of the NMS stock itself; \522\ no commenter 
objected to this approach. The Commission continues to believe in the 
rationale for this aspect of the proposal as described in the 
Reproposing Release. Therefore, the Commission is adopting Rule 612(a) 
substantially in the form reproposed in December 2004. The Commission 
is making a non-substantive amendment to clarify the rule. Reproposed 
Rule 612(a) would have stated that no market participant ``shall 
display, rank, or accept from any person a bid or offer, an order, or 
an indication of interest in any NMS stock equal to or greater than 
$1.00 in an increment smaller than $0.01.'' Rule 612(a) as adopted 
provides that no market participant ``shall display, rank, or accept 
from any person a bid or offer, an order, or an indication of interest 
in any NMS stock priced in an increment smaller than $0.01 if that bid 
or offer, order, or indication of interest is priced equal to or 
greater than $1.00 per share.'' The purpose of this revision is to 
clarify that the qualification ``priced equal to or greater than $1.00 
per share'' modifies the phrase ``a bid or offer, an order, or an 
indication of interest'' rather than ``any NMS stock.'' The adopted 
text also makes clear that this proviso applies to bids, offers, 
orders, and indications of interest priced equal to or greater than 
$1.00 per share. The

[[Page 37555]]

modifying phrase ``per share'' was not present in reproposed Rule 
612(a).
---------------------------------------------------------------------------

    \522\ See BSE Reproposal Letter at 2; Nasdaq Reproposal Letter 
at 20; SIA Reproposal Letter at 23.
---------------------------------------------------------------------------

    As a result of Rule 612(a), a broker-dealer may not, for example, 
accept a sell order in an NMS stock priced at $1.0025 per share, even 
if the NMS stock currently trades below $1.00.
2. Quotations Below $1.00
    The Commission initially proposed a threshold of $1.00 below which 
the prohibition on sub-penny quoting would not apply and requested 
comment on whether that threshold was appropriate. The majority of 
commenters addressing this issue believed that it would be useful for 
low-priced securities to trade in increments finer than a penny, 
because a penny would constitute a significant percentage of the 
overall price. These commenters viewed $1.00 as an appropriate 
threshold.\523\ One commenter stated that there is ``real demand for 
sub-penny trading (and therefore subpenny quoting) in securities 
trading below $1.00, due to the low trading value of the security.'' 
\524\ However, another commenter, Ameritrade, argued that Rule 612 
should not contain an exception for securities trading under 
$1.00.\525\ According to Ameritrade, ``[t]he appropriate answer to this 
issue is for the NYSE, AMEX and NASDAQ markets to uniformly enforce 
listing standards, which generally require a security to trade above 
$1.00.'' \526\
---------------------------------------------------------------------------

    \523\ See Archipelago Letter at 14; BSE Letter at 14; Citigroup 
Letter at 15; LSC Letter at 11; SIA Letter at 21; STANY Letter at 
14.
    \524\ Archipelago Letter at 14.
    \525\ See Ameritrade Reproposal Letter at 10.
    \526\ Id.
---------------------------------------------------------------------------

    The Commission is adopting the $1.00 threshold as proposed. The 
Commission agrees with the commenters who believe that sub-penny 
quotations for very low-priced securities largely represent genuine 
trading interest rather than unfair stepping ahead. In such cases, a 
sub-penny increment represents a significant amount of the price of the 
quotation or order. Accordingly, the prohibition on sub-penny quoting 
in paragraph (a) of Rule 612 will apply only to bids, offers, orders, 
and indications of interest that are priced $1.00 or more per share. 
With respect to Ameritrade's comment, while the Commission believes 
that SROs must vigorously enforce their listing standards, there are 
legitimate circumstances where securities may be trading below $1.00; 
therefore, the Commission believes it is appropriate for Rule 612 to 
address those circumstances.
    Before the Reproposing Release, two commenters suggested that the 
Commission establish an MPV for quotations below $1.00 per share; both 
recommended allowing such quotations to extend to four decimal 
places.\527\ The Commission agreed with these commenters and added a 
new paragraph (b) to reproposed Rule 612 that would have prohibited a 
bid, offer, order, or indication of interest priced less than $1.00 per 
share in an increment smaller than $0.0001. The Commission believes 
that, without limiting the number of decimal places used in quotations 
for very low-priced securities, the problems caused by sub-penny 
quoting of higher-priced securities, discussed above, could arise. 
Restricting quotations below $1.00 to four decimal places should avoid 
these problems. The same two commenters reacted favorably to this 
aspect of the Reproposing Release.\528\
---------------------------------------------------------------------------

    \527\ See Citigroup Letter at 15; SIA Letter at 21.
    \528\ See Citigroup Reproposal Letter at 8-9; SIA Reproposal 
Letter at 23.
---------------------------------------------------------------------------

    The Commission is adopting, as reproposed, the provision limiting a 
quotation under $1.00 per share to four decimal places. Thus, under new 
Rule 612, a quotation of $0.9987 x $1.00 is permitted but a quotation 
of $0.9987 x $1.0001 is not.\529\
---------------------------------------------------------------------------

    \529\ One commenter, while supporting the general prohibition on 
sub-penny quoting, noted that ``[t]here are many `subpenny' stocks 
on the OTCBB that trade at prices close to or less than $.0001. 
Imposing a high minimum tick for stocks in this category may 
adversely trading in those stocks.'' Angel Reproposal Letter at 6. 
The Commission notes that new Rule 612 applies only to NMS stocks, 
the definition of which generally does not include stocks quoted on 
the OTCBB. See 17 CFR 242.600(b)(47) (defining ``NMS stock''). 
Therefore, Rule 612 does not require that quotations below $1.00 per 
share in securities quoted exclusively on the OTCBB be limited to 
four decimal places.
---------------------------------------------------------------------------

    The Commission notes that it has made non-substantive revisions to 
Rule 612(b) in a manner similar to Rule 612(a). Reproposed Rule 612(b) 
would have stated that no market participant ``shall display, rank, or 
accept from any person a bid or offer, an order, or an indication of 
interest in any NMS stock less than $1.00 in an increment smaller than 
$0.0001.'' Rule 612(b) as adopted provides that no market participant 
``shall display, rank, or accept from any person a bid or offer, an 
order, or an indication of interest in any NMS stock priced in an 
increment smaller than $0.0001 if that bid or offer, order, or 
indication of interest is priced less than $1.00 per share.'' The 
purpose of this revision is to clarify that the qualification ``priced 
less than $1.00 per share'' modifies the phrase ``a bid or offer, an 
order, or an indication of interest'' rather than ``any NMS stock.'' 
The adopted text also makes clear that this proviso applies to bids, 
offers, orders, and indications of interest priced less than $1.00 per 
share. The modifying phrase ``per share'' was not present in reproposed 
Rule 612(b).
    During the Regulation NMS implementation period, the Commission 
intends to consult with the administrators of the Plans to help ensure 
that sub-penny quotations permitted by Rule 612 will be widely 
disseminated to the public. The Commission believes this is necessary 
so that the problem of hidden markets--where professionals can see and 
access more competitive sub-penny quotations that average investors 
cannot--is fully addressed.
3. Revisiting the Penny Increment
    Some commenters, while generally acknowledging problems caused by 
sub-penny quoting, recommended that the Commission consider increasing 
the MPV above $0.01.\530\ One commenter believed that ``[t]he 
Commission should seriously consider experimenting with different tick 
sizes to help determine the optimal tick policy.'' \531\ A second 
commenter recommended that the Commission establish an MPV of a $0.01 
for high-volume stocks, $0.05 middle-volume stocks, and $0.10 for the 
low-volume stocks.\532\ A third commenter argued that the appropriate 
MPV in the equities market is at least $0.05 ``or some reasonable, 
tiered alternative.'' \533\ The third commenter previously stated that 
``sub-penny quoting does little, if anything, to degrade the market 
from its current state'' because ``the true damage was done to the 
market in the shift from a fractionalized environment to a penny spread 
environment.'' \534\
---------------------------------------------------------------------------

    \530\ See Amex Letter at 30; Angel Letter at 10; BNY Letter at 
4; Citadel Letter at 10; e-mail from LaBranche & Co. to [email protected], dated January 26, 2005; McGuire Summary of 
Intended Testimony (no page numbers); Tullo Letter at 9.
    \531\ Angel Letter at 10.
    \532\ See Tullo Letter at 9.
    \533\ NextTrade Reproposal Letter at 12.
    \534\ NexTrade Letter at 9.
---------------------------------------------------------------------------

    Rule 612, as adopted, sets a floor for the MPV but does not, and is 
not designed to, determine the optimal MPV. Penny pricing in NMS stocks 
was established by rules proposed by NASD and the national securities 
exchanges and approved by the Commission pursuant to Section 19(b) of 
the Exchange Act.\535\ While some commenters argue that penny pricing 
impedes transparency and reduces liquidity, the move to decimals (and 
specifically the move to a penny

[[Page 37556]]

quotation increment for NMS stocks) also has significantly reduced 
spreads and reduced trading costs for investors who enter orders 
executed at or within the NBBO. As the Commission stated in the 
Reproposing Release,\536\ it believes that the establishment of a $0.01 
MPV, on balance, has benefited many investors. Accordingly, the 
Commission did not propose to raise the MPV in connection with 
Regulation NMS. The Commission's views on this matter have not changed 
since issuance of the Reproposing Release, and the Commission is not 
amending Rule 612 to raise the MPV.
---------------------------------------------------------------------------

    \535\ 15 U.S.C. 78s(b). See supra, note .
    \536\ See 69 FR at 77458.
---------------------------------------------------------------------------

4. Sub-Penny Trading
    The Commission stated in the Proposing Release that it did not at 
that time believe that trading in sub-penny increments raised the same 
concerns as sub-penny quoting. Therefore, the proposed rule would not 
have prohibited a market center or broker-dealer from executing and 
printing a trade in sub-penny increments that was, for example, the 
result of a midpoint or volume-weighted pricing algorithm, as long as 
it did not otherwise violate the proposed rule. In addition, a broker-
dealer could, consistent with the proposed rule, provide price 
improvement to a customer order that resulted in a sub-penny execution 
as long as the broker-dealer did not accept an order priced above $1.00 
per share in a sub-penny increment. The Commission sought specific 
comment on this aspect of the proposal.
    Every commenter that addressed this issue in response to the 
Proposing Release agreed that Rule 612 should permit sub-penny trades 
that result from midpoint and average-price algorithms.\537\ While most 
of these commenters believed that the rule should permit broker-dealers 
to offer sub-penny price improvement to their customers' orders,\538\ a 
few commenters urged the Commission to bar this practice.\539\ The 
Commission did not revise this aspect of the sub-penny rule in the 
Reproposing Release. Two commenters that addressed this issue in 
response to the Reproposing Release also believed that the rule should 
permit sub-penny trades that result from midpoint and average-price 
algorithms.\540\ One of these commenters added that sub-penny trades 
resulting from price improvement also should be permitted.\541\
---------------------------------------------------------------------------

    \537\ See ACIM Letter at 2; Amex Letter at 12; E*Trade Letter at 
11; Liquidnet Letter at 8; SIA Letter at 21; STA Letter at 7; STANY 
Letter at 14; UBS Letter at 10.
    \538\ See ACIM Letter at 2; Amex Letter, Exhibit A, at 31-32; 
BSE Letter at 14; E*Trade Letter at 11; Liquidnet Letter at 8; 
Morgan Stanley Letter at 21; SIA Letter at 21; STA Letter at 7; 
STANY Letter at 14; UBS Letter at 10.
    \539\ See CHX Letter at 23; Goldman Sachs Letter at 10; SIA 
Letter at 21.
    \540\ See BSE Reproposal Letter at 2; Citigroup Reproposal 
Letter at 9.
    \541\ See Citigroup Reproposal Letter at 9.
---------------------------------------------------------------------------

    After considering all views expressed on this issue, the Commission 
is adopting this aspect of Rule 612 as proposed and reproposed. Rule 
612 will not prohibit a sub-penny execution resulting from a midpoint 
or volume-weighted algorithm or from price improvement, so long as the 
execution did not result from an impermissible sub-penny order or 
quotation. The Commission believes at this time that trading in sub-
penny increments does not raise the same concerns as sub-penny quoting. 
Sub-penny executions do not cause quote flickering and do not decrease 
depth at the inside quotation. Nor do they require the same systems 
capacity as would sub-penny quoting. In addition, sub-penny executions 
due to price improvement are generally beneficial to retail investors.
5. Acceptance of Sub-Penny Quotations
    The Commission initially proposed to prohibit national securities 
exchanges, national securities associations, ATSs, vendors, and broker-
dealers from displaying, ranking, or accepting sub-penny orders or 
quotations in NMS stocks. One commenter argued that Rule 612 should 
allow a market participant to accept sub-penny quotations if it 
consistently re-prices such quotations to an acceptable increment and 
does not give the sub-penny quotations any special priority for ranking 
or execution purposes.\542\ A second commenter disagreed, arguing that 
rounding a sub-penny quotation to the nearest penny may be confusing 
for investors.\543\ The Commission agreed with the second commenter and 
reproposed Rule 612 continued to include a prohibition on accepting and 
rounding a sub-penny order.
---------------------------------------------------------------------------

    \542\ See Brut Letter at 26.
    \543\ See CHX Letter at 23.
---------------------------------------------------------------------------

    In response to the Commission's statements on this matter in the 
Reproposing Release, one commenter stated that the Commission should 
``continu[e] to allow (but, of course, not require) market centers to 
adjust the pricing of disallowed sub-penny quotations, so long as the 
unadjusted quotations are not displayed or considered for purposes of 
ranking.'' \544\ This commenter argued that adjusting such quotations 
``is a well-established practice'' and that prohibiting the practice 
``has the potential to create needless confusion and impose additional 
costs.'' \545\ Another commenter on reproposed Rule 612 argued 
similarly that keeping the established practice would not present ``any 
real potential for confusion among investors.'' \546\
---------------------------------------------------------------------------

    \544\ Nasdaq Reproposal Letter at 20.
    \545\ Id.
    \546\ Instinet Reproposal Letter at 18.
---------------------------------------------------------------------------

    Notwithstanding these comments, the Commission is adopting this 
aspect of Rule 612 as proposed and reproposed. A market participant, 
therefore, is prohibited from accepting a sub-penny order or quotation 
that is not permitted by the rule, even if it rounds the order or 
quotation to the nearest permissible pricing increment. While the 
Commission does not believe that a great deal of customer confusion is 
likely to arise in either case, it does believe that confusion is more 
likely to result if a broker-dealer, for example, accepted a customer 
order to buy at $20.001, then rounded and ultimately executed it at 
$20.00. A customer unfamiliar with Rule 612 could conceivably wonder 
why his or her order did not have priority above orders to buy at 
$20.00. A much simpler and more transparent approach is for Rule 612 to 
prohibit the acceptance of sub-penny orders generally (except for 
orders priced below $1.00 per share, which may extend to four decimal 
places), and for the broker-dealer to adhere to the rule by rejecting 
the customer's sub-penny order to buy at $20.001. The Commission sees 
no purpose that would be served by allowing the broker-dealer to accept 
this sub-penny order, since Rule 612 would in any case prohibit the 
full order from being displayed or considered for ranking or execution 
purposes.\547\
---------------------------------------------------------------------------

    \547\ The Commission previously has granted exemptions from 
Rules 11Ac1-1, 11Ac1-2, and 11Ac1-4 under the Exchange Act, 17 CFR 
240.11Ac1-1, 240.11Ac1-2, and 240.11Ac1-4, that permit orders and 
quotations to be accepted and executed in sub-penny increments but 
displayed in rounded, penny increments without a rounding 
identifier. See letter from David S. Shillman, Associate Director, 
Division, Commission, to Mai S. Shiver, Director of Regulatory 
Policy, PCX, dated Feb. 10, 2005; letter from David S. Shillman, 
Associate Director, Division, Commission, to Ellen J. Neely, Senior 
Vice President and General Counsel, CHX, dated July 15, 2004; letter 
from David S. Shillman, Associate Director, Division, Commission, to 
James C. Yong, Senior Vice President, Regulation, and General 
Counsel, NSX, dated June 30, 2004. See also letter to Ronald Aber, 
Vice President and General Counsel, Nasdaq, from Richard Lindsey, 
Director, Division, Commission, dated July 30, 1997 (no-action 
relief provided by Division similar to three Commission exemptions 
cited above). These exemptions are inconsistent with new Rule 612 
but by their terms expire on June 30, 2005, before the 
implementation date of Rule 612. Nasdaq's no-action letter does not 
by its terms include a sunset date. However, Nasdaq may not rely on 
this letter beyond the implementation date of Rule 612.

---------------------------------------------------------------------------

[[Page 37557]]

6. Application to Options Markets
    As initially proposed, Rule 612, by its terms, would have applied 
only to NMS stocks. The Commission requested comment on whether the 
rule also should apply to options.\548\ Currently, SRO rules require 
options to be quoted on the U.S. markets in increments of $0.05 and 
$0.10. Therefore, the problems that could be created by sub-penny 
quoting currently do not exist in the options markets.
---------------------------------------------------------------------------

    \548\ See Proposing Release, 69 FR at 11172.
---------------------------------------------------------------------------

    Two commenters believed that the rule should not apply to quoting 
in options.\549\ One of these commenters, assuming that the rule as 
proposed would allow options with a premium of less than $1.00 to be 
quoted in sub-pennies and options with a premium over $1.00 to be 
quoted in pennies, argued that this approach ``would overwhelm the 
already taxed capacity of existing options quote processing systems.'' 
\550\ The Commission did not believe at the time it issued the 
Reproposing Release that it was necessary for the sub-penny rule to 
extend to options, nor does it believe so now. The concerns created by 
sub-penny quoting--present to some extent in the equities markets--
currently do not exist in the options markets, where the smallest 
quoting increment is $0.05. Therefore, Rule 612 will not apply to 
options. If a national securities exchange seeks to quote options in 
pennies or sub-pennies in the future, it would first need to propose a 
rule change to that effect under Section 19(b) of the Exchange 
Act.\551\ The Commission would have an opportunity to consider such a 
proposal at that time, after publishing notice and obtaining public 
comment.\552\
---------------------------------------------------------------------------

    \549\ See Amex Letter, Exhibit A, at 32-33; SIA Letter at 21.
    \550\ Amex Letter, Exhibit A, at 32.
    \551\ 15 U.S.C. 78s(b).
    \552\ The Commission has previously stated that, ``[g]iven the 
implications of penny quoting for OPRA, penny quoting would require 
very careful review by the Commission.'' Securities Exchange Act 
Release No. 49068 (Jan. 13, 2004), 69 FR 2775, 2789 (Jan. 20, 2004) 
(``BOX Approval Order'').
---------------------------------------------------------------------------

    A third commenter,\553\ while agreeing strongly with the proposed 
sub-penny rule, argued that the Commission should prohibit the Boston 
Options Exchange (``BOX''), a facility of the Boston Stock Exchange, 
from using ``sub-increment'' pricing (i.e., penny prices below the 
standard $0.05 and $0.10 increments used for options) in its ``Price 
Improvement Period'' (``PIP'').\554\ By initiating a PIP auction, a BOX 
market participant may execute a portion of its agency order as 
principal in pennies, and BOX market makers can match that price or 
offer price improvement to those orders in penny increments during the 
three-second auction. The Commission previously approved the BOX 
trading rules, including the rules governing the PIP, pursuant to 
Section 19(b) of the Exchange Act.\555\ The PIP uses pennies in an 
auction, not in public quotations. Therefore, the Commission does not 
believe that the PIP raises the same concerns caused by sub-penny 
quotations of non-option securities and, therefore, that it is not 
necessary to prohibit the use of pennies in BOX's PIP.
---------------------------------------------------------------------------

    \553\ See CBOE Letter at 8.
    \554\ See BOX Approval Order, 69 FR at 2786-92 (explaining PIP 
auction).
    \555\ See id.
---------------------------------------------------------------------------

7. One-to-One Negotiating Systems
    One commenter--Liquidnet, an ATS whose system allows institutional 
traders to negotiate large-sized orders--argued that Rule 612 should 
not prohibit orders priced in half-penny increments for one-to-one 
negotiating systems.\556\ Liquidnet currently permits a user to submit 
an order at the mid-point of the spread, which would be at a half-penny 
increment if the spread were an odd number of cents wide (e.g., $10.00 
x $10.03). Liquidnet argues that the ``sub-penny pricing abuses that 
the SEC is trying to prevent are not applicable, because any orders are 
only seen by the two negotiating parties.'' \557\ Although the 
Commission does not believe it is necessary or appropriate to include 
in Rule 612 an exception for one-to-one negotiating systems such as 
Liquidnet's, it would consider a request for exemptive relief that 
would permit one-to-one negotiations of sub-penny trades through an 
ATS. The Commission will study this issue further during the Regulation 
NMS implementation period.
---------------------------------------------------------------------------

    \556\ See Liquidnet Reproposal Letter at 4.
    \557\ Id.
---------------------------------------------------------------------------

8. Implementation of Rule 612
    While the majority of commenters supported the sub-penny rule, a 
few specifically requested that the Commission implement it as quickly 
as possible.\558\ One of the commenters stated that there are no 
``significant technological or structural impediments to immediate 
implementation.'' \559\ The Commission agrees with this view. 
Currently, sub-penny quoting that would be prohibited by Rule 612 
exists only on a small number of ATSs and in a small number of NMS 
stocks. Nasdaq and all of the national securities exchanges already 
have rules that permit quoting only in $0.01 increments. No commenter 
indicated that converting ATS systems to comply with the rule would 
impose any significant burdens. In light of this, and the small number 
of impacted NMS stocks, the Commission believes that only minimal 
systems changes will be necessary for these ATSs to conform to Rule 612 
and has determined that the implementation date of Rule 612 will be 
August 29, 2005.
---------------------------------------------------------------------------

    \558\ See ACIM Letter at 2; ATD Reproposal Letter at 4; Charles 
Schwab Letter at 17; Merrill Lynch Reproposal Letter at 10; Nasdaq 
Letter at 1.
    \559\ ATD Reproposal Letter at 4.
---------------------------------------------------------------------------

    The Commission notes that it previously has granted exemptions from 
existing Rules 11Ac1-1, 11Ac1-2, and 11Ac1-4 under the Exchange Act 
that, among other things, allow certain exchanges to accept sub-penny 
orders and quotations and to disseminate them in rounded, penny 
increments without a rounding identifier.\560\ By their terms, these 
exemptions--which are not consistent with new Rule 612--expire on June 
30, 2005.
---------------------------------------------------------------------------

    \560\ See supra, note 547.
---------------------------------------------------------------------------

    Rule 612 permits, but does not require, a trading center to offer 
its users the ability to quote in sub-pennies in a limited number of 
cases. An exchange or association that wishes to offer this ability to 
its market participants will likely need to amend its rules before 
doing so. The Commission expects the SROs to consider this matter 
during the implementation period.\561\
---------------------------------------------------------------------------

    \561\ One commenter argued that the Commission should allow 
``sufficient time'' for systems development to accommodate sub-penny 
quoting permitted by Rule 612. See Amex Reproposal Letter at 1, n.1. 
Because Rule 612 permits but does not require market participants to 
quote very low-priced NMS stocks in sub-penny increments, the 
Commission does not believe it is necessary to offer market 
participants an extended period in which to build the systems 
capacity to support this activity before making Rule 612 effective.
---------------------------------------------------------------------------

V. Market Data Rules and Plan Amendments

    The Exchange Act rules and joint-SRO Plans for disseminating market 
information to the public are the heart of the NMS. Pursuant to these 
rules and Plans, investors are able to obtain real-time access to the 
best current quotes and most recent trades for all NMS stocks. As a 
result, investors of all types--large and small--have access to a 
comprehensive, accurate, and reliable source of information for the 
prices of any NMS stock at any time during the trading day.

[[Page 37558]]

    The SROs generate consolidated market data by participating in the 
Plans.\562\ Pursuant to the Plans, three separate networks disseminate 
consolidated market information for NMS stocks: (1) Network A for 
securities listed on the NYSE; (2) Network B for securities listed on 
the Amex and other national securities exchanges; and (3) Network C for 
securities traded on Nasdaq. For each security, the data includes: (1) 
An NBBO with prices, sizes, and market center identifications; (2) the 
best bids and offers from each SRO that includes prices, sizes, and 
market center identifications; and (3) a consolidated set of trade 
reports in the security. The Networks establish fees for this data, 
which must be filed for Commission approval.563-564 The 
Networks collect the applicable fees and, after deduction of Network 
expenses (which do not include the costs incurred by SRO participants 
to generate market data and supply such data to the Networks), 
distribute the remaining revenues to their individual SRO participants. 
As set forth in the following table, the Networks collected $434.1 
million in revenues derived from market data fees in 2004 and 
distributed $393.7 million to their individual SRO participants:
---------------------------------------------------------------------------

    \562\ See supra, note 40.
    \563-564\ See Exchange Act Rule 11Aa3-2(c)(1).

                             2004 Financial Information for Networks A, B, and C \1\
----------------------------------------------------------------------------------------------------------------
                                                 Network A        Network B        Network C          Total
----------------------------------------------------------------------------------------------------------------
Revenues....................................     $165,588,000     $103,901,000     $164,656,000     $434,145,000
Expenses....................................       10,317,000        3,921,000       26,196,000       40,434,000
    Net Income..............................      155,271,000       99,980,000      138,460,000      393,711,000
    Allocations:............................
    NYSE....................................      140,661,000        1,296,000                0      141,957,000
    NASD/Nasdaq.............................        8,296,000        8,360,000       61,672,000       78,328,000
    PCX.....................................        2,091,000       43,276,000       30,804,000       76,171,000
    NSX.....................................          694,000       14,498,000       36,717,000       51,909,000
    Amex....................................                0       28,301,000           30,000       28,331,000
    BSE.....................................        1,345,000          850,000        8,757,000       10,952,000
    CHX.....................................        1,995,000        2,946,000          480,000        5,421,000
    Phlx....................................          189,000          446,000                0          635,000
    CBOE....................................                0            7,000                0           7,000
----------------------------------------------------------------------------------------------------------------
\1\ The Network financial information for 2004 is preliminary and unaudited.

    The overriding objective of the Rule and Plan amendments adopted 
today is to preserve the vital benefits that investors currently enjoy, 
while addressing those particular problems with the current rules and 
Plans that are most in need of reform. The changes fall into three 
categories: (1) Modifying the current formulas for allocating market 
data revenues to the SROs to more appropriately reflect their 
contributions to public price discovery; (2) establishing non-voting 
advisory committees to broaden participation in Plan governance; and 
(3) updating and streamlining the various Exchange Act rules that 
govern the distribution and display of market information.

A. Response to Comments and Basis for Adopted Rules

1. Alternative Data Dissemination Models
    In addition to proposing specific rules and amendments, the 
Proposing Release discussed and requested comment on the Commission's 
decision not to propose an alternative model of data dissemination to 
replace the current consolidation model.\565\ The great strength of the 
current model is that it benefits investors, particularly retail 
investors, by enabling them to assess prices and evaluate the best 
execution of their orders by obtaining data from a single source that 
is highly reliable and comprehensive. But, by requiring vendors and 
broker-dealers to display data to investors that is consolidated from 
all markets, the current model effectively also requires the purchase 
of data from all markets. As a result, the most significant drawback of 
the current model is that it offers little opportunity for market 
forces to determine a Network's fees, or the allocation of those fees 
to a Network's SRO participants. Network fees must be closely 
scrutinized for fairness and reasonableness, and the revenues resulting 
from those fees must be allocated to the SROs pursuant to a Plan 
formula. In addition, individual markets have less freedom to innovate 
in individually providing their quotation and trade data. On the other 
hand, the consolidated display requirement can promote competition by 
assuring that markets, particularly smaller or newer ones, can obtain 
wide distribution of their displayed quotations.\566\ As noted in 
section I.A.1 above, vigorous competition among multiple markets 
trading the same securities is one of the distinctive characteristics 
of the U.S. equity markets. Thus, the existence of the Networks and the 
consolidated display requirement has not precluded the NMS from 
promoting the broad objective of assuring competition among markets.
---------------------------------------------------------------------------

    \565\ Proposing Release, 69 FR at 11176-11179.
    \566\ See Report of the Advisory Committee on Market 
Information: A Blueprint for Responsible Change (September 14, 2001) 
(available at http://www.sec.gov) (``Advisory Committee Report'') 
(recommending retention of the consolidated display requirement 
because it serves core investor protection and market integrity 
functions, as well as promoting market competition).
---------------------------------------------------------------------------

    In the Proposing Release, the Commission specifically considered 
three alternative models that potentially could introduce greater 
competition and flexibility into the dissemination of market data: (1) 
A deconsolidation model, (2) a competing consolidators model, and (3) a 
hybrid model. It decided not to propose any of these alternative models 
after consideration of the benefits and drawbacks of each model. The 
Commission did, however, request comment on whether it should develop 
an alternative model for disseminating market data to the public, and, 
in particular, on its evaluation of the strengths and weaknesses of the 
current model and of the various alternative models for the 
dissemination of market data.
    In response to the Commission's request for comment, a minority of 
commenters expressed their views regarding the appropriate structure 
for the dissemination of market information to the public. One group 
believed that the current model requiring the display of consolidated 
data in a stock through

[[Page 37559]]

a Plan processor has produced significant benefits for investors and 
the markets, although several also strongly recommended that its 
operation needed to be improved in significant respects.\567\ Another 
group of commenters, in contrast, asserted that the current system has 
inhibited competition among markets and that the Plans should be 
eliminated.\568\ These commenters further suggested deregulation of 
market data by allowing markets to sell their own data, and by allowing 
market forces and competition to control the pricing of such data. They 
advocated a competing consolidators model or a hybrid model.
---------------------------------------------------------------------------

    \567\ See, e.g., Amex Letter, Exhibit A at 11; Angel Letter I at 
1; CBOE Letter at 2, 9; CHX Letter at 18-20; Financial Information 
Forum Reproposal Letter at 3; Schwab Letter at 11-13; SIA Letter at 
26-28; STANY Letter at 14.
    \568\ See, e.g., Alliance of Floor Brokers Letter at 11; Letter 
from Daniel M. Clifton, Executive Director, American Shareholders 
Association, to Jonathan G. Katz, Secretary, Commission, dated June 
10, 2004 (``ASA Letter'') at 2; ArcaEx Letter at 4, 12, 14; Brut 
Letter at 22; Financial Services Roundtable Letter at 7; ISE Letter 
at 8-10; Nasdaq Letter II at 24-26; NYSE Letter, Attachment at 10-
11; Reuters Letter at 2; Specialist Assoc. Letter at 17.
---------------------------------------------------------------------------

a. Competing Consolidators Model
    Under a competing consolidators model, the consolidated display 
requirement would be retained, but the Plans and Networks would no 
longer be necessary. Each of the nine SROs that participate in the NMS, 
as well as Nasdaq, would be allowed to establish its own fees, to enter 
into and administer its own market data contracts, and to provide its 
own data distribution facility. Any number of data vendors or broker-
dealers (i.e., ``competing consolidators'') could purchase data from 
the individual SROs, consolidate the data, and distribute it to 
investors and other data users. Of the commenters that urged the 
Commission to adopt a competing consolidators model,\569\ the NYSE, for 
example, believed that allowing the markets to withdraw from the Plans 
would ``reestablish the link between the value of a market's data * * * 
and the fair allocation of costs among * * * users,'' thereby ending 
inter-market subsidies and market-distortive initiatives created by the 
current system.'' \570\ Similarly, ArcaEx stated that ``the best way to 
reform the [P]lans is to abolish them altogether and to adopt a 
competing consolidators model.'' \571\
---------------------------------------------------------------------------

    \569\ See, e.g., ArcaEx Letter at 12, 14; ISE Letter at 8-9; 
NYSE Letter, Attachment at 10-11.
    \570\ NYSE Letter at 7 and Attachment at 10. The NYSE provided 
several reasons for the elimination of the Plans.
    \571\ ArcaEx Letter at 14.
---------------------------------------------------------------------------

    The Commission has considered the comments advocating a competing 
consolidators model, but continues to question the extent to which the 
model would in fact subject the level of market data fees to 
competitive forces. If the benefits of a fully consolidated data stream 
are to be preserved for investors, every consolidator would need to 
purchase the data of each SRO to assure that the consolidator's data 
stream in fact included the best quotations and most recent trade 
report in all NMS stocks. Moreover, to comply with the adopted Order 
Protection Rule, each trading center would need the quotation data from 
every other trading center in a security. As a practical matter, 
payment of every SRO's fees would be mandatory, thereby affording 
little room for competitive forces to influence the level of fees. 
Consequently, far from freeing the Commission from involvement in 
market data fee disputes, the multiple consolidator model would require 
review of at least ten separate fees for individual SROs and Nasdaq. 
The overall level of fees would not be reduced unless one or more of 
the SROs or Nasdaq was willing to accept a significantly lower amount 
of revenues than they currently are allocated by the Plans. It seems 
unlikely that any SRO or Nasdaq would voluntarily propose to lower just 
its own fees and reduce its own current revenues, and some might well 
propose higher fees to increase their revenues, particularly those with 
dominant market shares whose information is most vital to investors. No 
commenter offered useful, objective standards for the Commission to use 
in evaluating the separate fees of SROs and Nasdaq. For this and for 
data quality concerns,\572\ the Commission remains unconvinced that 
discarding the current model in favor of a multiple consolidator model 
would benefit investors and the NMS in general.
---------------------------------------------------------------------------

    \572\ See Proposing Release, 69 FR at 11178.
---------------------------------------------------------------------------

b. Hybrid Model
    In its comment on the original proposal, Nasdaq advocated a hybrid 
model of data dissemination as a compromise if the Commission believes 
that it is necessary to retain the Plans.\573\ Under a hybrid approach, 
basic elements of the current model (including the consolidated display 
requirement and the Plans) would be retained for quotations 
representing the NBBO, but all trade reports and all quotations other 
than the NBBO would be deconsolidated. Because much less consolidated 
data would be disseminated under this model, the fees for consolidated 
data would be reduced commensurately. The individual SROs would 
distribute their own trade and quotation information separately and 
establish fees for such information. To obtain the data eliminated from 
the consolidated system, investors would need to pay the separate SRO 
fees.
---------------------------------------------------------------------------

    \573\ Nasdaq Letter II at 26-28.
---------------------------------------------------------------------------

    In its proposal, Nasdaq suggested that consolidated data fees 
should be reduced,\574\ but only in the context of advocating a hybrid 
model that would drastically reduce the quantity of consolidated data 
that would be disseminated to investors (i.e., by eliminating from the 
consolidated systems all trade reports and all quotations other than 
the NBBO). Nasdaq stated that the Commission should allow competitive 
forces to determine the individual SRO fees for deconsolidated data 
because trade reports and non-NBBO quotations are not ``essential to 
investors.'' \575\
---------------------------------------------------------------------------

    \574\ At the NMS Hearing, a representative of Nasdaq stated that 
the current $20 fee for professionals to obtain market data in 
Nasdaq stocks is too high; that the fee, based on a recent analysis 
of Nasdaq's cost structure, should be around $5 to $7; and that the 
$20 fee is a monopoly price ``set almost twenty years ago without 
any active review of how that relates.'' Hearing Tr. at 223-224, 
253. These remarks subsequently engendered some confusion among the 
public, which was reflected in many comments on the market data 
proposals addressing the level of fees. To put these comments in 
perspective and dispel any potential misconceptions, the following 
points should be kept in mind: (1) in 1999, the Commission undertook 
a comprehensive review of market data fees and revenues, which led 
to a 75% reduction in the fees paid by retail investors for market 
data (Market Information Release, 64 FR at 70614); (2) Nasdaq's 
suggested $5 to $7 monthly fee for professional investors would 
entitle them to only the NBBO in Nasdaq stocks, which is a fraction 
of the data that currently is disseminated for the $20 monthly fee 
for professional investors for consolidated trades and quotations in 
Nasdaq stocks; and (3) Nasdaq's $5 to $7 cost estimate encompassed 
only its own costs and therefore excluded the costs of other SROs 
that now represent a large percentage of trading in Nasdaq-listed 
stocks.
    \575\ Nasdaq Letter II at 27.
---------------------------------------------------------------------------

    The Commission believes, however, that comprehensive trade and 
quotation information, even beyond the NBBO, is vital to investors. The 
Commission remains concerned that an SRO with a significant share of 
trading in NMS stocks could exercise market power in setting fees for 
its data. Few investors could afford to do without the best quotations 
and trades of such an SRO that is dominant in a significant number of 
stocks. In the absence of a solid basis to believe that full trade and 
quotation information would continue to be widely available and 
affordable to all types of investors under a hybrid model, the 
Commission has determined that the most responsible course of action is 
to

[[Page 37560]]

take such immediate steps are necessary to improve the operation of the 
current consolidation model.\576\
---------------------------------------------------------------------------

    \576\ The Commission also is concerned about the risk of 
compromising the quality of market information if the hybrid model 
were adopted. Proposing Release, 69 FR at 11178.
---------------------------------------------------------------------------

2. Level of Fees and Plan Governance
a. Level of Fees
    In the Proposing Release, the Commission emphasized that one of its 
primary goals with respect to market data is to assure reasonable fees 
that promote the wide public availability of consolidated market data. 
Comment was requested on the extent to which investors and other data 
users were relatively satisfied with the products and fees offered by 
the Networks.\577\ At the NMS Hearing, several panelists addressed the 
current level of fees and questioned whether such fees remained 
reasonably related to the cost of market data.\578\ The Supplemental 
Release therefore noted the panelists' views and welcomed comments on 
the reasonableness of market data fees and whether the Commission 
should modify its approach to reviewing such fees.\579\
---------------------------------------------------------------------------

    \577\ Proposing Release, 69 FR at 11179.
    \578\ Hearing Tr. at 223-224, 228-229, 230-231, 233.
    \579\ Supplemental Release, 69 FR at 30148.
---------------------------------------------------------------------------

    Many commenters recommended that the level of market data fees 
should be reviewed and that, in particular, greater transparency 
concerning the costs of market data and the fee-setting process is 
needed.\580\ The Commission agrees. To respond to commenters' concerns, 
it has sought comment on market data fees in its concept release 
relating to SRO structure.\581\ The release discusses and requests 
comment on a number of issues raised by commenters in the context of 
SRO revenues and the funding of self-regulation--in particular, whether 
market data fees are reasonable, whether the Commission should 
reconsider a flexible cost-based approach as described in the 1999 
Market Information Release, and whether market data fees should be used 
to fund SRO operational or regulatory costs. The Commission also has 
taken steps to promote more transparency with respect to market data 
fees and the use of market data revenues through its proposal on SRO 
transparency.\582\ The proposal would greatly increase SRO transparency 
by requiring, among other things, that SROs file public reports with 
the Commission detailing their sources of revenues and their uses of 
these revenues. Such reports would enhance the public's ability to 
evaluate the role of market data revenues in funding SROs. For example, 
proposed amendments to Form 1, Exhibit I would require exchange SROs to 
disclose their revenues earned from market information fees, itemized 
by product, and proposed new Rule 17a-26 would require SROs to file 
electronic quarterly and annual reports on particular aspects of their 
regulatory activities.
---------------------------------------------------------------------------

    \580\ See, e.g., Ameritrade Reproposal Letter 10; Bloomberg 
Tradebook Letter at 8-9; Brut Letter at 21-23; Citigroup Letter at 
15; Financial Information Forum Letter at 3; Financial Services 
Roundtable Letter at 6-7; Goldman Sachs Letter at 2, 10; ICI Letter 
at 21-22; Morgan Stanley Letter at 21-22; Schwab Reproposal Letter 
at 3-5; SIA Reproposal Letter at 24; STANY Letter at 14; UBS Letter 
at 10.
    \581\ SRO Structure Release, supra note 49.
    \582\ SRO Transparency Release, supra note 50.
---------------------------------------------------------------------------

    Some commenters suggested that, instead of modifying the Plan 
formulas for allocating market data revenues, the Commission should 
impose a cost-based limitation on fees.\583\ Most, however, adopted a 
very restricted view of market data costs--solely the costs of the 
Networks to collect data from the individual SROs and disseminate it to 
the public.\584\ Yet nearly the entire financial burden of collecting 
and producing market data is borne by the individual markets, not by 
the Networks. If, for example, an SRO's systems break down on a high-
volume trading day and it can no longer provide its data to the 
Networks, investors would suffer the consequences of a defective data 
stream, regardless of whether the Networks are able to continue 
operating.
---------------------------------------------------------------------------

    \583\ See, e.g., Ameritrade Letter I at 10; Goldman Sachs Letter 
at 10; SIA Letter at 22.
    \584\ See, e.g., ASA Letter at 2; Citigroup Letter at 16; Schwab 
Letter at 6; SIA Letter at 25.
---------------------------------------------------------------------------

    The commenters' suggested approach to market data fees would 
eliminate any funding for the SROs that supply data to the Networks, 
which would have reduced SRO funding by $393.7 million in 2004.\585\ 
Before imposing such a significant and sudden reduction in SRO funding, 
the Commission must carefully consider the consequences this reduction 
might have on the integrity of the U.S. equity markets. When the 
Commission last reviewed market data fees and revenues in 1999, it 
noted the direct connection between an SRO's operational and regulatory 
functions and the value of its market information:
---------------------------------------------------------------------------

    \585\ See supra, table accompanying note 564.

    [T]he value of a market's information is dependent on the 
quality of the market's operation and regulation. Information is 
worthless if it is cut off during a systems outage (particularly 
during a volatile, high-volume trading day when reliable access to 
market information is most critical), tainted by fraud or 
manipulation, or simply fails to reflect accurately the buying and 
selling interest in a security.\586\
---------------------------------------------------------------------------

    \586\ Market Information Release, 64 FR at 70614-70615.

    Moreover, the U.S. equity markets are not alone in their reliance 
on market data revenues as a substantial source of funding. All of the 
other major world equity markets currently derive large amounts of 
revenues from selling market information, despite having significantly 
less trading volume and less market capitalization than the NYSE and 
Nasdaq. To illustrate, the following table sets forth the respective 
market information revenues, dollar value of trading, and market 
capitalization for the largest world equity markets in 2003: \587\
---------------------------------------------------------------------------

    \587\ Data for this table is derived from the 2003 annual 
reports of the various markets and from statistics compiled by the 
World Federation of Exchanges. The exchange rates are as of August 
15, 2004.

----------------------------------------------------------------------------------------------------------------
                                                                                                     Market
                                                           Data revenues      Trading volume     capitalization
                                                             (millions)        (trillions)        (trillions)
----------------------------------------------------------------------------------------------------------------
London.................................................               $180               $3.6               $2.5
NYSE...................................................                172                9.7               11.3
Nasdaq.................................................                147                7.1                2.8
Deutsche Bourse........................................                146                1.3                1.1
Euronext...............................................                109                1.9                2.1
Tokyo..................................................                 60                2.1                3.0
----------------------------------------------------------------------------------------------------------------

    In sum, the Commission is committed to assuring that investors are 
not required to pay unreasonable or unfair fees for the consolidated 
market information that they must have to participate in the U.S. 
equity markets. On the other hand, we must maintain high standards of 
SRO performance, without which the data they produce

[[Page 37561]]

would be worth little. Some commenters suggested that SRO funding 
should be provided through more specifically targeted fees, such as an 
additional regulatory fee to fund market regulation costs.\588\ Given 
the potential harm if vital SRO functions are not adequately funded, we 
believe that the level of market data fees is most appropriately 
addressed in a context that looks at SRO funding as a whole. The 
Commission's review of SRO structure, governance, and transparency 
provides a useful context in which these competing policy concerns can 
be evaluated and balanced appropriately.
---------------------------------------------------------------------------

    \588\ See, e.g., Citigroup Reproposal Letter at 9; Goldman Sachs 
Letter at 11.
---------------------------------------------------------------------------

    The Commission does not believe, however, that reform of the 
current revenue allocation formulas should be delayed until its review 
of fees is completed.\589\ The distortions caused by these formulas are 
substantial and ongoing. In particular, it appears that market 
participants increasingly are engaging in the practice of trade 
shredding (i.e., splitting large trades into multiple 100-share trades) 
as a means to increase their share of market data revenues under the 
current Plan formulas. As discussed below, the adopted formula would 
represent a substantial improvement because it is designed to eliminate 
trade shredding and other gaming of the current formulas and because it 
would more directly allocate revenues to those markets that contribute 
data to the consolidated data stream that is most useful to investors.
---------------------------------------------------------------------------

    \589\ See, e.g., SIA Reproposal Letter at 24 (allocation formula 
should not be revised prior to evaluating the level of market data 
fees).
---------------------------------------------------------------------------

b. Plan Governance
    The Commission is adopting, as proposed and reproposed, an 
amendment to the Plans that requires the creation of non-voting 
advisory committees (``Governance Amendment''). It provides that the 
members of an advisory committee have the right to submit their views 
to the Plan operating committees on Plan matters, including any new or 
modified product, fee, contract, or pilot program. Most commenters 
supported the Governance Amendment.\590\ They generally believed that 
expanding the participation of non-SROs parties in Plan governance 
would be a constructive step. Only a few commenters disagreed, stating 
that interested parties currently have the ability to communicate their 
views on Plan matters or questioning the efficacy of the 
committees.\591\
---------------------------------------------------------------------------

    \590\ See, e.g., Amex Letter at 10; Citigroup Letter at 17; 
Financial Information Forum Letter at 4; SIIA/FISD Reproposal Letter 
at 2; Financial Services Roundtable Letter at 6-7; ICI Letter at 4 
and 21 n. 35; Instinet Letter at 7, 46; Nasdaq Letter II at 33; 
Reuters Letter at 3; STANY Letter at 15.
    \591\ CBOE Letter at 2, 17; ISE Letter at 2; Specialist Assoc. 
Letter at 16. Two commenters on the reproposal suggested that the 
Commission should adopt the advisory committee structure currently 
in place for the Nasdaq UTP Plan. ArcaEx Reproposal Letter at 14; 
Letter from Bridget M. Farrell, Co-Chairman, and Michael P. 
Rountree, Co-Chairman, Operating Committee of the Nasdaq Unlisted 
Trading Privileges Plan, to Jonathan G. Katz, Secretary, Commission, 
dated Feb. 2, 2005 (``Nasdaq UTP Plan Reproposal Letter'') at 2. The 
Nasdaq UTP Plan advisory committee meets bi-annually and has the 
right to present written comments or inquiries to the Plan operating 
committee. The Commission has retained the reproposed committee 
structure, primarily because it believes that advisory committee 
members should have more direct involvement in the deliberations of 
Plan operating committees. Specifically, the Governance Amendment 
gives advisory committee members the right to attend meetings of the 
operating committee and to receive information disseminated to the 
operating committee.
---------------------------------------------------------------------------

    A number of commenters, however, believed that the proposal did not 
go far enough to reform the Plans and that even greater participation 
by interested non-SRO parties in the Plans is needed.\592\ The SIA 
recommended that the Commission ``amend the governance structures of 
the Plans to incorporate the types of changes that have been 
implemented recently in corporate governance generally.'' \593\ These 
commenters also raised concerns regarding several other aspects of Plan 
governance, including current administrative costs and burden, the 
unanimous vote requirement for Plan action, and the current process for 
reviewing SRO fee filings and Plan amendments. For instance, the SIA 
also believed that inconsistencies among the Networks regarding 
administrative requirements and burdens (i.e., agreements and 
contracts, billing policies, data use policies, and annual audit 
requirements) contribute to high market data fees and should be 
reduced, streamlined, and made uniform.\594\
---------------------------------------------------------------------------

    \592\ See, e.g., Letter from W. Hardy Callcott, to Jonathan G. 
Katz, Secretary, Commission, dated Dec. 30, 2004 (``Callcott 
Reproposal Letter'') at 4; Financial Services Roundtable Letter at 
6-7; Goldman Sachs Letter at 12-13; Instinet Reproposal Letter at 
17; Morgan Stanley Letter at 22; Schwab Reproposal Letter at 5; SIA 
Reproposal Letter at 27-28; STANY Letter at 15.
    \593\ SIA Reproposal Letter at 28.
    \594\ SIA Letter at 27-28.
---------------------------------------------------------------------------

    In many respects, the Commission agrees with the concerns expressed 
by commenters regarding administration of the Plans. Nevertheless, it 
is reluctant at this point to require more intrusive changes to Plan 
governance that might interfere with effective Plan operations. The 
Plans fulfill significant operational functions with respect to the 
systems that deliver consolidated data to the public on a daily basis. 
Moreover, improved governance structures at the SRO level also should 
contribute to improved governance of the Plans through their selection 
and guidance of SRO representatives on the Plan operating committees. 
The Commission therefore believes that the Governance Amendment 
represents a useful first step toward improving the responsiveness of 
Plan participants and the efficiency of Plan operations. Expanding the 
participation of interested parties other than SROs in Plan governance 
should increase the transparency of Plan business, as well as provide 
an established mechanism for alternative views to be heard by the Plans 
and the Commission. Earlier and more broadly based participation could 
contribute to the ability of the Plans to achieve consensus on disputed 
issues. With respect to Plan administration, promising private efforts 
are underway to improve consistency among data providers and to reduce 
administrative burdens.\595\ The Commission particularly believes that 
the Plans should give full consideration to the views of industry 
participants on steps that would streamline the administrative 
procedures and burdens of the three Plans. Enhanced participation of 
advisory committee members in Plan affairs should help further this 
process. The Commission will continue to monitor and evaluate Plan 
developments to determine whether any further action is warranted.
---------------------------------------------------------------------------

    \595\ See SIIA/FISD Reproposal Letter at 2-3 (SIIA/FISD 
developing guidelines to encourage uniformity in exchange and vendor 
administrative policies and procedures; guidelines will address 
exchange data delay intervals, subscriber agreement streamlining, 
billing and reporting period issues, and unit of count definitions).
---------------------------------------------------------------------------

3. Revenue Allocation Formula
    As discussed below, the Commission has adopted the Allocation 
Amendment with some modifications from the proposal and 
reproposal.\596\ Given the significant changes from the current Plan 
formulas, the Commission will monitor the operation of the new formula 
to assess whether it achieves its goals and whether any further 
modifications are warranted. As with any other aspects of the Plans, 
the language added to the Plans by the Allocation Amendment can be 
adjusted in the future pursuant to the normal

[[Page 37562]]

process of Commission-approved amendments.\597\
---------------------------------------------------------------------------

    \596\ As set forth in section VII below, the compliance date for 
the Allocation Amendment is September 1, 2006. Accordingly, Plan 
revenues for the first eight months of 2006 will be allocated in 
accordance with the current Plan formulas. Plan revenues for the 
remaining part of 2006 will be allocated in accordance with the new 
formula.
    \597\ Cf. Letter from Mary Yeager, Assistant Secretary, NYSE, to 
Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 (``NYSE 
Reproposal Letter II'') at 5 (suggesting that, given inability to 
anticipate all issues that may arise, markets should be allowed to 
make adjustments to market data plans).
---------------------------------------------------------------------------

    The proposal and reproposal included an amendment to the Plans that 
would modify their formulas for allocating market data revenues to SRO 
Participants. The current Plan formulas are based solely on the trading 
activity of an SRO. The proposed and reproposed formulas were intended 
to address three serious weaknesses in the old formulas: (1) The 
absence of any allocation of revenues for the quotations contributed by 
an SRO to the consolidated data stream; (2) an excessive emphasis on 
the number of trades reported by an SRO that has led to distortive 
trading practices, such as wash sales, trade shredding, and print 
facilities; and (3) a disproportional allocation of revenues for a 
relatively small number of stocks with extremely high trading volume, 
with a much smaller allocation to the thousands of other stocks 
included in a Network, typically issued by smaller companies, with less 
trading volume.
    To address these problems, the proposed formula included a number 
of elements, including a Quoting Share, an NBBO Improvement Share, a 
Trading Share, and a Security Income Allocation. The Quoting Share and 
NBBO Improvement Share would have provided an allocation of revenues 
for an SRO's quotations. In particular, the Quoting Share would have 
allocated revenues for all quotes, both automated and manual, according 
to the dollar size and length of time that such quotes equaled the 
price of the NBBO. It included an automatic cutoff of credit for manual 
quotations, however, when they were left alone at the NBBO. This cut-
off was intended to preclude SROs from being allocated revenues merely 
for slowness in updating their manual quotations. The NBBO Improvement 
Share would have allocated revenues to SROs for the extent to which 
they displayed quotations that improved the price of the NBBO.
    At the NMS Hearing, representatives of floor-based exchanges stated 
their intention to adopt hybrid trading models that would primarily 
display automated quotations.\598\ In response, the Commission, in its 
Supplemental Release, stated that the prospect of hybrid trading models 
presented an opportunity for simplifying the proposed allocation 
formula.\599\ It noted that the purpose of the automatic cutoff for 
manual quotations was to minimize the allocation of revenues for 
potentially stale quotations and requested comment on whether only 
automated quotes should be entitled to earn an allocation of revenues. 
The Supplemental Release also noted that the NBBO Improvement Share was 
significantly more complex than the other aspects of the proposed 
formula and that it had been proposed largely to counter the potential 
for an excessive allocation of revenues for manual quotations. As a 
result, the Reproposing Release included a reproposed allocation 
formula that eliminated the NBBO Improvement Share and excluded manual 
quotations from the Quoting Share.\600\ It also allocated revenues 
equally between the trading activity and quoting activity of Plan 
participants. Based on additional comments received in response to the 
reproposal, the Commission is adopting the reproposed allocation 
formula with certain modifications, as discussed below.
---------------------------------------------------------------------------

    \598\ Hearing Tr. at 85, 90-92, 94-97, 120-121.
    \599\ Supplemental Release, 69 FR at 30148.
    \600\ Reproposing Release, 69 FR at 77464.
---------------------------------------------------------------------------

    The comments on the proposal and reproposal generally addressed 
four broad categories of issues: (1) Whether the current Plan formulas 
need to be updated; (2) whether quotations should be considered in 
allocating revenues; (3) whether the size of trades should be 
considered in allocating revenues; and (4) whether the allocation of 
revenues should be allocated more evenly across all of a Network's 
stocks. These comments are discussed below.
a. Need for New Formula
    Many commenters agreed with the Commission that, if the Networks 
were to continue allocating revenues to the SROs, the current 
allocation formulas needed to be updated.\601\ Many of these commenters 
also believed that the proposed and reproposed formulas should be 
modified in several respects, and their specific suggestions to improve 
the proposed formula are discussed below. In general, however, they 
agreed with the objectives of the proposal and reproposal to eliminate 
much of the incentive for distortive trade reporting practices and to 
begin providing some allocation of revenues for the quotations that 
SROs contribute to the consolidated data stream.
---------------------------------------------------------------------------

    \601\ See, e.g., Bloomberg Tradebook Letter at 7; BSE Letter at 
15; Deutsche Bank Reproposal Letter at 4; Harris Reproposal Letter 
at 11; ICI Letter at 21; JP Morgan Reproposal Letter at 2; NYSE 
Reproposal Letter II at 3; STA Letter at 7; UBS Letter at 10; 
Vanguard Letter at 6.
---------------------------------------------------------------------------

    Other commenters, in contrast, opposed changing the current 
allocation formulas.\602\ Their specific objections to the proposed and 
reproposed formulas are discussed below, but they also opposed changing 
the current formulas for more general reasons. First, some believed 
that, rather than changing the formulas, the Commission simply should 
prohibit the particular distortive practices caused by the old formulas 
and enforce the existing prohibitions against such practices. 
Commenters also opposed the proposed and reproposed formulas because 
they believed they incorporated arbitrary judgments about the value of 
quotations and trades. Finally, those opposed to changing the Plan 
formulas believed that the proposed formula was simply too complex to 
be implemented effectively and that its costs exceeded any benefits 
that were likely to be gained.
---------------------------------------------------------------------------

    \602\ See, e.g., Brut Letter at 22; Instinet Reproposal Letter 
at 13; Letter from David Colker, Chief Executive Officer and 
President, National Stock Exchange, to Jonathan G. Katz, Secretary, 
Commission, dated Jan. 26, 2005 (``NSX Reproposal Letter'') at 4; 
Phlx Letter at 4.
---------------------------------------------------------------------------

    The Commission has considered the views of these commenters, but 
does not believe that they warrant leaving the current Plan formulas in 
place. First, the Commission intends to continue to enforce the 
existing prohibitions against distortive trade reporting practices. 
Rather than attempting to devise new prohibitions that address every 
conceivable harmful practice, however, it has determined to address 
directly the formula-driven distortions by adopting revisions to the 
current formulas. As long as the allocation of market data revenues is 
based primarily on reporting a large number of very small trades, the 
incentive for distortive trade reporting will continue. Moreover, as 
discussed below, the current formulas are flawed in several important 
respects beyond the incentives they create for distortive trade 
reporting practices.
    The Commission does not believe that the adopted formula 
incorporates arbitrary judgments about the value of trades and quotes. 
In this regard, it is important to recognize that any formula for 
allocating market data revenues would reflect some judgment regarding 
the contribution of the various SROs' data to the consolidated data 
stream; otherwise, the revenues could simply be allocated equally among 
all Plan participants. The Commission's goal in adopting a new formula 
is to improve on the judgments incorporated in the old Plan formulas to 
more fully achieve NMS objectives.
    For example, the current formula for Network A and Network B treats 
a 100-

[[Page 37563]]

share trade the same as a 20,000 share trade in the same stock, even 
though their importance for price discovery purposes clearly is not 
equal. All of the current Plan formulas value only the trades reported 
by an SRO (for Networks A and B, the number of reported trades; for 
Network C, the average of number and share volume of reported trades), 
thus treating a quotation as having no value except to the extent it 
resulted in a trade. Quotations are accorded no value even if they were 
fully accessible and established the NBBO for a substantial period of 
time, thereby providing price discovery for trades occurring at other 
markets that internalize orders with reference to the NBBO price. Such 
formulas based solely on an SRO's trading activity may have been 
adequate many years ago when a single market dominated each group of 
securities, but are seriously outdated now that trading is split among 
many different markets whose contributions to the public data stream 
can vary considerably.
    The adopted formula reflects fairly straightforward determinations 
about the kinds of data that, in general, are likely to be useful to 
investors. For example, a $50,000 quote at the NBBO in a stock is 
likely more useful to investors than a $2000 quote in the same stock. 
Similarly, a $50,000 trade in a stock is likely more useful to 
investors in assessing the trading trend of that stock than a $2000 
trade; again, not necessarily in every case, but in general and on 
average. By more appropriately weighing data that is useful to 
investors, the adopted formula represents a substantial improvement on 
the old formulas.\603\
---------------------------------------------------------------------------

    \603\ Some commenters were concerned that the formula's use of 
dollar volume calculations does not sufficiently allocate revenues 
to markets that trade low-priced stocks. See, e.g., BSE Letter at 
18; CHX Letter at 16. The Commission believes that dollar volume is 
the most appropriate measure, in general, of the importance to 
investors of trading and quoting information. Per share stock 
prices, in contrast, are a more arbitrary measure because they are 
dependent, to a large extent, on the number of shares a company 
chooses to issue, both originally and through stock splits and 
reverse stock splits. To the extent the commenters were concerned 
about the less active stocks of smaller companies, the Security 
Income Allocation of the adopted formula incorporates the square 
root function precisely to more appropriately allocate revenues to 
SROs that provide a venue for price discovery in these stocks. See 
section V.A.3.d below.
---------------------------------------------------------------------------

    Commenters on the original proposal generally believed that the 
originally proposed formula was complex and may have been difficult to 
implement efficiently.\604\ They particularly noted that the proposed 
NBBO Improvement Share was difficult to understand and had the 
potential to be abused through gaming behavior. The Commission agreed 
with these commenters and has modified the reproposed formula and 
adopted formula accordingly. Given that only automated quotations will 
be entitled to earn an allocation under the adopted formula, the 
originally proposed NBBO Improvement Share, as well as the proposed 
cutoff of credits for manual quotations left alone at the NBBO, have 
been deleted from the reproposed formula and remain deleted in the 
adopted formula. The elimination of these two elements greatly reduces 
the complexity of the adopted formula and promotes more efficient 
implementation of the formula. In addition, the 15% of the Security 
Income Allocation that was allocated to the NBBO Improvement Share in 
the proposed formula now has been shifted to the Quoting Share to 
assign an even allocation of revenues between trading and quoting.
---------------------------------------------------------------------------

    \604\ See, e.g., Angel Letter I at 11; Financial Information 
Forum Letter at 3; NYSE Letter, Attachment at 11.
---------------------------------------------------------------------------

    Other commenters asserted that it would overly costly and complex 
to calculate the other elements of the proposed formula.\605\ The 
Commission does not agree with this assertion. An SRO's Trading Share, 
for example, will not be materially more difficult to calculate than 
the current Network C formula, which is based on an average of an SRO's 
proportion of trades and share volume. The Security Income Allocation 
uses the square root function which is a simple arithmetic calculation. 
Some commenters believed that the Quoting Share, which incorporates the 
total dollar size of the NBBO in a stock throughout the trading year, 
would result in astronomically high numbers that would be extremely 
difficult to calculate.\606\ In fact, the largest number of Quote 
Credits in a year for even the highest price stock with the greatest 
displayed depth at the NBBO is be very unlikely to reach beyond the 
trillions, a number well within the capabilities of even the most basic 
spreadsheet program.\607\ Moreover, the allocation is determined by the 
proportion of an SRO's Quote Credits in relation to other SROs, not the 
absolute amount of Quote Credits.
---------------------------------------------------------------------------

    \605\ See, e.g., Brut Letter at 22-23; CBOE Letter at 2, 9; NSX 
Letter at 7.
    \606\ See, e.g., CBOE Letter at 14 (calculation of Quote Credits 
will ``yield astronomical numbers'' that ``can be expressed only in 
exponential terms''); NSX Letter at 7 (calculation of large number 
of Quote Credits is ``particularly ludicrous'').
    \607\ For example, assume a stock with an average price of $100 
per share has an unusually large average quoted size of 200,000 
shares at both the national best bid and the national best offer 
throughout every second of the trading year. Over an average 252 
trading days during a year, the total Quote Credits in this stock 
would be 235.9 trillion ($100*400,000*252*23,400 seconds per trading 
day). Quote Credits are only calculated for individual Network 
stocks and are not be totaled across all Network stocks.
---------------------------------------------------------------------------

    Some commenters suggested that revenue allocations under the 
formula should be calculated and paid out on a quarterly basis.\608\ 
Currently, the Networks make estimated quarterly payments subject to a 
final annual calculation and payment. Commenters believed quarterly 
calculations and payments would simplify administration of the formula 
and reduce the potential for disparities between quarterly estimated 
and annual final payments. The adopted Allocation Amendment does not 
alter the current Plan provisions for annual final payments. It is 
important to retain a final annual calculation and payment to minimize 
the potential for unusual trading activity, or intentional gaming 
behavior, to inappropriately distort an allocation within a quarter. 
The annual calculation will be based on numbers that are four times 
larger than the numbers for a quarterly calculation. These larger 
numbers will help smooth out the effect of unusual market activity in a 
particular quarter, as well as increase the difficulty of any attempt 
at gaming behavior. Of course, all of the formula's calculations can be 
updated daily, and quarterly estimated payments based on these 
calculations can continue to be made to SRO participants.
---------------------------------------------------------------------------

    \608\ See, e.g., NYSE Reproposal Letter II at 5; Nasdaq UTP Plan 
Reproposal Letter at 3.
---------------------------------------------------------------------------

    Finally, a few commenters were concerned about the effect of 
modifying the current allocation formulas on the existing business 
models and terms of competition for the various markets.\609\ The 
Commission recognizes that reforming formulas that have remained 
unchanged for many years could affect the competitive position of 
various markets. Given the severe deficiencies of these formulas, 
however, it does not believe that the interests of any particular 
business model should preclude updating the formulas to reflect current 
market conditions. The adopted formula is intended to reflect more 
appropriately the contributions of the various SROs to the consolidated 
data stream and thereby better align the interests of individual 
markets with the interests of investors. Moreover, by incorporating a 
much more broad-based measure of an SRO's contribution to the 
consolidated data stream, the adopted formula should be less subject to 
any particular type of gaming and distortion

[[Page 37564]]

than the narrowly-focused current Plan formulas.\610\
---------------------------------------------------------------------------

    \609\ See, e.g., Brut Letter at 22; CHX Letter at 21-22; NSX 
Letter at 6.
    \610\ Two commenters on the reproposal suggested adopting an 
allocation formula based solely on the dollar volume of trading. 
ArcaEx Reproposal Letter at 13; Nasdaq Reproposal Letter at 14. 
Dollar volume alone, however, is not a broad-based measure and would 
miss important aspects of an SRO's contribution to the public data 
stream. It would, for example, allocate a disproportionately large 
amount to block trades. Block trades often are internalized by 
securities dealers at prices based, at least partly, on current 
public quotations. A formula based solely on dollar volume would not 
adequately allocate revenues to the source of quotations relied on 
in pricing block trades.
---------------------------------------------------------------------------

b. Quotations That Equal the NBBO
    Many commenters supported the proposal to allocate a portion of 
market data revenues based on an SRO's quotations, particularly if only 
automated and accessible quotations would qualify for an 
allocation.\611\ Some commenters, however, were concerned about the 
risk of harmful gaming behavior by market participants.\612\ For 
example, Instinet stated that the ``fundamental problem with the 
Commission's proposed formula stems from the inherently low cost for 
market participants to generate quotation information and the 
consequent high potential for gaming behavior in any formula that 
attempts to reward such behavior.'' \613\ A specific type of gaming 
that concerned commenters was ``flickering quotes''--quotes that are 
flashed for a short period of time solely to earn market data revenues, 
but are not truly accessible and therefore do not add any value to the 
consolidated quote stream. Nasdaq discussed a number of other potential 
gaming behaviors, including posting quotations in inactive markets or 
for inactive securities so that they are less likely to be 
executed.\614\ Commenters also were concerned that such practices would 
increase quotation traffic and bandwidth costs, but with little or no 
benefit for the quality of the consolidated data stream.
---------------------------------------------------------------------------

    \611\ See, e.g., Bloomberg Tradebook Letter at 7-8; Morgan 
Stanley Letter at 22-23; NYSE Reproposal Letter II at 3; STA Letter 
at 7; Vanguard Letter at 6.
    \612\ See, e.g., ArcaEx Reproposal Letter at 13; CHX Letter at 
19; Instinet Reproposal Letter at 14; SIA Reproposal Letter at 30.
    \613\ Instinet Letter at 41.
    \614\ Nasdaq Reproposal Letter at 12-13.
---------------------------------------------------------------------------

    The Commission recognizes that abusive quoting behavior is a 
legitimate concern, particularly given that quotations have not been 
entitled to an allocation of market data revenues in the past. The 
adopted formula therefore incorporates a number of modifications to the 
reproposed formula to minimize the potential for abusive or costly 
quoting behavior.
    First, the adopted formula modifies the language of the reproposed 
formula to clarify that a quotation must be displayed by the Network 
processor for a minimum of one full second of time before it is 
entitled to earn any Quote Credits. This one-second time period is 
consistent with the one-second time period included in the flickering 
quotation exception in the Order Protection Rule and is designed to 
assure that only quotations that are readily accessible can earn Quote 
Credits. The time stamps assigned to quotations by the Network 
processors will control this determination. Accordingly, subsecond 
flickering quotations are excluded from the formula.
    Second, the adopted formula modifies the language of the reproposed 
formula to clarify that, consistent with the approach of the Order 
Protection Rule, each SRO participant in a Network is entitled to earn 
Quote Credits only for the SRO's best bid and best offer. Thus, for 
example, only a single, accessible best bid and best offer for each of 
the exchange SROs, Nasdaq, and the NASD will be entitled to earn Quote 
Credits. A best bid and best offer must be accessible by routing an 
order to a single market destination (i.e., currently, to a single 
exchange execution system, a single Nasdaq execution system, or a 
single ADF participant). By limiting the number of separate quotations 
that are entitled to earn Quote Credits, the adopted formula both 
reduces the ability of market participants to ``shred'' their quotes 
among many different markets and promotes equal regulation of exchange 
SROs, Nasdaq, and the NASD.
    Third, the adopted formula modifies the language of the reproposed 
formula to clarify that a quotation cannot earn Quote Credits while it 
locks or crosses a previously displayed automated quotation. This 
limitation is needed to remove any potential financial incentive for 
abusive quoting behavior that would be contrary to the purposes of the 
provisions on locking and crossing quotations set forth in the Access 
Rule.
    Finally, as discussed further below,\615\ the Security Income 
Allocation in the adopted formula modifies the reproposed formula by 
limiting the total revenues allocated to any particular Network 
security to no more than $4 per qualified transaction report. This 
limitation on each security's revenue allocation therefore will apply 
to both the Trading Share and Quoting Share. In contrast, the 
reproposed formula limited the allocation only for the Trading Share of 
a Network security to $2 per qualified transaction report, but shifted 
the excess balance of revenues to the Quoting Share for such Network 
security--thereby potentially increasing the risk of abusive quoting 
behavior in highly inactive Network securities. Under the adopted 
formula, the excess balance above the limitation will be allocated 
across all Network securities in direct proportion to their share of 
dollar volume of trading.
---------------------------------------------------------------------------

    \615\ Infra, section V.A.3.d.
---------------------------------------------------------------------------

    With these clarifications and modifications, the Commission does 
not believe that the Quoting Share of the adopted formula will be 
unacceptably vulnerable to gaming, particularly because only automated 
and fully accessible quotations will be entitled to earn a share of 
market data revenues. The potential cost of displaying such quotations, 
in the form of unprofitable trades, should not be underestimated. 
Quotations would earn significant revenues only if they represent a 
significant proportion of the total size of quotations displayed at the 
NBBO for a stock throughout the trading year. The risk of losses that 
could result from the execution of orders against large quotations 
would be likely to dwarf any potential allocation of market data 
revenues.\616\ With the advent of highly sophisticated order-routing 
algorithms, accessible automated quotations throughout the NMS can be 
hit at lightning speed. Some of these algorithms are specifically 
designed to search the market for displayed liquidity and sweep such 
liquidity immediately when it is displayed. The market discipline 
imposed by these order-routing practices should greatly reduce the 
potential for ``low cost'' quotations at the NBBO. A market participant 
would have to be prepared to trade at a price, particularly a price as 
attractive as the NBBO, before displaying accessible and automated 
quotations to earn market data revenues. Moreover, any quotations 
submitted for stocks that are inactively traded (and therefore less 
likely to attract trading

[[Page 37565]]

interest) will garner a very small Quoting Share allocation because the 
size of such allocation will be determined by the proportional dollar 
volume of trading in a stock.
---------------------------------------------------------------------------

    \616\ For example, Nasdaq asserted that approximately $1 million 
per month would be distributed among SROs based on quoting in the 
2000 least active Nasdaq stocks. Nasdaq Reproposal Letter at 13. In 
this scenario, an average of $500 per month would be allocated to 
each stock. Given the approximately 491,400 seconds of trading in an 
average month, the average available Quoting Share in a stock for 
each second would be approximately 1/10th of one cent, which would 
be further divided among bids and offers to approximately 1/20th of 
one cent. Moreover, this amount would be shared among all market 
participants quoting in the stock. Consequently, even the smallest 
losing trade (i.e., a one-cent loss on an executed 100-share quote) 
would wipe out 2000 seconds (more than 33 minutes) of the entire 
Quoting Share allocation for bids or offers in the stock.
---------------------------------------------------------------------------

    Finally, commenters were concerned that some quotations might be 
submitted to ``hide in the queue'' when a stock already has significant 
depth displayed at the NBBO.\617\ The strategy is risky, however, 
because of the desire for greater liquidity evidenced by the number of 
marketable limit orders entered but not filled, particularly for Nasdaq 
stocks, that was discussed above in section II.A.1.b. Typically, the 
volume of such orders searching for liquidity at the NBBO far exceeds 
the available liquidity (both displayed size and reserve size). Any 
quotations attempting to hide in the queue at the NBBO when liquidity 
seeking orders arrive would necessarily be executed immediately.\618\
---------------------------------------------------------------------------

    \617\ Nasdaq Reproposal Letter at 13; NYSE Reproposal Letter at 
2.
    \618\ Of course, the Commission and SROs will continue to 
monitor quoting activity for any conduct that violates the federal 
securities laws, the rules thereunder, or SRO rules and take 
appropriate action to address such conduct. For example, one 
commenter suggested that a market participant might enter a buy 
order at the national best bid at a time when there already is depth 
at such bid, but with instructions to ``cancel'' the order upon 
execution of orders earlier in the queue. NYSE Reproposal Letter at 
2. Such an order type would effectively be impossible to access 
because it always would be cancelled when at risk of execution. As a 
result, reflecting these orders in a displayed quotation would be a 
clear violation of the Rule 602(b) of Regulation NMS, which requires 
that displayed quotations be firm, as well as constitute a material 
misstatement to the market and investors concerning trading interest 
in the stock.
---------------------------------------------------------------------------

    A few commenters also opposed the proposed Quoting Share because 
they believed it represented an inappropriate attempt by the Commission 
to control the quoting behavior of market participants.\619\ ArcaEx, 
for example, stated that the ``most important question is how paying 
for top-of-book quotes--on a time- and size-weighted basis or on any 
other basis--encourages beneficial behavior,'' and questioned whether 
the Quoting Share would achieve this result. Brut asserted that ``[n]ot 
only would [the proposed formula] increase the potential unnatural 
trading and quoting behavior, it signifies a desire to use market 
structure regulation to micro-manage market participant behavior * * 
*.'' \620\
---------------------------------------------------------------------------

    \619\ ArcaEx Letter at 13; Brut Letter at 22, Phlx Letter at 4.
    \620\ Brut Letter at 22.
---------------------------------------------------------------------------

    These commenters appear to have misunderstood the Commission's 
objective in proposing to update the current Plan formulas. As noted 
above,\621\ it is unlikely that a marginal increase in market data 
revenues would significantly alter the quoting behavior of market 
participants, at least for those not already interested in trading a 
stock for separate reasons. The potential cost of unprofitable trades 
would be too high. Rather, the Commission's primary objective is to 
correct an existing flaw in the current formulas by allocating revenues 
to those SROs that, even now, benefit investors by contributing useful 
quotations to the consolidated data stream. Currently, such SROs do not 
receive any allocation for providing a venue for this beneficial 
quoting activity. Basing an allocation on the extent to which an SRO's 
quotes equal the NBBO is an appropriate means to correct this flaw, 
even if the allocation does not always reflect the precise value of 
quotations.\622\
---------------------------------------------------------------------------

    \621\ Supra, note 616 and accompanying text.
    \622\ ArcaEx noted that top-of-book quotes make only a partial 
contribution to price discovery and that depth-of-book quotes are 
particularly important since decimalization. ArcaEx Letter at 13. 
The Commission agrees that depth-of-book quotes are important to 
investors, and for that reason has adopted amendments to the market 
data rules to facilitate the independent dissemination of a market's 
depth of book. The rules will not prevent such a market from 
charging fees for depth-of-book quotations that are fair and 
reasonable and not unreasonably discriminatory.
---------------------------------------------------------------------------

c. Number and Dollar Volume of Trades
    The current Plan formulas allocate revenues based on the number of 
trades (Networks A and B) or on the average of number of trades and 
share volume of trades (Network C) reported by SROs. By focusing solely 
on trading activity (and particularly by rewarding the reporting of 
many trades no matter how small their size), these formulas have 
contributed to a variety of distortive trade reporting practices, 
including wash sales, shredded trades, and SRO print facilities. To 
address these practices and to establish a more broad-based measure of 
an SRO's contribution to the consolidated trade stream, the proposed 
formula provided that an SRO's Trading Share in a particular stock 
would be calculated by taking the average of the SRO's percentage of 
total dollar volume in the stock and the SRO's percentage of qualified 
trades in the stock. A ``qualified trade'' was defined as having a 
dollar volume of $5000 or more. The Proposing Release requested comment 
on whether this amount should be higher or lower, or whether trades 
with a size of less than $5000 should receive credit that was 
proportional to their size.\623\
---------------------------------------------------------------------------

    \623\ Proposing Release, 69 FR at 11181.
---------------------------------------------------------------------------

    Several commenters on the original proposal believed that small 
trades contribute to price discovery and should be entitled to earn at 
least some credit in the calculation of the number of qualified 
trades.\624\ The Commission agreed and included in the reproposed 
formula a provision that awards a fractional proportion of a qualified 
report for trades of less than $5000. The adopted formula also includes 
this provision. Thus, a $2500 trade will constitute 1/2 of a qualified 
transaction report. This approach greatly reduces the potential for 
large allocations attributable to shredded trades, while recognizing 
the contribution of small trades to price discovery.
---------------------------------------------------------------------------

    \624\ See, e.g., BSE Letter at 16; CHX Letter at 19-20; E*Trade 
Letter at 11.
---------------------------------------------------------------------------

    Two commenters on the original proposal asserted that the $5000 
threshold was arbitrary.\625\ As noted in the Proposing Release, an 
analysis of Network A data indicates that approximately 90% of dollar 
volume and 50% of trades exceed this threshold. The Commission believes 
that the $5000 figure represents a reasonable attempt to address the 
problem of shredding large trades into 100-share trades. By providing 
only a proportional allocation for trades with dollar amounts below 
this threshold, the ability of market participants to generate large 
revenue allocations by shredding trades would be greatly reduced. For 
example, a 2000-share trade in a $25 stock could be shredded into 
twenty trades in the absence of a dollar threshold for qualified 
trades, but could be shredded into only ten qualified trades under the 
reproposed formula. Moreover, when combined with the allocation of 50% 
of revenues to the Quoting Share and the allocation of another 25% of 
revenues based on the dollar volume of trades, the $5000 threshold for 
qualified trades will eliminate much of the potential reward for trade 
shredding under reproposed formula. In the example of the 2000-share 
trade in a $25 stock, the incentive for shredding would have been 
reduced by a total of 87.5% (75% + (50% * 25%).\626\
---------------------------------------------------------------------------

    \625\ E*Trade Letter at 11; Instinet Letter at 42.
    \626\ One commenter on the reproposal suggested that the dollar 
volume allocation for block trades be capped at $300,000 to preclude 
a disproportionate allocation. NYSE Reproposal Letter II at 4-5. The 
adopted formula does not include a cap on block trades because it 
would appear to be easily avoidable through trade-shredding. 
Moreover, the separate allocations for qualified transaction reports 
and for Quoting Shares serve to limit the extent to which block 
trades receive a disproportionate allocation under the adopted 
formula.

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[[Page 37566]]

d. Allocation of Revenues Among Network Stocks
    The proposed formula included a Security Income Allocation, 
pursuant to which a Network's total distributable revenues would be 
allocated among each of the Network's stocks based on the square root 
of dollar volume. The square root function was intended to adjust for 
the highly disproportionate level of trading in the very top tier of 
Network stocks. A few hundred stocks (e.g., the top 5%) are much more 
heavily traded than the other thousands of Network stocks. The 
Proposing Release noted that an allocation that simply was directly 
proportional to trading volume would fail to reflect adequately the 
importance of price discovery for the vast majority of stocks.\627\ The 
Reproposing Release retained this provision in the reproposed 
formula.\628\
---------------------------------------------------------------------------

    \627\ Proposing Release, 69 FR at 11180.
    \628\ Reproposing Release, 69 FR at 77466.
---------------------------------------------------------------------------

    Of the commenters that addressed this issue, several supported the 
use of a square root function to allocate revenues among stocks.\629\ 
Nasdaq, for example, noted that the ``methodology will reduce the 
disparity between the value of data of the most active and least active 
securities.'' \630\ Other commenters, in contrast, opposed the use of 
the square root function to allocate revenues among Network 
stocks.\631\ ArcaEx believed that the proposed allocation method 
``introduces a steeply progressive tax on liquid stocks to subsidize 
illiquid stocks'' and that the allocation of revenues should remain 
directly proportional to trading volume.\632\
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    \629\ Amex Letter, Exhibit A at 15; Nasdaq Letter II at 32; NYSE 
Reproposal Letter II at 3; Specialist Assoc. Letter at 16 n. 21.
    \630\ Nasdaq Letter II at 32.
    \631\ ArcaEx Reproposal Letter at 11; CBOE Letter at 11; 
Instinet Reproposal Letter at 13; Letter from Ronald A. Orguss, 
President, Xanadu Investment Co., to Jonathan G. Katz, Secretary, 
Commission, dated Jun. 29, 2004 (``Xanadu Letter'') at 2-3.
    \632\ ArcaEx Letter at 12.
---------------------------------------------------------------------------

    With one modification, the Commission has retained the square root 
function in the adopted formula to allocate distributable Network 
revenues more appropriately among all of the stocks included in a 
Network. Although the extent to which Network stocks are tiered 
according to trading volume varies among the three Networks, it is 
quite pronounced in each of them. The use of the square root function 
reflects the Commission's judgment that, on average and not necessarily 
in every particular case, information about a $50,000 trade in a stock 
with an average daily trading volume of $500,000 is marginally more 
useful to investors than a $50,000 trade in a stock with an average 
daily trading volume of $500 million. Markets that provide price 
discovery in less active stocks serve an extremely important function 
for investors in those stocks. Price discovery not only benefits those 
investors who choose to trade on any particular day, but also benefits 
those who simply need to monitor the status of their investment. 
Efficient secondary markets support buy-and-hold investors by offering 
them a ready opportunity to trade at any time at a fair price if they 
need to buy or sell a stock. Indeed, this enhanced assurance is one of 
the most important contributions of secondary markets to efficient 
capital-formation and to reducing the cost of capital for listed 
companies. The square root function allocates revenues to markets that 
perform this function for less-active stocks by marginally increasing 
their percentage of market data revenues, while still allocating a much 
greater dollar amount to more actively traded stocks.
    With respect to very inactively traded stocks, however, the adopted 
formula modifies the reproposed square root allocation by limiting the 
revenues that can be allocated to a single Network security to an 
amount that is no greater than $4 per qualified transaction report. The 
amount that exceeds this $4 limitation will be reallocated among all 
Network securities in direct proportion to their dollar volume of 
trading (which is heavily weighted toward the most actively traded 
stocks). The Commission is adopting this $4 limitation to respond to 
commenters' concerns about the potential for abusive quoting behavior 
in extremely inactive stocks by anyone seeking to game the Quoting 
Share allocation.\633\
---------------------------------------------------------------------------

    \633\ See supra, section V.A.3.b.
---------------------------------------------------------------------------

    The $4 limitation is consistent with the $2 limitation on Trading 
Share allocations in the proposed formula and reproposed formula.\634\ 
Whereas the $2 reproposed limitation applied only to the 50% revenue 
allocation for Trading Share, the $4 adopted limitation applies to 100% 
of the revenue allocation for a Network security. The $4 limitation 
will prevent extremely high allocations per qualified transaction 
report for very inactive Network stocks, particularly when compared 
with the current distributable revenues per trade of the Networks, 
which ranged from $0.14 to $1.03 in 2004.\635\ Consequently, the $4 
limitation is designed to achieve an appropriately balanced allocation 
among Network stocks by allowing room for a significant increase in the 
amounts currently allocated for many less active stocks, while also 
preventing unjustifiably high allocations for the most extremely 
inactive stocks that might create an inappropriate incentive for 
abusive quoting behavior.
---------------------------------------------------------------------------

    \634\ See Proposing Release, 69 FR at 11181; Reproposing 
Release, 69 FR at 77467.
    \635\ The distributable revenue per trade for a Network is 
calculated by dividing the total distributable net income of the 
Network by the total number of reported trades for the Network's 
securities. For the Networks in 2004, the distributable revenue per 
trade was 15.1 cents for Network A, 14.5 cents for Network C, and 
103.1 cents for Network B. The foregoing Network financial 
information is preliminary and unaudited.
---------------------------------------------------------------------------

    To illustrate the operation of the $4 limitation, assume that the 
initial square root allocation for a security with 10 qualified 
transaction reports during the year was $300, or an average allocation 
of $30 per qualified transaction report. Rather than allocate the full 
$300 to this extremely inactive security, the adopted formula limits 
the allocation to $4 per qualified transaction report, so that a total 
of only $40 would be allocated to the stock as its Security Income 
Allocation. The difference of $260 ($300 minus $40) would be 
reallocated among all Network securities in direct proportion to their 
share of dollar volume of trading.
4. Distribution and Display of Data
    Most commenters supported the provisions, set forth in both the 
proposal and reproposal, authorizing the independent distribution of 
market data outside of what is required by the Plans.\636\ They 
generally agreed that the proposal would allow investors and vendors 
greater freedom to make their own decisions regarding the data they 
need. They also believed that the proposed rule amendment's ``fair and 
reasonable'' and ``not unreasonably discriminatory'' standards are 
appropriate to ensure that the independently distributed market data 
would be made available to all investors and data users. A few 
commenters, in contrast, objected to the proposed standards, asserting 
that the standards would not effectively protect investors and ``weaker 
and newer markets from

[[Page 37567]]

predatory actions by stronger markets or the potential loss of data 
integrity.'' \637\
---------------------------------------------------------------------------

    \636\ See, e.g., Brut Letter at 21, 23; CBOE Letter at 2, 17; 
Citigroup Letter at 16; Financial Information Forum Reproposal 
Letter at 4; Letter from Coleman Stipanovich, Executive Director, 
State Board of Administration of Florida, to Jonathan G. Katz, 
Secretary, Commission, dated June 29, 2004 (``Florida State Board 
Letter'') at 2; Financial Services Roundtable Letter at 6; Goldman 
Sachs Letter at 12; ICI Letter at 4, 21 n. 35; Instinet Letter at 
45; Nasdaq Letter II at 33; NYSE Letter, Attachment at 12; Letter 
from P. Howard Edelstein, President and CEO, Radianz Americas, Inc., 
to Jonathan G. Katz, Secretary, Commission, dated Jan. 27, 2005 
(``Radianz Reproposal Letter'') at 1-2; Reuters Letter at 3.
    \637\ See, e.g., Amex Letter at 10, Exhibit A at 13.
---------------------------------------------------------------------------

    The Commission is adopting Rule 603(a) as proposed and 
reproposed.\638\ The ``fair and reasonable'' and ``not unreasonably 
discriminatory'' requirements in adopted Rule 603(a) are derived from 
the language of Section 11A(c) of the Exchange Act. Under Section 
11A(c)(1)(C), the more stringent ``fair and reasonable'' requirement is 
applicable to an ``exclusive processor,'' which is defined in Section 
3(a)(22)(B) of the Exchange Act as an SRO or other entity that 
distributes the market information of an SRO on an exclusive basis. 
Adopted Rule 603(a)(1) extends this requirement to non-SRO markets when 
they act in functionally the same manner as exclusive processors and 
are the exclusive source of their own data. Applying this requirement 
to non-SROs is consistent with Section 11A(c)(1)(F) of the Exchange 
Act, which grants the Commission rulemaking authority to ``assure equal 
regulation of all markets'' for NMS Securities.
---------------------------------------------------------------------------

    \638\ The Commission also is adopting the reproposed amendment 
to current Rule 11Aa3-1 (redesignated as Rule 601 under Regulation 
NMS), which rescinds the prohibition on SROs and their members from 
disseminating their trade reports independently. Given that members 
of an SRO will continue to be required to transmit their trades to 
the SRO (and SROs will continue to transmit trades to the Networks 
pursuant to the Plans), the Commission believe that SROs and their 
members also should be free to distribute their trades 
independently.
---------------------------------------------------------------------------

    Commenters were concerned about the statement in the Proposing 
Release that the distribution standards would prohibit a market from 
distributing its data independently on a more timely basis than it 
makes available the ``core data'' that is required to be disseminated 
through a Network processor.\639\ Instinet, for example, requested that 
the Commission clarify that the proposal would not require a market 
center to artificially slow the independent delivery of its data in 
order to synchronize its delivery with the data disseminated by the 
Network.\640\ Adopted Rule 603(a) will not require a market center to 
synchronize the delivery of its data to end-users with delivery of data 
by a Network processor to end-users. Rather, independently distributed 
data could not be made available on a more timely basis than core data 
is made available to a Network processor. Stated another way, adopted 
Rule 603(a) prohibits an SRO or broker-dealer from transmitting data to 
a vendor or user any sooner than it transmits the data to a Network 
processor.
---------------------------------------------------------------------------

    \639\ Amex Letter, Exhibit A at 12; Instinet Letter at 47; 
Reuters Letter at 2.
    \640\ Instinet Letter at 47.
---------------------------------------------------------------------------

    A majority of the commenters supported the Commission's proposed 
reduction of the consolidated display requirements, stating that it 
should lead to lower costs for investors.\641\ A few commenters, 
however, opposed eliminating the requirement to display a full montage 
of market BBOs.\642\ Amex, for example, believed that elimination of 
the montage would confuse investors and make it more complicated for 
vendors and broker-dealers to manage market data. Some commenters 
believed that, rather than reducing the consolidated display 
requirement, the Commission should expand the requirement to include 
additional information on depth-of-book quotations, stating that the 
NBBO alone has become less informative since decimalization.\643\
---------------------------------------------------------------------------

    \641\ See, e.g., Brut Letter at 21, 23; Financial Information 
Forum Letter at 3-4; Instinet Letter at 7, 45; Nasdaq Letter II at 
27, 32; Reuters Letter at 2-3.
    \642\ See, e.g., Amex Letter at 9 & Exhibit A at 12; Bloomberg 
Tradebook Letter at 9; Callcott Letter at 1, 2, 5.
    \643\ See, e.g., Bloomberg Reproposal Letter at 9; Schwab 
Reproposal Letter at 5.
---------------------------------------------------------------------------

    The Commission does not believe that streamlining the quotations 
included in the consolidated display requirement will detract from the 
quality of information made available to investors. Adopted Rule 
603(c), which is adopted today as proposed and reproposed, will 
continue to require the disclosure of basic quotation information 
(i.e., prices, sizes and market center identifications of the NBBO). 
Particularly for retail investors, the NBBO continues to retain a great 
deal of value in assessing the current market for small trades and the 
quality of execution of such trades. For example, statistics on order 
execution quality for small market orders (the order type typically 
used by retail investors) reveal that their average execution price is 
very close to, if not better than, the NBBO.\644\ The adopted 
consolidated display requirement will allow market forces, rather than 
regulatory requirements, to determine what, if any, additional 
quotations outside the NBBO are displayed to investors. Investors who 
need the BBOs of each SRO, as well as more comprehensive depth-of-book 
information, will be able to obtain such data from markets or third 
party vendors.
---------------------------------------------------------------------------

    \644\ See, e.g., S&P Index Study, Table 2 (slippage rates--the 
extent to which executions occur at prices inferior to the NBBO at 
time of order receipt--for small market orders range from -2.5 basis 
points (i.e., price improvement) to 0.5 basis points). The Dash 5 
statistics used in the S&P Index Study were calculated using the 
NBBO at time of order receipt, whereas trade-through statistics used 
in the Trade-Through Study were calculated using the market BBOs at 
the time of order execution. In addition, the Dash 5 statistics 
reflect the overall average of order executions inside the NBBO, at 
the NBBO, and outside the NBBO. The trade-through statistics focus 
solely on trades executed outside the best prices. Consequently, the 
two sets of statistics are not directly comparable.
---------------------------------------------------------------------------

B. Description of Adopted Rules and Amendments

1. Allocation Amendment
    For the reasons just discussed, the Commission is adopting with 
modifications an amendment to each of the Plans (``Allocation 
Amendment'') that incorporates a broad based measure of the 
contribution of an SRO's quotes and trades to the consolidated data 
stream.\645\ The adopted formula reflects a two-step process. First, a 
Network's distributable revenues (e.g., $150 million) will be allocated 
among the many individual securities (e.g., 3000) included in the 
Network's data stream. Second, the revenues that are allocated to an 
individual security (e.g., $200,000) will be allocated among the SROs 
based on measures of the usefulness to investors of the SROs' trades 
and quotes in the security. The Allocation Amendment provides that, 
notwithstanding any other provision of a Plan, its SRO participants 
shall receive an annual payment for each calendar year that is equal to 
the sum of the SRO's Trading Shares and Quoting Shares in each Network 
security for the year.\646\ These two types of Shares are dollar 
amounts that are calculated based on SRO trading and quoting activity 
in each Network security.
---------------------------------------------------------------------------

    \645\ In 2002, the Commission abrogated several SRO proposals 
for rebating data revenues to market participants. Securities 
Exchange Act Release No. 46159 (July 2, 2002), 67 FR 45775 (July 10, 
2002). The purpose of the abrogation was to allow more time for the 
Commission to consider market data issues. Given that the current 
Plan allocation formulas will be updated to allocate revenues for 
more beneficial quoting and trading behavior, the Commission will 
consider whether rebates will be permitted after implementation of 
the adopted formula, taking into account whether their terms meet 
applicable Exchange Act standards and SROs are able to meet their 
regulatory responsibilities. Such SRO rebates would, of course, have 
to be filed with the Commission for notice, comment, and Commission 
consideration pursuant to Section 19(b) of the Exchange Act.
    \646\ Two commenters were concerned that the new formula might 
prohibit the Network's current practice of making estimated 
quarterly payments of Network revenues, with a final reconciliation 
at the end of the year. BSE Letter at 18, 19; CHX Letter at 22. The 
language of the reproposed formula and adopted formula, however, 
merely tracks existing Plan language for the calculation of ``Annual 
Shares'' or ``annual payments.'' Nothing in the adopted formula 
prohibits Networks from making estimated quarterly payments.
---------------------------------------------------------------------------

    For the reasons discussed in section V.A.3 above, the Commission 
finds that

[[Page 37568]]

the Allocation Amendment is necessary and appropriate in the public 
interest, for the protection of investors and the maintenance of fair 
and orderly markets, to remove impediments to, and perfect the 
mechanisms of, a national market system, and otherwise in furtherance 
of the purposes of the Exchange Act.
a. Security Income Allocation
    The first step of the adopted formula is to allocate a Network's 
total distributable revenues among the many different securities that 
are included in a Network (the ``Security Income Allocation''). 
Paragraph (b) of the adopted Allocation Amendment bases this allocation 
primarily on the square root of dollar volume of trading in each 
security. Use of the square root function will more appropriately 
allocate revenues among stocks with widely differing trading volume. A 
small number of Network stocks are much more heavily traded than the 
great majority of Network stocks. By proportionally shifting revenues 
away from the very top tier of active stocks and increasing the 
allocation across other stocks, the Security Income Allocation is 
intended to reflect more adequately the importance of price discovery 
for all Network stocks.
    For the most inactively traded securities, however, the square root 
function can disproportionately allocate revenues for a small number of 
trades during the year. For example, the square root allocation for a 
security with 10 qualified transaction reports during the year might be 
$300. Rather than allocate the full $300 to such an inactively traded 
security (for an average allocation per qualified transaction report of 
$30), the adopted formula includes a cap of $4 per qualified 
transaction report, so that a total of only $40 will be allocated to 
the inactive security pursuant to the square root allocation. The 
difference of $260 ($300 minus $40) will be reallocated among all 
Network securities in direct proportion to the dollar volume of 
transaction reports in Network securities. A transaction report with a 
dollar volume of $5000 or more constitutes one qualified report. A 
transaction report with a dollar volume of less than $5000 constitutes 
a proportional fraction of a qualified transaction report.
b. Trading Share
    Under paragraph (c) of the adopted Allocation Amendment, an SRO's 
Trading Share in a particular Network security will be a dollar amount 
that is determined by multiplying: (1) an amount equal to 50% of the 
Security Income Allocation for the Eligible Security by (2) the SRO's 
Trade Rating in the security. A Trade Rating will be a number that 
represents the SRO's proportion of dollar volume and qualified trades 
in the security, as compared to the dollar volume and qualified trades 
of all SROs. The Trade Ratings of all SROs will add up to a total of 
one. Thus, for example, multiplying 50% of the Security Income 
Allocation for a Network security (e.g., $200,000) by an SRO's Trade 
Rating in that security (e.g., 0.2555) would produce a dollar amount 
(e.g., 50% x $200,000 x 0.2555 = $25,550) that is the SRO's Trading 
Share for the security for the year.
    Applying 50% of the Security Income Allocation to the Trading Share 
reflects a judgment that generally trades and quotes are of 
approximately equal importance for price discovery purposes. An SRO's 
Trade Rating will be calculated by taking the average of: (1) the SRO's 
percentage of total dollar volume reported in the Network security 
during the year and (2) the SRO's percentage of the total number of 
qualified transaction reports in the Network security for the year. A 
transaction report with a dollar volume of $5000 or more will 
constitute one qualified report. A transaction report with a dollar 
volume of less than $5000 will constitute a proportional fraction of a 
qualified transaction report. As a result, all sizes of transaction 
reports will contribute toward an SRO's Trade Rating.
c. Quoting Share
    Under paragraph (d) of the adopted Allocation Amendment, an SRO's 
Quoting Share in a particular Network Security will be a dollar amount 
that is determined by multiplying (1) an amount equal to 50% of the 
Security Income Allocation for the security by (2) the SRO's Quote 
Rating in the security. A Quote Rating will be a number that represents 
the SRO's proportion of best bids and best offers that equaled the 
price of the NBBO during the year (``Quote Credits''), as compared to 
the Quote Credits of all SRO's during the year. The Quote Ratings of 
all SROs will add up to a total of one. Multiplying 50% of the Security 
Income Allocation for a Network security by an SRO's Quote Rating in 
that security will produce a dollar amount that is the SRO's Quoting 
Share for the security for the year.
    An SRO will earn one Quote Credit for each second of time and 
dollar value of size that the SRO's automated best bid or best offer 
during regular trading hours equals the price of the NBBO and does not 
lock or cross a previously displayed automated quotation.\647\ To 
qualify for credits, the quoted price must be displayed for at least 
one full second, and the relevant size will be the minimum size that 
was displayed during the second. Thus, for example, a bid with a dollar 
value of $4000 (e.g., a bid of $20 with a size of 200 shares) that 
equals the national best bid for three full seconds would be entitled 
to 12,000 Quote Credits. If an SRO quotes simultaneously at both the 
national best bid and the national best offer, it would earn Quote 
Credits for each quote. An automated quotation is defined by reference 
to adopted Rule 600(b)(3) under Regulation NMS. Thus, an SRO's manual 
quotations will not be entitled to earn any Quote Credits.
---------------------------------------------------------------------------

    \647\ Regular trading hours are defined in Rule 600(b)(64) of 
Regulation NMS as between 9:30 a.m. and 4:00 p.m. Eastern Time, 
unless otherwise specified pursuant to the procedures established in 
Rule 605(a)(2). One commenter suggested that the reproposal trades 
also should have limited trades to those reported during regular 
trading hours. NYSE Reproposal Letter II at 4. The Commission 
believes that after-hours trades generally have price discovery 
value and is retaining the current Plan practice of including them 
in the allocation formula.
---------------------------------------------------------------------------

2. Governance Amendment
    For the reasons discussed above in section V.A.2.b, the Governance 
Amendment is adopted as proposed and reproposed. Paragraph (a) mandates 
the formation of a Plan advisory committee. Paragraph (b) of the 
Governance Amendment sets forth the composition and selection process 
for such an advisory committee. Members of the advisory committee will 
be selected by the Plan operating committee, by majority vote, for two-
year terms. At least one representative must be selected from each of 
the following five categories: (1) A broker-dealer with a substantial 
retail investor customer base; (2) a broker-dealer with a substantial 
institutional investor customer base; (3) an ATS; (4) a data vendor; 
and (5) an investor. Each Plan participant also will have the right to 
select one additional member to the advisory committee that is not 
employed by or affiliated with any Plan participant or its affiliates 
or facilities.
    Paragraphs (c) and (d) of the Governance Amendment set forth the 
function of the advisory committee and the requirements for its 
participation in Plan affairs. Pursuant to paragraph (c), members of an 
advisory committee have the right to submit their views to the 
operating committee on Plan matters, including, but not limited to, any 
new or modified product, fee, contract, or pilot program that is 
offered or used

[[Page 37569]]

pursuant to the Plan. Paragraph (d) provides that members have the 
right to attend all operating committee meetings and to receive any 
information distributed to the operating committee relating to Plan 
matters, except when the operating committee, by majority vote, decides 
to meet in executive session after determining that an item of Plan 
business requires confidential treatment.
    For the reasons discussed in section V.A.2.b above, the Commission 
finds that the Governance Amendment is necessary and appropriate in the 
public interest, for the protection of investors and the maintenance of 
fair and orderly markets, to remove impediments to, and perfect the 
mechanisms of, a national market system, and otherwise in furtherance 
of the purposes of the Exchange Act.
3. Consolidation, Distribution, and Display of Data
a. Independent Distribution of Information
    The Commission is adopting the reproposed amendment to current Rule 
11Aa3-1 (redesignated as Rule 601), which rescinds the prohibition on 
SROs and their members from disseminating their trade reports 
independently.\648\ Under adopted Rule 601, members of an SRO will 
continue to be required to transmit their trades to the SRO (and SROs 
would continue to transmit trades to the Networks pursuant to the 
Plans), but such members also will be free to distribute their own data 
independently, with or without fees.
---------------------------------------------------------------------------

    \648\ See supra, note 638. Adopted Regulation NMS removes the 
definitions in former paragraph (a) of Rule 11Aa3-1 and places them 
in adopted Rule 600(b). Current subparagraphs (c)(2) and (c)(3) of 
Rule 11Aa3-1 are rescinded. As a result, current subparagraph (c)(4) 
of current Rule 11Aa3-1 is redesignated as subparagraph (b)(2) of 
adopted Rule 601.
---------------------------------------------------------------------------

    For the reasons discussed above in section V.A.4, the Commission 
also is adopting, as proposed and reproposed, Rule 603(a), which 
establishes uniform standards for distribution of both quotations and 
trades that will create an equivalent regulatory regime for all types 
of markets. First, Rule 603(a)(1) requires that any market information 
\649\ distributed by an exclusive processor, or by a broker or dealer 
(including ATSs and market makers) that is the exclusive source of the 
information, be made available to securities information processors on 
terms that are fair and reasonable. Rule 603(a)(2) requires that any 
SRO, broker, or dealer that distributes market information must do so 
on terms that are not unreasonably discriminatory. These requirements 
prohibit, for example, a market from making its ``core data'' (i.e., 
data that it is required to provide to a Network processor) available 
to vendors on a more timely basis than it makes available the core data 
to a Network processor. With respect to non-core data, however, Network 
processors occupy a unique competitive position. As Network processor, 
it acts on behalf of all markets in disseminating consolidated 
information, yet it also may be closely associated with the competitor 
of a market. The Commission believes that markets should have 
considerable leeway in determining whether, or on what terms, they 
provide additional, non-core data to a Network processor.
---------------------------------------------------------------------------

    \649\ The information covered by the amendment tracks the 
language of Section 11A(c) of the Exchange Act, which applies to 
``information with respect to quotations for or transactions in'' 
securities. This statutory language encompasses a broad range of 
information, including information relating to limit orders held by 
a market center. See, e.g., S. Report No. 94-75, 94th Cong., 1st 
Sess. 9 (1975) (``In the securities markets, as in most other active 
markets, it is critical for those who trade to have access to 
accurate, up-to-the-second information as to the prices at which 
transactions in particular securities are taking place (i.e., last 
sale reports) and the prices at which other traders have expressed 
their willingness to buy or sell (i.e., quotations).'').
---------------------------------------------------------------------------

b. Consolidation of Information
    For the reasons discussed above in section V.A.1, the Commission is 
retaining the current consolidation model and adopting the 
consolidation requirements of Rule 603(b) as proposed and reproposed. 
All of the SROs currently participate in Plans that provide for the 
dissemination of consolidated information for the NMS stocks that they 
trade. The Plans were adopted in order to enable the SROs to comply 
with Exchange Act rules regarding the reporting of trades and 
distribution of quotations. With respect to trades, paragraph (b) of 
Exchange Act Rule 11Aa3-1 (redesignated as Rule 601(a)) requires each 
SRO to file transaction reporting plans that specify, among other 
things, how its transactions are to be consolidated with the 
transactions of other SROs. With respect to quotations, paragraph 
(b)(1) of Exchange Act Rule 11Ac1-1 (redesignated as Rule 602(a)(1)) 
requires an SRO to establish and maintain procedures for making its 
best quotes available to vendors.
    To confirm by Exchange Act rule that both existing and any new SROs 
will be required to continue to participate in such joint-SRO plans, 
adopted Rule 603(b) requires SROs to act jointly pursuant to one or 
more NMS plans to disseminate consolidated information for NMS stocks. 
Such consolidated information must include an NBBO that is calculated 
in accordance with the definition set forth in adopted Rule 
600(b)(42).\650\ In addition, the NMS plans will be required to provide 
for the dissemination of all consolidated information for an individual 
NMS stock through a single processor. Thus, different processors would 
be permitted to disseminate information for different NMS stocks (e.g., 
SIAC for Network A stocks, and Nasdaq for Network C stocks), but all 
quotations and trades in a stock must be disseminated through a single 
processor. As a result, information users, particularly retail 
investors, will be able to obtain data from a single source that 
reflects the best quotations and most recent trade price for a 
security, no matter where such quotations and trade are displayed in 
the NMS.
---------------------------------------------------------------------------

    \650\ Adopted Rule 600(b)(42) of Regulation NMS defines 
``national best bid and national best offer.''
---------------------------------------------------------------------------

c. Display of Consolidated Information
    For the reasons discussed above in section V.A.4, the Commission is 
adopting, as proposed and reproposed, Rule 603(c) (previously Exchange 
Act Rule 11Ac1-2), which substantially revises the consolidated display 
requirement. It incorporates a new definition of ``consolidated 
display'' (set forth in adopted Rule 600(b)(13)) that is limited to the 
prices, sizes, and market center identifications of the NBBO and 
``consolidated last sale information'' (which is defined in Rule 
600(b)(14)). The consolidated information on quotations and trades must 
be provided in an equivalent manner to any other information on 
quotations and trades provided by a securities information processor or 
broker-dealer. Beyond disclosure of this basic information, market 
forces, rather than regulatory requirements, will be allowed to 
determine what, if any, additional data from other market centers is 
displayed. In particular, investors and other information users 
ultimately will be able to decide whether they need additional 
information in their displays.
    In addition, adopted Rule 603(c) narrows the contexts in which a 
consolidated display is required to those when it is most needed--a 
context in which a trading or order-routing decision could be 
implemented. For example, the consolidated display requirement will 
continue to cover broker-dealers who provide on-line data to their 
customers in software programs from which trading decisions can be 
implemented. Similarly, the

[[Page 37570]]

requirement will continue to apply to vendors who provide displays that 
facilitate order routing by broker-dealers. It will not apply, however, 
when market data is provided on a purely informational Web site that 
does not offer any trading or order-routing capability.\651\
---------------------------------------------------------------------------

    \651\ The amendment would retain the exemptions currently set 
forth in Rule 11Ac1-2(f) (redesignated as Rule 603(c)(2)) for 
exchange and market linkage displays. The current exemption for 
displays used by SROs for monitoring or surveillance purposes would 
no longer be necessary because of the limitation of the amendment to 
trading and order-routing contexts.
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VI. Regulation NMS

    To simplify the structure of the rules adopted under Section 11A of 
the Exchange Act (``NMS rules''), the rules adopted today will 
designate the NMS rules as Regulation NMS, renumber the NMS rules, and 
establish a new definitional rule, Rule 600 (``NMS Security Designation 
and Definitions''). Rule 600(a) replaces Exchange Act Rule 11Aa2-1, 
which designates ``reported securities'' as NMS securities. In 
addition, Rule 600(b) includes, in alphabetical order, all of the 
defined terms used in Regulation NMS. Regulation NMS includes Rules 
610, 611, and 612, which are adopted in this release, in addition to 
the existing NMS rules. The new rule series is Rule 600 through Rule 
612 (17 CFR 242.600-612).
    Rule 600 provides a single set of definitions that will be used 
throughout Regulation NMS. To create a single set of definitions, Rule 
600 updates or deletes from the existing NMS rules some terms that have 
become obsolete and eliminates the use of multiple inconsistent 
definitions for identical terms. In addition, Rule 600 adopts new 
terms, ``NMS security'' and ``NMS stock,'' to replace some terms that 
have been eliminated. These terms are necessary to maintain 
distinctions between NMS rules that apply only to equity securities and 
ETFs (e.g., Exchange Act Rules 11Ac1-4 and 11Ac1-5, redesignated as 
Rules 604 and 605) and those that apply to equity securities, ETFs, and 
options (e.g., Exchange Act Rules 11Ac1-1 and 11Ac1-6, redesignated as 
Rules 602 and 606). Rule 600 retains, unchanged, most definitions used 
in the existing NMS rules and includes definitions used in the new NMS 
rules adopted today. The definitional changes do not affect the 
substantive requirements of the existing NMS rules. In addition, the 
Commission is adopting technical amendments to a number of other 
Commission rules that cross-reference current NMS rules or that use 
terms that Regulation NMS amends or eliminates.
    The Commission received no comments regarding reproposed Rule 600, 
the reproposed redesignation of the NMS rules as Regulation NMS, or the 
reproposed changes to other Commission rules. Accordingly, the 
Commission is adopting Rule 600 and redesignating the NMS rules as 
Regulation NMS, and adopting technical amendments to certain other 
Commission rules that cross-reference current NMS rules or that use 
terms that Regulation NMS amends or eliminates, substantially as 
proposed.

A. Description of Regulation NMS

    Regulation NMS renumbers and, in some cases, renames the existing 
NMS rules, and incorporates Rule 600 and the other NMS rules adopted 
today. Where applicable, existing NMS rules are being amended to remove 
the definitions that have been consolidated in Rule 600. The titles and 
numbering of the rules in Regulation NMS, including the NMS rules 
adopted today, are as follows:
     Rule 600: NMS Security Designation and Definitions 
(replaces Exchange Act Rule 11Aa2-1, which the Commission is 
rescinding, and incorporates definitions from the existing NMS rules 
and the new rules adopted today);
     Rule 601: Dissemination of Transaction Reports and Last 
Sale Data with Respect to Transactions in NMS Stocks (renumbers and 
renames Exchange Act Rule 11Aa3-1, the substance of which is being 
modified); \652\
---------------------------------------------------------------------------

    \652\ In the market data rules, discussed in section V, the 
Commission is adopting substantive amendments to Exchange Act Rule 
11Aa3-1 (redesignated as Rule 601).
---------------------------------------------------------------------------

     Rule 602: Dissemination of Quotations in NMS Securities 
(renumbers and renames Exchange Act Rule 11Ac1-1 (``Quote Rule''), the 
substance of which remains largely intact);
     Rule 603: Distribution, Consolidation, and Display of 
Information with Respect to Quotations for and Transactions in NMS 
Stocks (renumbers and renames Exchange Act Rule 11Ac1-2 (``Vendor 
Display Rule''), the substance of which is being modified 
substantially); \653\
---------------------------------------------------------------------------

    \653\ See supra section V for a discussion of the substantive 
amendments to the Vendor Display Rule.
---------------------------------------------------------------------------

     Rule 604: Display of Customer Limit Orders (renumbers 
Exchange Act Rule 11Ac1-4 (``Limit Order Display Rule''), the substance 
of which remains largely intact);
     Rule 605: Disclosure of Order Execution Information 
(renumbers Exchange Act Rule 11Ac1-5, the substance of which remains 
largely intact);
     Rule 606: Disclosure of Order Routing Information 
(renumbers Exchange Act Rule 11Ac1-6, the substance of which remains 
largely intact);
     Rule 607: Customer Account Statements (renumbers Exchange 
Act Rule 11Ac1-3, the substance of which remains largely intact);
     Rule 608: Filing and Amendment of National Market System 
Plans (renumbers Exchange Act Rule 11Aa3-2, the substance of which 
remains largely intact);
     Rule 609: Registration of Securities Information 
Processors: Form of Application and Amendments (renumbers Exchange Act 
Rule 11Ab2-1, the substance of which remains largely intact);
     Rule 610: Access to Quotations (adopted in this release);
     Rule 611: Order Protection Rule (adopted in this release); 
and
     Rule 612: Minimum Pricing Increment (adopted in this 
release).

B. Rule 600--NMS Security Designation and Definitions

1. NMS Security Designation--Transaction Reporting Requirements for 
Equities and Listed Options
    Section 11A(a)(2) of the Exchange Act directs the Commission to 
``designate the securities or classes of securities qualified for 
trading in the national market system.'' \654\ The 1975 Amendments and 
the legislative history to the 1975 Amendments were silent as to the 
particular standards the Commission should employ in designating NMS 
securities.\655\ Instead, Congress provided the Commission with the 
flexibility and discretion to base NMS designation standards on the 
Commission's experience in facilitating the development of an NMS.\656\
---------------------------------------------------------------------------

    \654\ 15 U.S.C. 78k-1(a)(2).
    \655\ See Securities Exchange Act Release No. 23817 (Nov. 17, 
1986), 51 FR 42856 (Nov. 26, 1986) (proposing amendments to Exchange 
Act Rules 11Aa2-1 and 11Aa3-1).
    \656\ See id.
---------------------------------------------------------------------------

    To satisfy the requirement that it designate the securities 
qualified for trading in the NMS, the Commission adopted Exchange Act 
Rule 11Aa2-1 in 1981.\657\ Exchange Act Rule 11Aa2-1 (redesignated as 
Rule 600(a)) defined the term ``national market system security'' to 
mean ``any reported

[[Page 37571]]

security as defined in Rule 11Aa3-1.'' A ``reported security'' was 
``any security or class of securities for which transaction reports are 
collected, processed and made available pursuant to an effective 
transaction reporting plan.'' \658\ An ``effective transaction 
reporting plan'' was ``any transaction reporting plan approved by the 
Commission pursuant to this section.'' \659\ A ``transaction reporting 
plan'' was ``any plan for collecting, processing, making available or 
disseminating transaction reports with respect to transactions in 
reported securities filed with the Commission pursuant to, and meeting 
the requirements of, this section.'' \660\ The effective transaction 
reporting plans are the CTA Plan and the Nasdaq UTP Plan.
---------------------------------------------------------------------------

    \657\ See Securities Exchange Act Release No. 17549 (Feb. 17, 
1981), 46 FR 13992 (Feb. 25, 1981) (adopting Exchange Act Rule 
11Aa2-1).
    \658\ See former Exchange Act Rule 11Aa3-1(a)(4).
    \659\ See former Exchange Act Rule 11Aa3-1(a)(3).
    \660\ See former Exchange Act Rule 11Aa3-1(a)(2).
---------------------------------------------------------------------------

    In addition to identifying those securities deemed to be NMS 
securities, when adopted, the Exchange Act Rule 11Aa2-1 designation 
also tacitly identified those securities that did not meet that 
designation (i.e., securities other than those that were so designated 
as NMS securities). Historically, securities excluded from this 
designation included standardized options and small capitalization 
equity securities (a subset of which has been identified as Nasdaq 
SmallCap securities). Trading in options and Nasdaq SmallCap securities 
has increased over the past three decades and gradually many of the 
rules that govern NMS securities have been applied to these securities. 
As a result, much of the terminology that has been used to distinguish 
NMS securities from options and Nasdaq SmallCap securities has become 
obsolete.
    For example, the Nasdaq UTP Plan provides for the collection from 
Plan participants, and the consolidation and dissemination to vendors, 
subscribers and others, of quotation and transaction information in 
``eligible securities.'' Prior to 2001, the Nasdaq UTP Plan defined an 
``eligible security'' as any Nasdaq National Market security as to 
which unlisted trading privileges have been granted to a national 
securities exchange pursuant to Section 12(f) of the Exchange Act or 
that is listed on a national securities exchange.\661\ In 2001, the 
Nasdaq UTP Plan was amended to include Nasdaq SmallCap securities.\662\ 
As a result, Nasdaq SmallCap securities became ``eligible securities'' 
because they are now reported through an effective transaction 
reporting plan (i.e., the Nasdaq UTP Plan), bringing them within the 
purview of the NMS security designation. Several definitions in the 
existing NMS rules, however, do not reflect the inclusion of Nasdaq 
SmallCap securities in the Nasdaq UTP Plan and therefore must be 
updated. Regulation NMS does so.
---------------------------------------------------------------------------

    \661\ See Securities Exchange Act Release No. 28146 (June 26, 
1990), 55 FR 27917 (July 6, 1990) (order approving the Nasdaq UTP 
Plan on a pilot basis
    \662\ In 2001, the Nasdaq UTP Plan was amended to, among other 
things, revise the definition of ``eligible securities'' to include 
Nasdaq SmallCap securities. See Securities Exchange Act Release No. 
45081 (Nov. 19, 2001), 66 FR 59273 (Nov. 27, 2001) (order approving 
Amendment No. 12 to the Nasdaq UTP Plan). See NASD Rule 4200 for the 
definition of a Nasdaq SmallCap security.
---------------------------------------------------------------------------

    In addition, transactions in exchange-listed options are reported 
through the Plan for Reporting of Consolidated Options Last Sale 
Reports and Quotation Information (``OPRA Plan'').\663\ Unlike the CTA 
Plan and the Nasdaq UTP Plan--transaction reporting plans that the 
Commission approved pursuant to Exchange Act Rules 11Aa3-1 and 11Aa3-2 
(redesignated as Rules 601 and 608)--the Commission approved the OPRA 
Plan pursuant to Exchange Act Rule 11Aa3-2 (redesignated as Rule 
608).\664\ As such, the OPRA Plan is an ``effective national market 
system plan'' but not an ``effective transaction reporting plan.'' 
While at their core the CTA Plan, the Nasdaq UTP Plan, and the OPRA 
Plan perform essentially the same function (i.e., they govern the 
consolidated reporting of securities transactions by Plan 
participants), because the OPRA Plan is not an effective transaction 
reporting plan, listed options covered by the OPRA Plan are technically 
not ``securities for which transaction reports are collected, 
processed, and made available pursuant to an effective transaction 
reporting plan.'' Therefore, listed options were not considered NMS 
securities as defined by Exchange Act Rule 11Aa2-1. While the impact of 
this distinction may not be readily apparent, the differences in the 
way the Plans are designated dictates the securities laws and 
regulations that apply to securities reported pursuant to those Plans.
---------------------------------------------------------------------------

    \663\ The exchanges that are participants to the OPRA Plan are 
Amex, BSE, CBOE, ISE, PCX, and Phlx.
    \664\ See Securities Exchange Act Release No. 17638 (Mar. 18, 
1981), 22 S.E.C. Docket 484 (Mar. 31, 1981). Exchange Act Rule 
11Aa3-2 (redesignated as Rule 608) codifies the procedures that SROs 
must follow to seek approval for or amendment of a national market 
system plan.
---------------------------------------------------------------------------

    Further, as discussed below, some terms in the existing NMS rules 
have become superfluous or outdated, and some NMS rules define 
identical terms differently. To provide a consolidated set of 
definitions applicable to all of the NMS rules, Regulation NMS 
eliminates these inconsistencies. The definitional changes adopted 
today, however, are not intended to change materially the scope of the 
existing NMS rules.

2. NMS Security and NMS Stock

    Some NMS rules, including the Quote Rule (redesignated as Rule 602) 
and Exchange Act Rule 11Ac1-6 (redesignated as Rule 606), currently 
apply to both: (1) Equities, ETFs and related securities for which 
transaction reports are made available pursuant to an effective 
transaction reporting plan; and (2) listed options for which market 
information is made available pursuant to an effective national market 
system plan. To provide a single term that will be used in any 
provision of Regulation NMS that applies to both categories of 
securities, Regulation NMS adopts a new term, ``NMS security.'' 
Specifically, Regulation NMS defines an ``NMS security'' as ``any 
security or class of securities for which transaction reports are 
collected, processed, and made available pursuant to an effective 
transaction reporting plan, or an effective national market system plan 
for reporting transactions in listed options.'' \665\
---------------------------------------------------------------------------

    \665\ Rule 600(b)(46). This definition was used to define a 
``reported security'' in the Quote Rule. See former Exchange Act 
Rule 11Ac1-1(a)(20). For the reasons described below, the Commission 
is eliminating the term ``reported security'' from the Quote Rule 
and does not include it in Regulation NMS.
---------------------------------------------------------------------------

    Because many rules in Regulation NMS, including the Limit Order 
Display Rule (redesignated as Rule 604) and Exchange Act Rule 11Ac1-5 
(redesignated as Rule 605), continue to be inapplicable to listed 
options, Regulation NMS adopts a new term, ``NMS stock'' that will be 
used in those provisions. Regulation NMS defines the term ``NMS stock'' 
as ``any NMS security other than an option.'' \666\
---------------------------------------------------------------------------

    \666\ Rule 600(b)(47). The term ``NMS stock'' is defined in part 
with reference to the term ``transaction reporting plan.'' The 
definition of the term ``transaction reporting plan'' as proposed 
used the term ``NMS stocks.'' Thus, to avoid circularity, the 
Commission has clarified the definition of ``transaction reporting 
plan'' in Rule 600(b)(82) as adopted by replacing the phrase ``NMS 
stocks'' with the term ``securities.''
---------------------------------------------------------------------------

3. Changes to Existing Definitions in the NMS Rules
    Rule 600(b) provides a single set of definitions that will be used 
throughout Regulation NMS. To create a single set of definitions, 
Regulation NMS eliminates multiple, inconsistent definitions of 
identical terms. In addition, Regulation NMS amends some definitions in 
the NMS rules to reflect changed conditions in the marketplace

[[Page 37572]]

or to modernize references.\667\ For example, as discussed above, 
several definitions in the existing NMS rules have been rendered 
obsolete by the extension of the Nasdaq UTP Plan to Nasdaq SmallCap 
securities.\668\ Because the Nasdaq UTP Plan includes Nasdaq SmallCap 
securities, those securities now are ``securities for which transaction 
reports are collected, processed and made available pursuant to an 
effective transaction reporting plan'' (i.e., they are ``reported'' 
securities).\669\ For this reason, it is no longer necessary to 
distinguish, as several existing NMS rules do, between ``reported'' 
securities and equity securities for which market information is made 
available through Nasdaq.\670\ Accordingly, Regulation NMS eliminates 
or revises the defined terms in the existing NMS rules that make this 
distinction.
---------------------------------------------------------------------------

    \667\ The term ``electronic communications network'' was 
proposed to be defined in the Proposing Release and Reproposing 
Release to mean ``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; except that the term electronic communications 
network shall not include: (i) Any system that crosses multiple 
orders at one or more specified times at a single price set by the 
system (by algorithm or by any derivative pricing mechanism) and 
does not allow orders to be crossed or executed against directly by 
participants outside of such times; or (ii) Any system operated by, 
or on behalf of, an OTC market maker or exchange market maker that 
executes customer orders primarily against the account of such 
market maker as principal, other than riskless principal.'' The 
Commission has modified this definition to insert the phrase ``for 
the purposes of Sec.  242.602(b)(5)'' at the beginning of the 
definition to avoid inadvertently narrowing the scope of the term 
``electronic communications network'' as used in the term ``vendor'' 
in Rule 600(b)(83) (formerly Exchange Act Rule 11Ac1-2(a)(2)). See 
also infra, section VI.B.3.g. This modification makes the definition 
consistent with the definition of ``electronic communications 
network'' in former Rule 11Ac1-1(a)(8).
    \668\ See supra, section VI.B.1.
    \669\ The Vendor Display Rule and Exchange Act Rule 11Aa3-1 
(redesignated as Rule 601) defined the term ``reported security'' to 
mean ``any security or class of securities for which transaction 
reports are collected, processed and made available pursuant to an 
effective transaction reporting plan.'' See former Exchange Act 
Rules 11Ac1-2(a)(20) and 11Aa3-1(a)(4). As discussed more fully 
below, the Quote Rule provides a different definition of ``reported 
security.''
    \670\ See e.g., paragraph (a)(4) of the Vendor Display Rule 
(defining ``subject security'' to mean ``(i) any reported security; 
and (ii) any other equity security as to which transaction reports, 
last sale data or quotation information is disseminated through 
NASDAQ''); and paragraph (a)(6) of the Quote Rule (defining 
``covered security'' to mean ``any reported security and any other 
security for which a transaction report, last sale data or quotation 
information is disseminated through an automated quotation system as 
described in Section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 
78c(a)(51)(A)(ii))'').
---------------------------------------------------------------------------

a. Covered Security
    Different definitions of the term ``covered security'' appeared in 
the Quote Rule, the Limit Order Display Rule, and Exchange Act Rule 
11Ac1-6 (redesignated as Rule 606).\671\ In addition, as discussed 
below, the term has become obsolete. Therefore, Regulation NMS 
eliminates the term ``covered security'' from the NMS rules and 
replaces it with the term ``NMS security'' or ``NMS stock,'' as 
applicable, depending upon the scope of the particular rule.
---------------------------------------------------------------------------

    \671\ Although the Quote Rule and the Limit Order Display Rule 
each defined the term ``covered security'' as ``any reported 
security and any other security for which a transaction report, last 
sale data or quotation information is disseminated through an 
automated quotation system as described in Section 3(a)(51)(A)(ii) 
of the Act (15 U.S.C. 78c(a)(51)(A)(ii)),'' the scope of the 
definitions was not identical because each rule defines the term 
``reported security'' differently. The Quote Rule defined a 
``reported security'' to mean ``any security or class of securities 
for which transaction reports are collected, processed and made 
available pursuant to an effective transaction reporting plan, or an 
effective national market system plan for reporting transactions in 
listed options.'' See former Exchange Act Rule 11Ac1-1(a)(20). The 
Limit Order Display Rule defined a ``reported security'' to mean 
``any security or class of securities for which transaction reports 
are collected, processed, and made available pursuant to an 
effective transaction reporting plan.'' See former Exchange Act Rule 
11Ac1-4(a)(10).
    Exchange Act Rule 11Ac1-6 (redesignated as Rule 606) defined the 
term ``covered security'' to mean: ``(i) any national market system 
security and any other security for which a transaction report, last 
sale data or quotation information is disseminated through an 
automated quotation system as defined in Section 3(a)(51)(A)(ii) of 
the Act (15 U.S.C. 78c(a)(51)(A)(ii)); and (ii) any option contract 
traded on a national securities exchange for which last sale reports 
and quotation information are made available pursuant to an 
effective national market system plan.'' See former Exchange Act 
Rule 11Ac1-6(a)(1).
---------------------------------------------------------------------------

b. Reported Security
    Several NMS rules used the term ``reported security.'' Although the 
Limit Order Display Rule, the Vendor Display Rule, and Exchange Act 
Rule 11Aa3-1 (redesignated as Rule 601) contained identical definitions 
of ``reported security,'' the Quote Rule provided a different 
definition.\672\ Because the term ``reported security'' was defined 
inconsistently in the NMS rules and in light of the changes to related 
terms, Regulation NMS eliminates the term ``reported security'' from 
the NMS rules and replaces it with the term ``NMS security'' or ``NMS 
stock,'' depending on the scope of the particular rule.
---------------------------------------------------------------------------

    \672\ The Limit Order Display Rule, the Vendor Display Rule, and 
Exchange Act Rule 11Aa3-1 defined a ``reported security'' to mean 
``any security or class of securities for which transaction reports 
are collected, processed and made available pursuant to an effective 
transaction reporting plan.'' See former Exchange Act Rules 11Ac1-
4(a)(10), 11Ac1-2(a)(20), and 11Aa3-1(a)(4). The Quote Rule defined 
the term ``reported security'' to mean ``any security or class of 
securities for which transaction reports are collected, processed, 
and made available pursuant to an effective transaction reporting 
plan, or an effective national market system plan for reporting 
transactions in listed options.'' See former Exchange Act Rule 
11Ac1-1(a)(20). As discussed above, this release adopts substantial 
modifications to the Vendor Display Rule.
---------------------------------------------------------------------------

    The Limit Order Display Rule used the term ``reported security'' 
solely for the purpose of defining the term ``covered security.'' \673\ 
Because Regulation NMS eliminates the term ``covered security,'' the 
term ``reported security'' also is not needed in the Limit Order 
Display Rule (redesignated as Rule 604). Therefore, the term ``NMS 
stock'' replaces the term ``covered security'' in the Limit Order 
Display Rule.
---------------------------------------------------------------------------

    \673\ The Limit Order Display Rule defined a ``covered 
security'' to include both reported securities and other securities 
for which market information is disseminated through Nasdaq. See 
former Exchange Act Rule 11Ac1-4(a)(5).
---------------------------------------------------------------------------

    Similarly, the Quote Rule used the term ``reported security'' 
primarily to define the term ``covered security.'' \674\ Because 
Regulation NMS eliminates the term ``covered security,'' the 
redesignated Quote Rule (redesignated as Rule 602) also will not use 
the term ``reported security.'' \675\
---------------------------------------------------------------------------

    \674\ The Quote Rule defined a ``covered security'' to include 
both reported securities and other securities for which market 
information is disseminated through Nasdaq. See former Exchange Act 
Rule 11Aa1-1(a)(6).
    \675\ In paragraph (b)(1)(ii) of the Quote Rule (redesignated as 
Rule 602), which requires a registered national securities 
association to disseminate quotations at all times when last sale 
information is available with respect to ``reported securities,'' 
the reference to ``reported security'' is being replaced by a 
reference to ``NMS security.''
---------------------------------------------------------------------------

c. Subject Security
    The Quote Rule and the Vendor Display Rule both used the term 
``subject security,'' although they define the term differently. To 
eliminate this inconsistency, the amended Vendor Display Rule 
(redesignated as Rule 603) does not use the term ``subject security'' 
and Regulation NMS retains a slightly modified version of the 
definition of ``subject security'' currently found in the Quote Rule.
    The Vendor Display Rule defined the term ``subject security'' to 
mean ``(i) any reported security; and (ii) any other equity security as 
to which transaction reports, last sale data or quotation information 
is disseminated through NASDAQ.'' \676\ As discussed above, the 
extension of the Nasdaq UTP Plan to include Nasdaq SmallCap securities 
rendered obsolete the distinction between a ``reported security'' and a 
security for which market information is disseminated through Nasdaq.

[[Page 37573]]

Accordingly, the amended Vendor Display Rule (redesignated as Rule 603) 
uses the term ``NMS stock'' rather than ``subject security.''
---------------------------------------------------------------------------

    \676\ See former Exchange Act Rule 11Ac1-2(a)(4).
---------------------------------------------------------------------------

    The Quote Rule defined the term ``subject security'' to mean:

    (i) With respect to an exchange: (A) Any exchange-traded 
security other than a security for which the executed volume of such 
exchange, during the most recent calendar quarter, comprised one 
percent or less of the aggregate trading volume for such security as 
reported in the consolidated system; and (B) Any other covered 
security for which such exchange has in effect an election, pursuant 
to paragraph (b)(5)(i) of this section, to collect, process, and 
make available to quotation vendors bids, offers, quotation sizes, 
and aggregate quotation sizes communicated on such exchange; and
    (ii) With respect to a member of an association: (A) Any 
exchange-traded security for which such member acts in the capacity 
of an OTC market maker unless the executed volume of such member, 
during the most recent calendar quarter, comprised one percent or 
less of the aggregate trading volume for such security as reported 
in the consolidated system; and (B) Any other covered security for 
which such member acts in the capacity of an OTC market maker and 
has in effect an election, pursuant to paragraph (b)(5)(ii) of this 
section, to communicate to its association bids, offers and 
quotation sizes for the purpose of making such bids, offers and 
quotation sizes available to quotation vendors.\677\

    \677\ See former Exchange Act Rule 11Ac1-1(a)(25) (emphasis 
added).
---------------------------------------------------------------------------

    Because the Quote Rule (redesignated as Rule 602) will continue to 
apply to both listed options and equities covered by an effective 
transaction reporting plan, Regulation NMS's definition of ``subject 
security'' revises the Quote Rule's definition of ``subject security'' 
by replacing references to a ``covered security'' with references to an 
``NMS security.'' In addition, for the reasons discussed below, 
Regulation NMS replaces the phrase ``reported in the consolidated 
system'' with the phrase ``reported pursuant to an effective 
transaction reporting plan or effective national market system plan.''
d. Consolidated System
    As noted above, the definition of the term ``subject security'' in 
the Quote Rule used the phrase ``reported in the consolidated system.'' 
\678\ Paragraph (a)(5) of the Quote Rule defines the term 
``consolidated system'' to mean ``the consolidated transaction 
reporting system, including a transaction reporting system operating 
pursuant to an effective national market system plan.'' \679\
---------------------------------------------------------------------------

    \678\ Id.
    \679\ See former Exchange Act Rule 11Ac1-1(a)(5).
---------------------------------------------------------------------------

    Regulation NMS clarifies the definition of ``subject security'' by 
eliminating the phrase ``reported in the consolidated system'' and 
replacing it with the phrase ``reported pursuant to an effective 
transaction reporting plan or an effective national market system 
plan.'' Thus, Regulation NMS defines a ``subject security'' to include, 
among other things: (1) With respect to a national securities exchange, 
any exchange-traded security other than a security for which the 
executed volume of such exchange, during the most recent calendar 
quarter, comprised one percent or less of the aggregate trading volume 
for such security as reported pursuant to an effective transaction 
reporting plan or effective national market system plan; and (2) with 
respect to a member of a national securities association, any exchange-
traded security for which such member acts in the capacity of an OTC 
market maker unless the executed volume of such member, during the most 
recent calendar quarter, comprised one percent or less of the aggregate 
trading volume for such security as reported pursuant to an effective 
transaction reporting plan or effective national market system 
plan.\680\
---------------------------------------------------------------------------

    \680\ Rule 600(b)(73).
---------------------------------------------------------------------------

    This change provides a clearer definition of ``subject security'' 
by indicating that the trading volume referred to in the definition is 
the trading volume in a security that is reported pursuant to an 
effective transaction reporting plan or an effective national market 
system plan. Although replacing the phrase ``reported in the 
consolidated system'' with the phrase ``reported pursuant to an 
effective transaction reporting plan or an effective national market 
system plan'' produces a clearer definition of ``subject security,'' it 
does not alter the scope or the substance of the definition.\681\
---------------------------------------------------------------------------

    \681\ This change also impacts certain non-NMS rules that define 
the term ``consolidated system.'' See, e.g., Exchange Act Rule 10b-
18(a)(7) (``consolidated system means the consolidated transaction 
reporting system contemplated by Rule 11Aa3-1''). As discussed 
below, the Commission also is amending certain non-NMS rules that 
are affected by the definitional changes adopted today.
---------------------------------------------------------------------------

e. National Securities Exchange
    Section 3(a)(1) of the Exchange Act defines the term ``exchange'' 
to mean ``any organization, association, or group of persons * * * 
which constitutes, maintains, or provides a market place or facilities 
for bringing together purchasers and sellers of securities or for 
otherwise performing with respect to securities the functions commonly 
performed by a stock exchange as that term is generally understood * * 
*.'' \682\ Exchange Act Rule 3b-16,\683\ adopted in 1998, interprets 
the statutory definition of ``exchange'' broadly to include any 
organization, association, or group of persons that: (1) Brings 
together the orders for securities of multiple buyers and sellers; and 
(2) uses established, non-discretionary methods (whether by providing a 
trading facility or by setting rules) under which such orders interact 
with each other, and the buyers and sellers entering such orders agree 
to the terms of a trade. Exchange Act Rule 3b-16 was designed to 
provide ``a more comprehensive and meaningful interpretation of what an 
exchange is in light of today's markets.'' \684\
---------------------------------------------------------------------------

    \682\ 15 U.S.C. 78c(a)(1).
    \683\ 17 CFR 240.3b-16.
    \684\ See Securities Exchange Act Release No. 40760 (Dec. 8, 
1998), 63 FR 70844 (Dec. 22, 1998) (adopting Regulation ATS).
---------------------------------------------------------------------------

    The Quote Rule's definition of an ``exchange market maker'' defined 
the term ``national securities exchange'' as an ``exchange.'' \685\ To 
avoid confusion between a ``national securities exchange'' and the 
broader interpretation of ``exchange'' set forth in Exchange Act Rule 
3b-16, Regulation NMS uses the term ``national securities exchange'' 
rather than ``exchange'' throughout the Regulation. The national 
securities exchange definition is intended to capture only those 
entities that operate as national securities exchanges and that are 
registered as such with the Commission. It is not intended to capture 
those entities that meet the ``exchange'' definition under Regulation 
ATS but that operate as something other than a national securities 
exchange. The use of this term is consistent with the use of the term 
``exchange'' in the existing NMS rules.
---------------------------------------------------------------------------

    \685\ Specifically, the Quote Rule stated that the term 
``exchange market maker'' shall mean ``any member of a national 
securities exchange (`exchange') who is registered as a specialist 
or market maker pursuant to the rules of such exchange.'' See former 
Exchange Act Rule 11Ac1-1(a)(9). The statutory requirements 
applicable to a national securities exchange are set forth in 
Section 6 of the Exchange Act, 15 U.S.C. 78f.
---------------------------------------------------------------------------

f. OTC Market Maker
    The Quote Rule and Exchange Act Rule 11Ac1-5 (redesignated as Rule 
605) defined the term ``OTC market maker'' differently.\686\ Unlike the 
Quote Rule, Exchange Act Rule 11Ac1-5 defined the term ``OTC market 
maker'' to include an explicit reference to a securities dealer that 
holds itself out as being willing to buy from and sell to customers or 
others in the United States.

[[Page 37574]]

Regulation NMS retains the reference to transactions with ``customers 
or others in the United States'' to indicate clearly that a foreign 
dealer could be an ``OTC market maker'' if it acts as a securities 
dealer with respect to customers or others in the United States.
---------------------------------------------------------------------------

    \686\ Compare former Exchange Act Rules 11Ac1-1(a)(13) and 11 
AC1-5(a)(18).
---------------------------------------------------------------------------

    Accordingly, Regulation NMS defines ``OTC market maker'' as ``any 
dealer that holds itself out as being willing to buy from and sell to 
its customers, or others, in the United States, an NMS stock for its 
own account on a regular or continuous basis otherwise than on a 
national securities exchange.'' \687\
---------------------------------------------------------------------------

    \687\ The definition of ``OTC market maker'' uses the term ``NMS 
stock'' because there is no OTC market in standardized options.
---------------------------------------------------------------------------

g. Vendor
    The term ``vendor'' or ``quotation vendor'' was defined differently 
in three NMS rules: The Quote Rule, the Vendor Display Rule, and 
Exchange Act Rules 11Aa3-1 (redesignated as Rule 601).\688\ Although 
the definitions are similar, the definition of ``vendor'' in the Vendor 
Display Rule was the most comprehensive because it encompasses any SIP 
that disseminates transaction reports, last sale data, or quotation 
information, whereas the other definitions were less complete in 
identifying the types of information that vendors typically make 
available. To provide a uniform and comprehensive definition of the 
term ``vendor,'' Regulation NMS includes the definition of ``vendor'' 
as it was defined in the Vendor Display Rule.\689\
---------------------------------------------------------------------------

    \688\ The Quote Rule defined the term ``quotation vendor'' to 
mean ``any securities information processor engaged in the business 
of disseminating to brokers, dealers or investors on a real-time 
basis, bids and offers made available pursuant to this section, 
whether distributed through an electronic communications network or 
displayed on a terminal or other display device.'' See former 
Exchange Act Rule 11Ac1-1(a)(19). Former Exchange Act Rule 11Aa3-
1(a)(11) defined the term ``vendor'' to mean ``any securities 
information processor engaged in the business of disseminating 
transaction reports or last sale data with respect to transactions 
in reported securities to brokers, dealers or investors on a real-
time or other current and continuing basis, whether through an 
electronic communications network, moving ticker or interrogation 
device.'' The Vendor Display Rule defined the term ``vendor'' to 
mean ``any securities information processor engaged in the business 
of disseminating transaction reports, last sale data or quotation 
information with respect to subject securities to brokers, dealers 
or investors on a real-time or other current and continuing basis, 
whether through an electronic communications network, moving ticker 
or interrogation device.'' See former Exchange Act Rule 11Ac1-
2(a)(2).
    \689\ See former Exchange Act Rule 11Ac1-2(a)(2). The Commission 
modified the adopted definition of vendor to conform to a technical 
change being made to the definition of ``quotations'' and 
``quotation information'' in Rule 600(b)(62). See infra, note 699 
and accompanying text.
---------------------------------------------------------------------------

h. Best Bid, Best Offer, and National Best Bid and National Best Offer
    The Quote Rule and the Vendor Display Rule defined the terms ``best 
bid'' and ``best offer'' differently. The Quote Rule stated that 
``[t]he terms best bid and best offer shall mean the highest priced bid 
and the lowest priced offer.'' \690\ The Vendor Display Rule defined 
the terms ``best bid'' and ``best offer'' as follows: \691\
---------------------------------------------------------------------------

    \690\ See former Exchange Act Rule 11Ac1-1(a)(3).
    \691\ See former Exchange Act Rule 11Ac1-2(a)(15).
---------------------------------------------------------------------------

    (i) With respect to quotations for a reported security, the highest 
bid or lowest offer for that security made available by any reporting 
market center pursuant to Sec.  240.11Ac1-1 (Rule 11Ac1-1 under the 
Act) (excluding any bid or offer made available by an exchange during 
any period such exchange is relieved of its obligations under 
paragraphs (b)(1) and (2) of Sec.  240.11Ac1-1 by virtue of paragraph 
(b)(3)(i) thereof); Provided, however, that in the event two or more 
reporting market centers make available identical bids or offers for a 
reported security, the best bid or best offer (as the case may be) 
shall be computed by ranking all such identical bids or offers (as the 
case may be) first by size (giving the highest ranking to the bid or 
offer associated with the largest size), then by time (giving the 
highest ranking to the bid or offer received first in time); and
    (ii) With respect to quotations for a subject security other than a 
reported security, the highest bid or lowest offer (as the case may be) 
for such security disseminated by an over-the-counter market maker in 
Level 2 or 3 of NASDAQ.
    In addition, Exchange Act Rule 11Ac1-5(a)(7) defined the term 
``consolidated best bid and offer'' to mean ``the highest firm bid and 
the lowest firm offer for a security that is calculated and 
disseminated on a current and continuous basis pursuant to an effective 
national market system plan.''
    Regulation NMS retains the definitions of ``best bid'' and ``best 
offer'' used in the Quote Rule. A new term called ``national best bid 
and national best offer'': (1) Replaces the term ``best bid and best 
offer'' as that term is used in the Vendor Display Rule; and (2) 
replaces the term ``consolidated best bid and offer'' as that term is 
used in Exchange Act Rule 11Ac1-5 (redesignated as Rule 605). This new 
term refers to the best quotations that are calculated and disseminated 
by a plan processor pursuant to an effective national market system 
plan.\692\ The definition of ``national best bid and national best 
offer'' also addresses instances where multiple market centers transmit 
identical bids and offers to the plan processor pursuant to an NMS plan 
by establishing the way in which these bids and offers are to be 
prioritized.\693\
---------------------------------------------------------------------------

    \692\ The definition of ``reporting market center'' in paragraph 
(a)(14) of the Vendor Display Rule, which was incorporated into that 
Rule's definitions of ``best bid'' and ``best offer,'' is no longer 
necessary and therefore is being deleted.
    \693\ See Rule 600(b)(42).
---------------------------------------------------------------------------

i. Bid, Offer, Customer, Nasdaq Security, Quotations, Quotation 
Information, and Responsible Broker or Dealer
    Regulation NMS also updates or clarifies the following terms in the 
NMS rules: ``Bid;'' ``offer;'' ``customer;'' ``Nasdaq security;'' 
``quotations''; ``quotation information;'' and ``responsible broker or 
dealer.''
    The Quote Rule defined the terms ``bid'' and ``offer'' to mean 
``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.'' \694\ Regulation NMS updates this definition 
by replacing the term ``OTC market maker'' with the phrase ``member of 
a national securities association'' and calls the term ``bid or offer'' 
rather than ``bid and offer'' to reflect the fact that the terms are 
not always used in the conjunctive. Modifying the definition to apply 
to any member of a national securities association clarifies that bids 
and offers include quotations communicated not only by OTC market 
makers but also by ATSs, ECNs, and order entry firms that are members 
of the NASD but that are not market makers.
---------------------------------------------------------------------------

    \694\ See former Exchange Act Rule 11Ac1-1(a)(4). Paragraph 
(a)(6) of the Vendor Display Rule used the Quote Rule's definition 
of ``bid'' and ``offer'' for reported securities, but it defined 
``bid'' and ``offer'' for Nasdaq SmallCap securities as ``the most 
recent bid or offer price of an over-the-counter market maker 
disseminated through Level 2 or 3 of NASDAQ.'' Because Nasdaq 
SmallCap securities now are reported securities, it is unnecessary 
to maintain the distinction between reported securities and Nasdaq 
SmallCap securities. Accordingly, to update and provide a single 
definition of the terms ``bid'' and ``offer,'' Regulation NMS 
eliminates the definitions of ``bid'' and ``offer'' used in the 
Vendor Display Rule and retains modified versions of the terms as 
they are defined in the Quote Rule.
---------------------------------------------------------------------------

    Expanding the definition of ``bid'' and ``offer'' could have the 
unintended consequence of also expanding the scope of the Quote Rule 
(redesignated as Rule 602) where those terms are used to apply to 
members of a national

[[Page 37575]]

securities association that are not OTC market makers (e.g., ECNs and 
ATSs). To avoid this unintended expansion of the scope of the Quote 
Rule (redesignated as Rule 602), Regulation NMS proposed a revised 
version of the Quote Rule's definition of ``responsible broker or 
dealer.'' \695\ In particular, Regulation NMS proposed to amend the 
portion of the definition of ``responsible broker or dealer'' found in 
paragraph (a)(21)(ii) of the Quote Rule \696\ to limit its scope to 
bids and offers communicated by an OTC market maker. The Commission 
does not believe, however, that amending the definition of 
``responsible broker or dealer'' is necessary because the definition of 
the term ``subject security'' effectively serves to limit the scope of 
the Quote Rule, with respect to a member of a national securities 
association, to members acting in the capacity of an OTC market 
maker.\697\ The Commission therefore is modifying the proposed 
definition of ``responsible broker or dealer'' in Rule 600(b)(65)(ii) 
to replace the term ``an OTC marker maker'' with the term ``a member of 
an association'' and to replace the term ``the OTC market maker'' with 
the term ``the member.'' \698\
---------------------------------------------------------------------------

    \695\ See former Exchange Act Rule 11Ac1-1(a)(21).
    \696\ See former Exchange Act Rule 11Ac1-1(a)(21)(ii).
    \697\ Rule 600(b)(73)(ii) as adopted defines ``subject 
security'' to mean, with respect to a member of a national 
securities association, (A) any exchange-traded security for which 
such member acts in the capacity of an OTC market maker unless the 
executed volume of such member, during the most recent calendar 
quarter, comprised one percent or less of the aggregate trading 
volume for such security as reported pursuant to an effective 
transaction reporting plan or effective national market system plan; 
and (B) any other NMS security for which such member acts in the 
capacity of an OTC market maker and has in effect an election, 
pursuant to Sec.  242.602(a)(5)(ii), to communicate to its 
association bids, offers, and quotation sizes for the purpose of 
making such bids, offers, and quotation sizes available to a vendor.
    \698\ As adopted, Rule 600(b)(65)(ii) defines the term 
``responsible broker or dealer'' to mean, when used with respect to 
bids and offers communicated by a member of an association to a 
broker or dealer or a customer, the member communicating the bid or 
offer (regardless of whether such bid or offer is for its own 
account or on behalf of another person). This modification conforms 
the definition of ``responsible broker or dealer'' in Rule 
600(b)(65)(ii) as adopted to the definition of ``responsible broker 
or dealer'' in former Rule 11Ac1-1(a)(21)(ii) with respect to its 
application to a member of an association.
    The Commission also is making a change to paragraph (b)(3)(i) of 
Rule 602 from the reproposal to insert the word ``size'' after the 
phrase ``such revised quotation.'' This change will correct the 
inadvertent deletion of ``size'' in a prior amendment to this rule 
(the Quote Rule) and will not have any substantive effect.
---------------------------------------------------------------------------

    The Commission also is making a non-substantive modification to the 
definition of ``quotations'' and ``quotation information'' in Rule 
600(b)(62) from the reproposal to delete the term ``quotation 
information'' and to delete the phrase ``where applicable, quotations 
sizes and aggregate quotation sizes.'' The deleted term and phrase are 
no longer necessary because they were included in a definition used in 
the Vendor Display Rule, which is being substantially modified and no 
longer uses the deleted term or phrase.\699\ As adopted, Rule 
600(b)(62) simply defines the term ``quotation'' to mean a bid or an 
offer.
---------------------------------------------------------------------------

    \699\ Conforming modifications are being made to the definition 
of ``dynamic market monitoring device,'' ``interrogation device,'' 
and ``vendor'' in Rules 600(b)(20), 600(b)(31), and 600(b)(83) to 
replace the term ``quotation information'' with the term 
``quotations.''
---------------------------------------------------------------------------

    Regulation NMS also amends the definition of the term ``customer.'' 
The Quote Rule defined that term to mean ``any person that is not a 
registered broker-dealer.'' \700\ To indicate that the scope of the 
definition includes broker-dealers that are exempt from registration as 
well as registered broker-dealers, Regulation NMS revises the 
definition by deleting the term ``registered.'' Thus, Regulation NMS 
defines the term ``customer'' to mean ``any person that is not a 
broker-dealer.''
---------------------------------------------------------------------------

    \700\ See former Exchange Act Rule 11Ac1-1(a)(26).
---------------------------------------------------------------------------

    Exchange Act Rule 11Aa3-1 (redesignated as Rule 601) defined the 
term ``NASDAQ security'' to mean ``any registered equity security for 
which quotation information is disseminated in the National Association 
of Securities Dealers Automated Quotation system (``NASDAQ'').'' \701\ 
This acronym is now outdated. Therefore, to modernize this definition 
and to ensure that any type of registered security that Nasdaq lists is 
covered by the definition, Regulation NMS defines the term ``Nasdaq 
security'' to mean ``any registered security listed on The Nasdaq Stock 
Market, Inc.''
---------------------------------------------------------------------------

    \701\ See former Exchange Act Rule 11Aa3-1(a)(6).
---------------------------------------------------------------------------

4. Definitions in the Regulation NMS Rules Adopted Today
    Rule 600(b) includes a number of new definitions used in Regulation 
NMS Rules 610 through 612, which are adopted in this release. These new 
terms are discussed in detail in Sections II through V above. 
Specifically, for the reasons discussed above, Regulation NMS adopts 
the following terms: automated quotation, automated trading center, 
consolidated display, consolidated last sale information, intermarket 
sweep order, manual quotation, protected bid or protected offer, SRO 
display-only facility, SRO trading facility, trade-through, and trading 
center.

C. Changes to Other Rules

    In addition to the changes described above, the rules adopted today 
amend a number of rules that cross-reference current NMS rules or that 
use terms that Regulation NMS amends or eliminates. These amendments 
are intended to be non-substantive. Specifically, the rules adopted 
today make conforming changes to the following rules:\702\ Sec.  
200.30-3; \703\ Sec.  200.800, Subpart N; \704\ Sec.  201.101; \705\ 
Rule 144 \706\ under the Securities Act of 1933; \707\ Exchange Act 
Rule 0-10; \708\ Exchange Act Rule 3a51-1; \709\ Exchange Act Rule 3b-
16; \710\ Exchange Act Rules 10a-1; \711\ Exchange Act Rule 10b-10; 
\712\ Exchange Act Rule 10b-18; \713\ Exchange Act Rule 15b9-1; \714\ 
Exchange Act Rule 12a-7; \715\ Exchange Act Rule 12f-1; \716\ Exchange 
Act Rule 12f-2; \717\ Exchange Act Rule 15c2-11; \718\ Exchange Act 
Rule 19c-

[[Page 37576]]

3; \719\ Exchange Act Rule 19c-4; \720\ Exchange Act Rule 31; \721\ 
Rule 100 of Regulation M under the Exchange Act; \722\ Rule 300 of 
Regulation ATS under the Exchange Act; \723\ Rule 301 of Regulation ATS 
under the Exchange Act; \724\ Sec.  249.1001; \725\ and Rule 17a-7 
under the Investment Company Act of 1940.\726\
---------------------------------------------------------------------------

    \702\ In addition, the Commission voted to approve a conforming 
amendment to Exchange Act Rule 3a55-1 and Commodity Exchange Act 
(``CEA'') Rule 41.11. These rules were adopted jointly by the 
Commission and the Commodity Futures Trading Commission (``CFTC'') 
pursuant Section 3(a)(55)(F)(ii) of the Exchange Act and Section 
1a(25)(E)(ii) of the CEA and the amendment also must be adopted 
jointly. Section 3(a)(55)(F)(ii) of the Exchange Act and Section 
1a(25)(E)(ii) of the CEA provide that the two Commissions shall, by 
rule or regulation, jointly specify the method to be used to 
determine market capitalization and dollar value of average daily 
trading volume for purposes of definition of ``narrow-based security 
index'' (and exclusions from that definition). Exchange Act Rule 
3a55-1 and CEA Rule 41.11 refer to ``reported securities as defined 
in Sec.  240.11Ac1-1.'' The rules adopted today eliminate the term 
``reported security'' from the NMS rules and replace it with the 
term ``NMS security'' or ``NMS stock,'' depending on the scope of 
the particular rule. To reflect these changes, the joint technical 
amendment would replace the phrase ``reported securities as defined 
in Sec.  240.11Ac1-1'' with the phrase ``NMS securities, as defined 
in Sec.  242.600 of this chapter'' in Exchange Act Rule 3a55-1 and 
make a corresponding change in CEA Rule 41.11.
    \703\ 17 CFR 200.30-3. In addition to conforming changes, the 
Commission is amending this rule to delegate to the Director of the 
Division of Market Regulation the authority to grant exemptions to 
Rules 610 through 612.
    \704\ 17 CFR 200.800, Subpart N.
    \705\ 17 CFR 201.101.
    \706\ 17 CFR 230.144.
    \707\ 15 U.S.C. 77a et seq.
    \708\ 17 CFR 240.0-10.
    \709\ 17 CFR 240.3a51-1.
    \710\ 17 CFR 240.3b-16.
    \711\ 17 CFR 240.10a-1.
    \712\ 17 CFR 240.10b-10.
    \713\ 17 CFR 240.10b-18.
    \714\ 17 CFR 240.15b9-1.
    \715\ 17 CFR 240.12a-7.
    \716\ 17 CFR 240.12f-1.
    \717\ 17 CFR 240.12f-2.
    \718\ 17 CFR 240.15c2-11.
    \719\ 17 CFR 240.19c-3.
    \720\ 17 CFR 240.19c-4.
    \721\ 17 CFR 240.31.
    \722\ 17 CFR 242.100.
    \723\ 17 CFR 242.300.
    \724\ 17 CFR 242.301. The Commission also is adopting a 
technical change to Rule 301(b)(3)(iii) of Regulation ATS to correct 
a cross-reference to Rule 301(b)(3)(ii)(A) by deleting the reference 
to subparagraph (A). This change has no substantive effect.
    \725\ 17 CFR 249.1001.
    \726\ 17 CFR 270.17a-7.
---------------------------------------------------------------------------

VII. Effective Date and Phased-In Compliance Dates

    Rules 610, 611, 612, the amendment to Rule 301 of Regulation ATS, 
the amendments to the Market Data Rules and Plans discussed above in 
Section V, and the Regulation NMS amendments discussed above in Section 
VI will become effective on August 29, 2005. The compliance date for 
Rule 612, the amendment to Rule 301 of Regulation ATS, the amendments 
to the Market Data Rules and Plans discussed above in Section V other 
than the Allocation Amendment, and the Regulation NMS amendments 
discussed above in Section VI will be the same date as the effective 
date. Given the significant systems and other changes necessary to 
implement the remaining regulatory changes adopted today, the 
Commission has decided to establish delayed compliance dates for these 
new regulatory requirements.
    Compliance with Rules 610 and Rule 611 will be phased-in as 
follows:
     Phase I. The first phase-in of NMS stocks subject to Rule 
610 and 611 will begin on June 29, 2006. Beginning on June 29, 2006, 
and continuing until the beginning of Phase II, all trading centers 
must begin trading 100 NMS stocks of each of Networks A and C, and 50 
NMS stocks of Network B, pursuant to the requirements of Rules 610 and 
611. The particular NMS stocks will be chosen by the primary listing 
market, in consultation with Commission staff, to be reasonably 
representative of the range of each Network's securities. The primary 
purpose of Phase 1 is to allow all market participants to verify the 
functionality of their systems and procedures necessary to effectively 
comply with the Rules.
     Phase II. Phase II will begin on August 31, 2006. As of 
that date, trading centers must begin trading all NMS stocks pursuant 
to the requirements of Rules 610 and 611.
    The compliance date for the Allocation Amendment to the Plans will 
be September 1, 2006.

VIII. Paperwork Reduction Act

A. Order Protection Rule

    The Order Protection Rule contains collection of information 
requirements within the meaning of the Paperwork Reduction Act of 
1995.\727\ The Commission published a notice requesting comment on the 
collection of information requirements in both the Proposing Release 
and Reproposing Release, and submitted these requirements to the Office 
of Management and Budget (``OMB'') for review in accordance with 44 
U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, 
and a person is not required to respond to, an information collection 
unless it displays a currently valid OMB control number. The title of 
the affected collection is ``Order Protection Rule'' under OMB control 
number 3235-0600.
---------------------------------------------------------------------------

    \727\ 44 U.S.C. 3501 et seq. (``Paperwork Reduction Act'').
---------------------------------------------------------------------------

    In the Proposing Release, the Commission proposed to create three 
new information collections.\728\ The first collection of information 
arose from the proposed requirement that trading centers adopt policies 
and procedures reasonably designed to prevent the execution of a 
transaction at prices inferior to prices displayed by other trading 
centers. The other two collections of information related to 
requirements in a proposed exception to the Order Protection Rule 
included in the Proposing Release--the opt-out exception.\729\ The 
Order Protection Rule as reproposed did not, and as adopted does not, 
contain an opt-out exception, and therefore, the collections of 
information associated with the proposed opt-out exception are no 
longer applicable.
---------------------------------------------------------------------------

    \728\ See section III.G.1. of the Proposing Release.
    \729\ See section III.G.1. of the Proposing Release.
---------------------------------------------------------------------------

    The discussion below reflects the information collection 
requirements of the Order Protection Rule as adopted.
1. Summary of Collection of Information
    The Order Protection Rule requires a trading center to establish, 
maintain, and enforce written policies and procedures reasonably 
designed to prevent the execution of trades on that trading center at 
prices inferior to protected quotations displayed by other trading 
centers, unless a valid exception applies, and, if relying on such an 
exception, that are reasonably designed to assure compliance with the 
terms of the exception. The nature and extent of the policies and 
procedures that a trading center will be required to establish to 
comply with this requirement will depend upon the type, size, and 
nature of the trading center.
2. Proposed Use of Information
    The requirement that each trading center establish, maintain, and 
enforce written policies and procedures reasonably designed to prevent 
the execution of trades on that trading center at prices inferior to 
protected quotations displayed by other trading centers or to assure 
compliance with the terms of an exception will help ensure that the 
trading center and its customers, subscribers, members, and employees, 
as applicable, generally avoid engaging in trade-throughs, unless a 
valid exception is applicable.
3. Respondents
    The requirement for each trading center to establish written 
policies and procedures reasonably designed to prevent the execution of 
trade-throughs will apply to eight registered national securities 
exchanges that trade NMS stocks and the NASD,\730\ and approximately 
600 broker-dealers registered with the Commission.\731\ The Commission 
did not receive any comment on these estimates.
---------------------------------------------------------------------------

    \730\ There are eight national securities exchanges (Amex, BSE, 
CBOE, CHX, NSX, NYSE, Phlx and PCX) and one national securities 
association (NASD) that trade NMS stocks and thus will be subject to 
the Rule. The ISE does not trade NMS stocks and thus will not be 
subject to the Rule.
    \731\ This estimate includes the approximately 585 firms that 
were registered equity market makers or specialists at year-end 2003 
(this number was derived from annual FOCUS reports and discussion 
with SRO staff), as well as ATSs that operate trading systems that 
trade NMS stocks. The Commission believes it is reasonable to assume 
that in general, firms that are block positioners--i.e., firms that 
are in the business of executing orders internally--are the same 
firms that are registered market makers (for instance, they may be 
registered as a market maker in one or more Nasdaq stocks and carry 
on a block positioner business in exchange-listed stocks), 
especially given the amount of capital necessary to carry on such a 
business.
---------------------------------------------------------------------------

    The Commission has considered each of these respondents for the 
purposes of calculating the reporting burden under the Order Protection 
Rule.
4. Total Annual Reporting and Recordkeeping Burden
    Trading centers will need to develop written policies and 
procedures for preventing and monitoring for trade-throughs that do not 
fall within an enumerated exception, and, if relying on such an 
exception, that are reasonably

[[Page 37577]]

designed to assure compliance with the terms of the exception, to 
assure that they are in compliance with the Rule.
    Although the exact nature and extent of the required policies and 
procedures that a trading center will be required to establish likely 
will vary depending upon the nature of the trading center (e.g., SRO 
vs. non-SRO, full service broker-dealer vs. market maker), the 
Commission broadly estimates that it would take an SRO trading center 
approximately 270 hours of legal,\732\ compliance,\733\ information 
technology \734\ and business operations personnel \735\ time,\736\ and 
a non-SRO trading center approximately 210 hours of legal, compliance, 
information technology and business operations personnel time,\737\ to 
develop the required policies and procedures.
---------------------------------------------------------------------------

    \732\ Based on industry sources, the Commission estimates that 
the average hourly rate for outsourced legal service in the 
securities industry is between $150 per hour and $300 per hour. For 
purposes of this Release, the Commission will use the highest rate 
of $300 per hour to determine potential outsourced legal costs 
associated with the proposed rule. For in-house legal services, the 
Commission estimates that the average hourly rate for an attorney in 
the securities industry is approximately $82 per hour. The $82 per 
hour figure for an attorney is from the Securities Industry 
Association, Report on Management & Professional Earnings in the 
Securities Industry 2003 (Sept. 2003), adjusted by the SEC staff for 
an 1800-hour work-year with a 35% upward adjustment for overhead, 
reflecting the cost of supervision, space, and administrative 
support.
    \733\ The Commission estimates that the average hourly rate for 
an assistant compliance director in the securities industry is 
approximately $103 per hour. The $103 per hour figure for an 
assistant compliance director is from the Securities Industry 
Association, Report on Management & Professional Earnings in the 
Securities Industry 2003 (Sept. 2003), adjusted by the SEC staff for 
an 1800-hour work-year with a 35% upward adjustment for overhead, 
reflecting the cost of supervision, space, and administrative 
support.
    \734\ The Commission estimates that the average hourly rate for 
a senior computer programmer in the securities industry is 
approximately $67 per hour. The $67 per hour figure for a senior 
computer programmer is from the Securities Industry Association, 
Report on Management & Professional Earnings in the Securities 
Industry 2003 (Sept. 2003), adjusted by the SEC staff for an 1800-
hour work-year with a 35% upward adjustment for overhead, reflecting 
the cost of supervision, space, and administrative support.
    \735\ The Commission estimates that the average hourly rate for 
an operations manager in the securities industry is approximately 
$70 per hour. The $70 per hour figure for an operations manager is 
from the Securities Industry Association, Report on Management & 
Professional Earnings in the Securities Industry 2002 (Sept. 2002), 
adjusted by the SEC staff for an 1800-hour work-year with a 35% 
upward adjustment for overhead, reflecting the cost of supervision, 
space, and administrative support.
    \736\ The Commission anticipates that of the 270 hours it 
estimates will be spent to establish the required policies and 
procedures, 120 hours will be spent by legal personnel, 105 hours 
will be spent by compliance personnel, 20 hours will be spent by 
information technology personnel and 25 hours will be spent by 
business operations personnel of the SRO trading center.
    \737\ The Commission anticipates that of 210 hours it estimates 
will be spent to establish policies and procedures, 87 hours will be 
spent by legal personnel, 77 hours will be spent by compliance 
personnel, 23 hours will be spent by information technology 
personnel and 23 hours will be spent by business operations 
personnel of the non-SRO trading center.
---------------------------------------------------------------------------

    Included within this estimate, the Commission expects that SRO and 
non-SRO respondents may incur one-time external costs for out-sourced 
legal services. While the Commission recognizes that the amount of 
legal outsourcing utilized to help establish written policies and 
procedures may vary widely from entity to entity, it estimates that on 
average, each trading center would outsource 50 hours of legal time in 
order to establish policies and procedures in accordance with the Rule.
    The Commission estimates that there will be an initial one-time 
burden of 220 burden hours per SRO trading center or 1,980 hours,\738\ 
and 160 burden hours per non-SRO trading center \739\ or 96,000 hours, 
for a total of 97,980 burden hours to establish policies and procedures 
reasonably designed to prevent the execution of a trade-through, for an 
estimated one-time initial cost of $8,646,405.\740\ The Commission 
estimates a capital cost of approximately $9,135,000 for both SRO and 
non-SRO trading centers resulting from outsourced legal work \741\ for 
a total one-time initial cost of $17,781,405.\742\
---------------------------------------------------------------------------

    \738\ The estimated 1,980 burden hours necessary for SRO trading 
centers to establish policies and procedures are calculated by 
multiplying nine times 220 hours (9 x 220 hours = 1,980 hours).
    \739\ The estimated 96,000 burden hours necessary for non-SRO 
trading centers to establish policies and procedures are calculated 
by multiplying 600 times 160 hours (600 x 160 hours = 96,000 hours).
    \740\ This figure was calculated as follows: (70 legal hours x 
$82) + (105 compliance hours x $103) + (20 information technology 
hours x $67) + (25 business operation hours x $70) = $19,645 per SRO 
x 9 SROs = $176,805 total cost for SROs; (37 legal hours x $82) + 
(77 compliance hours x $103) + (23 information technology hours x 
$67) + (23 business operation hours x $70) = $14,116 per broker-
dealer x 600 broker-dealers = $8,469,600 total cost for broker-
dealers; $176,805 + $8,469,600 = $8,646,405.
    \741\ This figure was calculated as follows: (50 legal hours x 
$300 x 9 SROs) + (50 legal hours x $300 x 600 broker-dealers) = 
$9,135,000.
    \742\ This figured was calculated by adding $8,646,405 and 
$9,135,000.
---------------------------------------------------------------------------

    Once a trading center has established written policies and 
procedures reasonably designed to prevent trade-throughs in its market, 
the Commission estimates that it will take the average SRO and non-SRO 
trading center approximately two hours per month of internal legal time 
and three hours of internal compliance time to ensure that its written 
policies and procedures are up-to-date and remain in compliance with 
Rule 611. The Commission staff estimates that these ongoing costs will 
be 60 hours annually per respondent, for a total estimated annual cost 
of $3,456,684.\743\
---------------------------------------------------------------------------

    \743\ This figure was calculated as follows: (2 legal hours x 12 
months x $82) x (9 + 600) + (3 compliance hours x 12 months x $103) 
x (9 + 600)) = $3,456,684.
---------------------------------------------------------------------------

    The Commission did not receive any comments on its PRA burden 
estimates.
5. General Information About Collection of Information
    This collection of information will be mandatory. The Commission 
expects that the written policies and procedures that will be generated 
pursuant to Rule 611 will be communicated to the members, subscribers, 
and employees (as applicable) of all entities covered by the Rule. To 
the extent that this information is made available to the Commission, 
it will not be kept confidential. Any records generated in connection 
with the Rule's requirement to establish written policies and 
procedures will be required to be preserved in accordance with, and for 
the periods specified in, Exchange Act Rules 17a-1 \744\ and 17a-
4(e)(7).\745\
---------------------------------------------------------------------------

    \744\ 17 CFR 240.17a-1.
    \745\ 17 CFR 240.17a-4(e)(7).
---------------------------------------------------------------------------

B. Access Rule

    In the Proposing Release and Reproposing Release, the Commission 
requested comment on its preliminary view that proposed Rule 610 and 
the proposed amendment to Rule 301(b)(5) under Regulation ATS do not 
contain a collection of information requirement as defined by the 
Paperwork Reduction Act.\746\ No comments were received that addressed 
the issue. The Commission continues to believe that Rule 610 and the 
amendment to Rule 301(b)(5) do not contain a collection of information 
requirement.
---------------------------------------------------------------------------

    \746\ Proposing Release, 69 FR at 11160; Reproposing Release, 69 
FR at 77476.
---------------------------------------------------------------------------

C. Sub-Penny Rule

    In the Proposing Release and Reproposing Release, the Commission 
stated its preliminary view that proposed Rule 612 does not contain a 
collection of information requirement as defined by the Paperwork 
Reduction Act.\747\ No comments were received that addressed this 
issue. The Commission continues to believe that Rule 612 does not 
contain a collection of information requirement.
---------------------------------------------------------------------------

    \747\ Proposing Release, 69 FR at 11172; Reproposing Release, 69 
FR at 77476.

---------------------------------------------------------------------------

[[Page 37578]]

D. Market Data Rules and Plan Amendments

    In the Proposing Release and Reproposing Release, the Commission 
stated its preliminary view that the proposed amendments to the joint-
industry plans and to Exchange Act Rules 11Aa3-1 and 11Ac1-2 
(redesignated as Rules 601 and 603) do not impose a collection of 
information requirement as defined by the Paperwork Reduction Act.\748\ 
No comments were received that addressed this issue. The Commission 
continues to believe that these amendments do not contain a collection 
of information requirement.
---------------------------------------------------------------------------

    \748\ Proposing Release, 69 FR at 11186; Reproposing Release, 69 
FR at 77476-77.
---------------------------------------------------------------------------

E. Regulation NMS

    In the Proposing Release and Reproposing Release, the Commission 
stated its preliminary view that proposed Rule 600, the redesignation 
of the NMS rules, and the conforming amendments to various rules do not 
impose a collection of information requirement as defined by the 
Paperwork Reduction Act.\749\ No comments were received that addressed 
this issue. The Commission continues to believe that these amendments 
do not contain a collection of information requirement.
---------------------------------------------------------------------------

    \749\ Proposing Release, 69 FR at 11197; Reproposing Release, 69 
FR at 77477.
---------------------------------------------------------------------------

IX. Consideration of Costs and Benefits

    In the Proposing Release and Reproposing Release, the Commission 
identified certain costs and benefits of the Regulation NMS proposals, 
and, to help evaluate the costs and benefits, requested comment on all 
aspects of the costs and benefits and encouraged commenters to identify 
or supply any relevant data concerning the costs or benefits of the 
proposal.\750\ To the extent commenters discussed costs and benefits, 
the Commission has considered those comments.
---------------------------------------------------------------------------

    \750\ Proposing Release, 69 FR at 11148-11150, 11161, 11172-73, 
11186-89, 11197-98; Reproposing Release, 69 FR at 77441, 77474, 
77475, 77477, 77480, 77488, 77489.
---------------------------------------------------------------------------

A. Order Protection Rule

    Rule 611 requires a trading center (which includes national 
securities exchanges and national securities associations that operate 
SRO trading facilities, ATSs, market makers, and block positioners) to 
establish, maintain, and enforce written policies and procedures that 
are reasonably designed to prevent trade-throughs on that trading 
center of protected quotations, and, if relying on an exception, that 
are reasonably designed to assure compliance with the terms of the 
exception. To qualify for protection, a quotation is required to be 
displayed and immediately accessible through automatic execution. The 
Rule also requires a trading center to regularly surveil to ascertain 
the effectiveness of the policies and procedures and to take prompt 
remedial action to remedy deficiencies in such policies and procedures. 
As discussed above in Section II.A.5, the Commission has determined to 
adopt the Market BBO Alternative with respect to the scope of 
quotations that will be protected under the Rule. The Commission 
believes that providing enhanced protection for the best bids and 
offers of each exchange, The NASDAQ Stock Market, and the ADF will 
represent a major step toward achieving the objectives of intermarket 
price protection, but with fewer of the costs and potential drawbacks 
associated with the Voluntary Depth Alternative.
    Rule 611 includes a variety of exceptions to make intermarket price 
protection as efficient and workable as possible. These include an 
intermarket sweep exception, which allows market participants 
simultaneously to access multiple price levels at different trading 
centers--a particularly important function now that trading in penny 
increments has dispersed liquidity across multiple price levels. The 
intermarket sweep exception enables trading centers that receive sweep 
orders to execute those orders immediately, without waiting for better-
priced quotations in other markets to be updated. In addition, Rule 611 
provides exceptions for the quotations of trading centers experiencing, 
among other things, a material delay in providing a response to 
incoming orders, as well as for flickering quotations with prices that 
have been displayed for less than one second. Both exceptions serve to 
limit the application of Rule 611 to quotations that are truly 
automated and accessible. In response to commenters, the Commission 
also is including in the Rule an exception for certain ``stopped'' 
orders.\751\
---------------------------------------------------------------------------

    \751\ See supra, section II.A.4.
---------------------------------------------------------------------------

1. Benefits
    Although commenters were divided on the central issue of whether 
intermarket protection of displayed quotations is needed to promote the 
fairest and most efficient markets for investors, many commenters 
strongly supported the adoption of a rule against trade-throughs 
without an opt-out for all NMS stocks to promote best execution of 
market orders, to protect the best displayed prices, and encourage the 
public display of limit orders.\752\ These commenters noted that such a 
rule would encourage the use of displayed limit orders, thus increasing 
depth and liquidity in the market.\753\ Some of these commenters also 
stated that the trade-through proposal would increase investor 
confidence by helping to eliminate the impression of unfairness when an 
investor's order executes at a price that is worse than the best 
displayed quotation, or when a trade occurs at a price that is inferior 
to the investor's displayed order.\754\ As discussed above in Section 
II.A.1, the Commission agrees with these commenters.
---------------------------------------------------------------------------

    \752\ See supra, section II.A.1.
    \753\ See, e.g., BNY Letter at 2; Consumer Federation Letter at 
2; ICI Letter at 7.
    \754\ See, e.g., Consumer Federation Letter at 2; ICI Letter at 
7.
---------------------------------------------------------------------------

    The Commission believes that the Order Protection Rule will enhance 
the overall fairness and efficiency of the NMS and produce significant 
benefits for investors. The Order Protection Rule will benefit 
investors by promoting the best execution of customer market orders, 
promoting the fair treatment of customer limit orders, and 
strengthening protection of limit orders to promote greater depth and 
liquidity for NMS stocks and thereby minimize investor transaction 
costs. By providing greater protection for displayed prices, the Rule 
should serve to enhance the depth and liquidity of the NMS, and thus 
contribute to the maintenance of fair and orderly markets. By better 
protecting the interests of investors, both those that post limit 
orders and those that execute against posted limit orders, the Rule 
will promote investor confidence in the NMS. The Rule will be a 
significant improvement over the existing ITS trade-through rule, and 
will level the competitive playing field among markets by eliminating 
the potential advantage that the ITS rule afforded to manual markets.
    By requiring trading centers to establish written policies and 
procedures reasonably designed to prevent trade-throughs on their 
markets and to comply with exceptions, and by requiring them to 
regularly surveil to ascertain the effectiveness of the policies and 
procedures and to take prompt remedial action to remedy deficiencies in 
such policies and procedures, the Commission believes that the Rule 
also will offer greater assurance, on an order-by-order basis, to 
investors that submit market orders that their orders in fact will be 
executed at

[[Page 37579]]

the best readily available prices, which can be difficult for 
investors, particularly retail investors, to monitor. As noted above, 
some commenters stated that the trade-through proposal would increase 
investor confidence by helping to eliminate the impression of 
unfairness when an investor's order executes at a price that is worse 
than the best displayed quotation.\755\ Most retail investors 
justifiably expect that their orders will be executed at the NBBO. 
Investors generally can know the best quoted prices at the time they 
place an order by referring to the consolidated quotation stream for a 
stock. In the interval between order submission and order execution, 
however, quoted prices can change. If the order execution price differs 
from the quoted price at order submission, it can be particularly 
difficult for retail investors to assess whether the difference was 
attributable to changing quoted prices or to an inferior execution by 
the market. By protecting the BBO of each exchange, the NASDAQ Stock 
Market, and the NASD, the Rule will further the interests of investors, 
particularly retail investors, in obtaining--and the ability of broker-
dealers to achieve--best execution on an order-by-order basis, because 
the market to which a broker-dealer routes an order will not execute 
the order at a price that is inferior to a protected bid or offer 
displayed on the other market (unless an exception applies).\756\
---------------------------------------------------------------------------

    \755\ See supra, note 59.
    \756\ The Commission emphasizes that adoption of Rule 611 would 
in no way lessen a broker-dealer's duty of best execution. See 
supra, section II.B.4.
---------------------------------------------------------------------------

    The Order Protection Rule also will promote the fair and orderly 
treatment of limit orders for NMS stocks. Many of the limit orders that 
are bypassed are small orders that often will have been submitted by 
retail investors. Retail investors will participate directly in the 
U.S. equity markets only to the extent that they perceive that their 
orders will be treated fairly and efficiently. The Commission agrees 
with commenters that the Order Protection Rule will increase investor 
confidence by helping to eliminate the impression of unfairness when a 
trade occurs at a price that is inferior to the investor's displayed 
order.\757\ By better protecting the interests of all investors--both 
those that execute against posted limit orders and those that post 
limit orders--the Rule will bolster investor confidence in the 
integrity of the NMS, which will encourage investors to be more willing 
to invest in the market, thus adding depth and liquidity to the markets 
and promoting the ability of listed companies to raise capital.
---------------------------------------------------------------------------

    \757\ See supra, note 59.
---------------------------------------------------------------------------

    The Order Protection Rule also is designed to promote greater depth 
and liquidity for NMS stocks and thereby minimize implicit investor 
transaction costs. Depth and liquidity will be increased only to the 
extent that limit order users are given greater incentives than 
currently exist to display a larger percentage of their trading 
interest. Investors who post limit orders should not see trades 
occurring on another market at a price inferior to their orders, except 
in circumstances where an exception applies. Price protection 
encourages the display of limit orders by increasing the likelihood 
that they will realize an execution in a timely manner. Limit orders 
typically establish the best prices for an NMS stock. Greater use of 
limit orders will enhance price discovery and increase market depth and 
liquidity, thereby improving the quality of execution for large orders 
of institutional investors. The Commission believes that the Order 
Protection Rule is necessary to, and will serve to, enhance protection 
of displayed prices. By requiring trading centers to establish written 
policies and procedures reasonably designed to prevent trade-throughs 
and to comply with exceptions, and by requiring them to regularly 
surveil to ascertain the effectiveness of the policies and procedures 
and to take prompt remedial action to remedy deficiencies in such 
policies and procedures, the Rule will help ensure that displayed limit 
orders are not routinely bypassed by transactions occurring in other 
markets at inferior prices.
    Almost all commenters agreed that the current ITS trade-through 
rule must be fixed to accommodate the realities of today's NMS, in 
particular the differences in operation among automated and non-
automated markets. The Commission believes that Rule 611, by providing 
protection only for automated quotations displayed by automated trading 
centers, will significantly update the ITS trade-through rule. 
Intermarket efficiency and certainty of execution in the NMS will be 
improved as automated markets will no longer need to wait for responses 
from non-automated markets and thus will be able to execute trades more 
quickly without regard for potentially unavailable quotations displayed 
on non-automated markets. The Rule also will level the playing field by 
eliminating the potential competitive advantage the existing ITS rule 
provides to manual markets. In addition, by providing an incentive for 
non-automated markets to automate--because market participants may be 
less likely to send their order flow to a market center whose orders 
are not protected by the Order Protection Rule--the Rule generally 
should improve the accessibility of bids and offers for all investors 
and increase the efficiency of the NMS.
    The Commission believes that the benefits of strengthening price 
protection for exchange-listed stocks (e.g., by eliminating the gaps in 
ITS coverage of block positioners and 100-share quotes) and introducing 
price protection for Nasdaq stocks will be substantial, although the 
total amount is difficult to quantify. One objective, though quite 
conservative, estimate of benefits is the dollar amount of quotations 
that annually are traded through. The Commission staff's analysis of 
trade-through rates indicates that over 12 billion shares of displayed 
quotations in Nasdaq and NYSE stocks were traded through in 2003, by an 
average amount of 2.3 cents for Nasdaq stocks and 2.2 cents for NYSE 
stocks.\758\ These traded-through quotations represent approximately 
$209 million in Nasdaq stocks and $112 million in NYSE stocks, for a 
total of $321 million in bypassed limit orders and inferior prices for 
investors in 2003 that could have been addressed by strong trade-
through protection.\759\ The Commission believes that this $321 million 
estimated annual benefit, particularly when combined with the benefits 
of enhanced investor confidence in the fairness and orderliness of the 
equity markets, justifies the one-time costs of implementation and 
ongoing annual costs of the Order Protection Rule.
---------------------------------------------------------------------------

    \758\ Trade-Through Study at 3, 5.
    \759\ Id. at 3.
---------------------------------------------------------------------------

    Two commenters on the reproposal asserted that the dollar amount of 
traded-through quotations overstated the benefits of order protection 
because ``trading is for the most part a zero-sum game.'' \760\ They 
believed that trades executed at inferior prices were random noise that 
sometimes benefited and sometimes disadvantaged a particular investor, 
stating that ``[i]t is only if one class of investors systematically 
loses out to another class as a result of trade-throughs that there is 
a problem* * *'' \761\
---------------------------------------------------------------------------

    \760\ Angel Reproposal Letter at 4; see also Fidelity Reproposal 
Letter at 8.
    \761\ Angel Reproposal Letter at 4.
---------------------------------------------------------------------------

    The Commission does not agree that trades executed at inferior 
prices should be considered merely a transfer of benefits from one 
group of investors to another equally-situated group of investors. 
There are at least three parties

[[Page 37580]]

affected by every trade-through transaction (1) The party that received 
an inferior price; (2) the party whose superior-priced limit order was 
traded-through; and (3) the contra party to the trade-through 
transaction that received an advantageous price. The redistributions of 
welfare resulting from trade-through transactions cannot reasonably be 
expected to occur randomly across these parties. Customers of brokers 
that are doing a poor job of routing orders are more likely to be 
harmed than customers of brokers that are doing a better job.\762\ 
Investors who generally submit limit orders at the best prices are more 
likely to be harmed than customers who generally submit less 
aggressively-priced limit orders.
---------------------------------------------------------------------------

    \762\ As discussed above, it can be difficult for retail 
investors in particular to monitor whether their orders in fact 
received the best available price at the time of order execution. 
See supra, note 53 and accompanying text.
---------------------------------------------------------------------------

    Thus, trade-through transactions can result in direct harm to two 
parties, as well as more general harm to the efficiency of the markets 
by dampening the incentive for aggressive quoting. Moreover, even when 
the party receiving an inferior price does so willingly (such as when 
an institution accepts a block trade at a price away from the inside 
quotation),\763\ the party whose quotation was traded through and the 
efficiency of the markets still are harmed. Finally, many trade-
throughs are dealer internalized trades, where the party receiving the 
advantageous price is not an investor but a market intermediary, and 
therefore such trades cannot be considered a transfer of benefits from 
one group of investors to another equally-situated group of investors. 
This transfer of benefits from investors to market intermediaries 
cannot be dismissed as mere ``random noise.''
---------------------------------------------------------------------------

    \763\ Fidelity and the Battalio/Jennings Paper stated that the 
staff study should not have included block trades in its estimate of 
the benefits of strengthened trade-through protection. Fidelity 
Reproposal Letter II at 1; Battalio/Jennings Paper at 2. The 
Commission does not agree. First, the amount that block trades 
contributed to the $321 million estimate is very small. Block trades 
represented only 1.9% of total trade-throughs in Nasdaq stocks and 
1.1% of total trade-throughs in NYSE stocks. Trade-Through Study, 
Tables 6, 13. Most importantly, the staff study used the lesser of 
the size of the traded-through quotation and the size of the trade-
through transaction when calculating the $321 million. Id. at 3. 
Thus, if a 10,000 share transaction traded through a 100-share 
quotation, only 100 shares counted toward the estimation of 
benefits. The Battalio/Jennings Paper incorrectly asserted that the 
staff study did not use this conservative approach. Battalio/
Jennings Paper at 2. Finally, block trades are appropriately 
included in the estimation of benefits because their failure to 
interact with significant displayed quotations is one of the most 
serious problems with respect to the protection of limit orders that 
the Order Protection Rule is designed to address. See supra, section 
II.A.1.c.
---------------------------------------------------------------------------

    In addition, economic theory predicts that, in an auction market, 
buyers who place the highest value on a stock will bid most 
aggressively.\764\ If an incoming market order is allocated to an 
investor who is not bidding the best price, this re-allocation is 
neither zero-sum nor random. It systematically reallocates trades away 
from those investors for whom the welfare gains would be largest. The 
argument also can be framed in terms of an investor's preferences with 
respect to the tradeoff between price and execution speed. Among those 
investors who trade using limit orders, we would expect more aggressive 
limit orders to be submitted by those investors who place more value on 
speed or certainty of execution and relatively less value on price. 
Conversely, we would expect investors who place a lower value on speed 
and certainty of execution and a higher value on price to submit less 
aggressive limit orders. When an incoming market order is executed 
against a limit order with an inferior price, the result is: (1) A 
faster execution for an investor who does not place as much value on 
speed of execution; and (2) a lost execution or slower execution for 
the investor who places a higher value on prompt execution. This is not 
a zero-sum redistribution.
---------------------------------------------------------------------------

    \764\ See, e.g., B. Hollifield, R. Miller and P. Sandas, 
``Empirical Analysis of Limit Order Markets,'' 71 Review of Economic 
Studies 1027-1063 and n. 4 (2004).
---------------------------------------------------------------------------

    Moreover, the $321 million estimate is a conservative measure of 
the total benefits of the Order Protection Rule. It does not attempt to 
measure any gains from trading associated with investors' private 
values, beyond those expressed in their limit order prices. The Order 
Protection Rule can be expected to generate other categories of 
benefits that are not quantified in the $321 million estimate, such as 
the benefits that can be expected to result from increased use of limit 
orders, increased depth, and increased order interaction.
    Thus, the Commission believes that the $321 million estimate of 
benefits is conservative because it is based solely on the size of 
displayed quotations in the absence of strong price protection. In 
essence, it measures the problem--a shortage of quoted depth--that the 
Order Protection Rule is designed to address, rather than the benefits 
that it could achieve. Every trade-through transaction potentially 
sends a message to market participants that their displayed quotations 
can be and are ignored by other market participants. When the total 
share volume of trade-through transactions that do not interact with 
displayed quotations reaches 9% and above for hundreds of the most 
actively traded NMS stocks,\765\ this message is unlikely to be missed 
by those who watched their quotations being traded through. Certainly, 
the common practice of trading through displayed size is most unlikely 
to prompt market participants to display even greater size.
---------------------------------------------------------------------------

    \765\ See Trade-Through Study, Tables 4.
---------------------------------------------------------------------------

    A primary objective of the Order Protection Rule is to increase 
displayed depth and liquidity in the NMS and thereby reduce transaction 
costs for a wide spectrum of investors, particularly institutional 
investors that must trade in large sizes. Precisely estimating the 
extent to which strengthened price protection will improve market depth 
and liquidity, and thereby lower the transaction costs of investors, is 
very difficult. The difficulty of estimation should not hide from view, 
however, the enormous potential benefits for investors of improving the 
depth and efficiency of the NMS. Because of the huge dollar amount of 
trading volume in NMS stocks--more than $17 trillion in 2003 \766\--
even the most incremental improvement in market depth and liquidity 
could generate a dollar amount of benefits that annually would dwarf 
the one-time start-up costs of implementing trade-through protection.
---------------------------------------------------------------------------

    \766\ World Federation of Exchanges, Annual Report (2003), at 
86.
---------------------------------------------------------------------------

    One approach to evaluating the potential benefits of the Order 
Protection Rule is to examine a category of investors that stand to 
benefit a great deal from improved depth and liquidity for NMS stocks--
the shareholders in U.S. equity mutual funds. In 2003, the total assets 
of such funds were $3.68 trillion.\767\ The average portfolio turnover 
rate for equity funds was 55%, meaning that their total purchases and 
sales of securities amounted to approximately $4.048 trillion.\768\ A 
leading authority on the trading costs of institutional investors has 
estimated that in the second quarter of 2003 the average price impact 
experienced by investment managers ranged from 17.4 basis points for 
giant-capitalization stocks, 21.4 basis points for large-capitalization 
stocks, and up to 35.4 basis points for micro-capitalization

[[Page 37581]]

stocks.\769\ In addition, it estimated the cost attributable to adverse 
price movements while searching for liquidity for institutional orders, 
which often are too large simply to be presented to the market. Its 
estimate of these liquidity search costs ranged from 13 basis points 
for giant capitalization stocks, 23 basis points for large 
capitalization stocks, and up to 119 basis points for micro-
capitalization stocks.
---------------------------------------------------------------------------

    \767\ Investment Company Institute, Mutual Fund Fact Book 
(2004), at 55.
    \768\ Id. at 64. Portfolio turnover is reported as the lesser of 
portfolio sales or purchases divided by average net assets. Because 
price impact occurs for both purchases and sales, the turnover rate 
must be doubled, then multiplied by total fund assets, to estimate 
the total value of trading that would be affected by an improvement 
in depth and liquidity.
    \769\ Plexus Group, Inc., Commentary 80, ``Trading Truths: How 
Mis-Measurement of Trading Costs Is Leading Investors Astray,'' 
(April 2004), at 2-3.
---------------------------------------------------------------------------

    To obtain a conservative estimate of price impact costs and 
liquidity search costs incurred across all stocks, the total market 
impact and liquidity search costs for giant capitalization stocks (30.4 
basis points) and the total market impact and liquidity search costs 
for large capitalization stocks (44.4 basis points) are averaged 
together to yield a figure of 37.4 basis points.\770\ The much higher 
market impact and liquidity search costs of midcap, smallcap, and 
microcap stocks are not included. Using this estimate of 37.4 basis 
points, the shareholders in U.S. equity mutual funds incurred implicit 
transaction costs of $15.1 billion in 2003. Based on a hypothetical 
assumption that, in light of the current share volume of trade-through 
transactions that does not interact with displayed liquidity, 
intermarket trade-through protection could improve depth and liquidity 
for NMS stocks by 5% (or an average reduction of 1.87 basis points in 
price impact and liquidity search costs for large investors), the 
savings in transaction costs for U.S equity funds alone, and the 
improved returns for their millions of individual shareholders, would 
have amounted to approximately $755 million in 2003.
---------------------------------------------------------------------------

    \770\ Cf. supra, note 146 and accompanying text (Plexus estimate 
of average transaction costs, including commissions, during the 
fourth quarter of 2003 for Nasdaq and NYSE stocks as, respectively, 
83 basis points and 55 basis points; commissions average 12 basis 
points for large capitalization stocks).
---------------------------------------------------------------------------

    Of course, the benefits of improved depth and liquidity for the 
equity holdings of other types of investors, including pension funds, 
insurance companies, and individuals, are not incorporated in the 
foregoing calculations. In 2003, these other types of investors held 
78% of the value of publicly traded U.S. equity outstanding, with 
equity mutual funds holding the remaining 22%.\771\ For example, 
pension funds alone held $9 trillion in assets in 2003, of which an 
estimated $4.9 trillion was held in equity investments other than 
mutual funds.\772\ Thus, the implicit transaction costs incurred by 
institutional investors each year is likely at least double the $15.1 
billion estimated for equity mutual funds, for a total of more than $30 
billion. Assuming that these other types of investors experienced a 
reduction in transaction costs that equaled the reduction of trading 
costs for equity mutual funds, the assumed 5% improvement in market 
depth and liquidity could yield total transaction cost savings for all 
investors of over $1.5 billion annually. Such savings would improve the 
investment returns of equity ownership, thereby promoting the 
retirement and other long-term financial interests of individual 
investors and reducing the cost of capital for listed companies.
---------------------------------------------------------------------------

    \771\ Mutual Fund Factbook, supra note 767, at 59.
    \772\ Id. at 91 (employer-sponsored pension market held 
estimated $9.0 trillion in assets in 2003, $7.7 trillion of which 
were not represented by mutual fund assets); Milliman, Inc., Pension 
Fund Survey (available at www.milliman.com) (consulting firm's 
survey of 2003 annual reports for 100 of largest U.S. corporations 
found that the median equity allocation for pension fund assets was 
65%).
---------------------------------------------------------------------------

2. Costs
    Some commenters expressed concern over the anticipated cost of 
implementing the original trade-through proposal.\773\ These commenters 
argued that Rule 611 would be too expensive and that the costs 
associated with implementing it would outweigh the perceived benefits 
of the Rule. Some commenters were concerned about the cost of specific 
requirements in the proposed rule, particularly the procedural 
requirements associated with the proposed opt-out exception (e.g., 
obtaining informed consent from customers and disclosing the NBBO to 
customers).\774\ As discussed above, however, the Order Protection Rule 
as reproposed did not (and as adopted does not) contain an opt-out 
exception, as was originally proposed.\775\ Therefore, the concerns 
expressed by commenters relating to the costs of implementing an opt-
out exception are not applicable, and were not included in the 
Reproposing Release. In the Reproposing Release, the Commission also 
refined its estimate of the number of broker-dealers that would be 
required to establish, maintain, and enforce written policies and 
procedures to prevent trade-throughs.\776\ Taken together, these 
changes substantially reduced the estimated costs associated with the 
implementation of and ongoing compliance with the reproposed Rule. 
Commenters also expressed concern that applying the trade-through 
proposal to the Nasdaq market would harm market efficiency and 
execution quality.\777\ As discussed above, the Commission believes 
that a rule that serves to limit the incidence of trade-throughs will 
improve market efficiency and benefit execution quality.\778\
---------------------------------------------------------------------------

    \773\ See, e.g., Bloomberg Tradebook Letter at 14; Fidelity 
Letter I at 12; Instinet Letter at 14, 15; Nasdaq Letter II at 2; 
Peake Letter I at 2; Reg NMS Study Group Letter at 4; Rosenblatt 
Securities Letter II at 4; STANY Letter at 3; UBS Letter at 8.
    \774\ See, e.g., Ameritrade Letter I at 8; Brut Letter at 10-12; 
Citigroup Letter at 8-9; E*TRADE Letter at 7; Financial Information 
Forum Letter at 2; JP Morgan Letter at 4; SIA Letter at 12-15.
    \775\ See supra, section II.A.4.
    \776\ As noted in the Reproposing Release, the Commission 
revised the estimated number of broker-dealers that would be subject 
to the reproposed Rule from the original proposal. The revised 
number includes the approximately 585 firms that were registered 
equity market makers or specialists at year-end 2003 (this number 
was derived from annual FOCUS reports and discussion with SRO 
staff), as well as ATSs that operate trading systems that trade NMS 
stocks. The Commission believes it is reasonable to assume that in 
general, firms that are block positioners--i.e., firms that are in 
the business of executing orders internally--are the same firms that 
are registered market makers (for instance, they may be registered 
as a market maker in one or more Nasdaq stocks and carry on a block 
positioner business in exchange-listed stocks), especially given the 
amount of capital necessary to carry on such a business.
    \777\ See, e.g., Archipelago Reproposal Letter at 5-6; Citadel 
Letter at 6; Hudson River Trading Letter at 1-2; Instinet Reproposal 
Letter at 9, 14; Nasdaq Reproposal Letter at 2.
    \778\ See supra, section II.A.1.
---------------------------------------------------------------------------

    A number of commenters generally expressed the view that there 
would be significant costs associated with implementing and complying 
with the reproposed Rule,\779\ with some commenters stating the belief 
that the costs would outweigh any potential benefits.\780\ Commenters 
did not, however, discuss the specific estimated cost figures included 
in the Reproposing Release or include their own estimates. Many 
commenters expressed concerns with the costs associated with 
implementing the Voluntary Depth Alternative, believing that the costs 
of implementing the Voluntary Depth Alternative would be substantially 
greater than the Market BBO Alternative.\781\ As discussed above in 
Section II.A.5, the Commission is adopting the Market BBO Alternative 
and not the Voluntary Depth Alternative. The Commission does not

[[Page 37582]]

believe that the inclusion of a stopped order exception will materially 
impact the estimated costs included in the Reproposing Release.\782\ 
The Commission therefore continues to estimate implementation costs for 
the Order Protection Rule of approximately $143.8 million and annual 
costs of approximately $21.9 million, as discussed below.
---------------------------------------------------------------------------

    \779\ See, e.g., CIBC Reproposal Letter at 4; Knight Securities 
Reproposal Letter at 5; Lava Reproposal Letter at 1; Merrill Lynch 
Reproposal Letter at 5; SIA Reproposal Letter at 11.
    \780\ See, e.g., Angel Reproposal Letter at 2; Instinet 
Reproposal Letter at 7; Knight Securities Reproposal Letter at 5; 
MFA Reproposal Letter at 2.
    \781\ See, e.g., Amex Reproposal Letter at 3; ATD Reproposal 
Letter at 4; BNY Reproposal Letter at 3; CHX Reproposal Letter at 2; 
NYSE Reproposal Letter I, Detailed Comments at 8; RBC Capital 
Markets Reproposal Letter at 6; STANY Reproposal Letter at 9.
    \782\ The estimated cost figures included the Reproposing 
Release did not include additional costs that would have been 
associated with the Voluntary Depth Alternative.
---------------------------------------------------------------------------

    The Commission recognizes, as noted by commenters, that there will 
be significant one-time costs to implement the Order Protection Rule. 
Trading centers will necessarily incur costs associated with 
establishing written policies and procedures reasonably designed to 
prevent trade-throughs--in other words, with determining a course of 
action for how the trading center will comply with the requirements of 
the Rule, including compliance with the exceptions contained in the 
Rule. Although the extent of these costs will vary because the exact 
nature and extent of each trading center's written policies and 
procedures will depend on the type, size and nature of each entity's 
business, as discussed above in Section VIII.A., for purposes of the 
PRA the Commission broadly estimates that SRO trading centers will 
incur a one-time initial cost for establishing such policies and 
procedures of approximately $311,805 (calculated by multiplying the 
average cost of $34,645 per SRO trading center by the 9 SRO trading 
centers), and non-SRO trading centers will incur a one-time initial 
cost for establishing policies and procedures of approximately 
$17,469,600 (calculated by multiplying the average cost of $29,116 per 
non-SRO trading center by the 600 non-SRO trading centers), for a total 
of $17,781,405.\783\
---------------------------------------------------------------------------

    \783\ See supra, notes 736 to 742 and accompanying text.
---------------------------------------------------------------------------

    Each trading center also will incur initial up-front costs 
associated with taking action necessary to implement the written 
policies and procedures it has developed, which will include necessary 
modifications to order routing and execution systems to ``hard-code'' 
compliance with the Rule and the exceptions. For instance, 
modifications to order routing and execution systems will need to be 
made to route and execute orders in compliance with the requirements of 
the Rule to prevent trade-throughs of protected quotations (which 
include, for instance, the ability to recognize quotations identified 
in the consolidated quotation system as manual quotations on a 
quotation-by-quotation basis). Trading centers will need to make sure 
they have connectivity to other trading centers in the NMS that could 
post protected quotations, whether through proprietary linkages or 
through use of third-party services. As noted below, however, the 
Commission believes that most of this private linkage functionality 
already exists, particularly in the market for Nasdaq securities. 
Surveillance systems will need to be modified to assure an effective 
mechanism for monitoring transactions after-the-fact for ongoing 
compliance purposes. Also, trading systems will need to be programmed 
to recognize when exceptions to the operative provisions of Rule 611 
are applicable. For example, trading centers will need to be able to 
identify outgoing and recognize incoming orders as intermarket sweep 
orders. Data feeds and market vendor systems will need to be modified 
to accommodate order identifiers for manual quotations and intermarket 
sweep orders, which costs (to the extent incurred) will likely be 
passed along to the end users of these systems, the trading centers. 
These costs are included within the estimates below.
    For non-SRO trading centers that rely upon their own internal order 
routing and execution management systems, of which the Commission 
estimated in the Reproposing Release that there are approximately 20, 
the Commission estimates the average cost of necessary systems changes 
to implement the Rule will be approximately $3 million per trading 
center, for a total one-time start-up cost of approximately $60 
million.\784\ The Commission estimates that the remaining non-SRO 
trading centers that will be subject to the Rule will utilize outside 
vendors to provide these services, consistent with their current use of 
such services for order routing and execution management. For these 
non-SRO trading centers, the Commission estimates the cost of necessary 
systems modifications that will be passed along to the trading centers 
to be approximately $50,000 per trading center, for a total initial 
cost of $21 million.\785\ The Commission also estimates that the 
average cost to the nine SROs to make necessary system modifications to 
implement the Rule will be $5 million per SRO, for a total of $45 
million. Therefore, estimated overall total one-time implementation 
costs, added to PRA costs, are approximately $144 million.
---------------------------------------------------------------------------

    \784\ This number is an average estimated cost; thus, it likely 
overestimates the costs for some trading centers and underestimates 
it for others. For instance, it likely overestimates the cost for 
ATS trading centers, particularly smaller ones, as opposed to full-
service broker-dealer trading centers, in part because of the 
narrower business focus of some ATSs.
    \785\ Given that floor-based market-makers and specialists 
utilize exchange execution systems, the Commission believes it is 
reasonable to assume that such market-makers and specialists will 
not incur substantial systems-related costs to implement the Rule 
independent of the costs that will be incurred by the exchange on 
whose floor they operate to make changes to the exchange's execution 
systems. Thus, these entities (approximately 160 of the 585) are not 
directly included within the cost estimates.
---------------------------------------------------------------------------

    In addition, broker-dealers that do not fall within the definition 
of a trading center but that employ their own smart-order routing 
technology to route orders to multiple trading centers could choose to 
route orders in compliance with the intermarket sweep exception. These 
broker-dealers would need to make necessary modifications to their 
order routing practices and proprietary order routing systems to 
monitor the protected quotations of trading centers and to properly 
identify such intermarket sweep orders. The Commission does not believe 
that this category of broker-dealers is very large. The Commission also 
believes it likely that most if not all of these non-trading center 
broker-dealers that employ their own order-routing technology already 
have systems in place that monitor best-priced quotations across 
markets, and thus does not believe that the changes necessary to 
implement the intermarket sweep order will be substantial.
    With respect to maintaining and updating its required written 
policies and procedures to ensure they continue to be in compliance 
with the Rule, for purposes of the PRA the Commission estimates that 
the average annual cost for each trading center will be approximately 
$5,676 per trading center per year, for a total annual cost for all 
trading centers of $3,456,684.\786\ With regard to ongoing monitoring 
for and enforcement of trading in compliance with the Rule, the 
Commission believes that, once the tools necessary to carry out on-
going monitoring have been put in place (which are included in the 
above cost estimates), a trading center will be able to incorporate 
ongoing monitoring and enforcement within the scope of its existing 
surveillance and enforcement policies and procedures without a 
substantial additional burden.
---------------------------------------------------------------------------

    \786\ See supra, note 743 and accompanying text.
---------------------------------------------------------------------------

    The Commission recognizes, however, that this ongoing compliance 
will not be cost-free, and that trading centers will incur some 
additional annual costs associated with ongoing compliance, including 
compliance costs of reviewing transactions. For instance, the 
Commission recognizes that access to a

[[Page 37583]]

database of BBO information for each trading center whose quotations 
will be protected by the Order Protection Rule will be necessary to 
monitor transactions for compliance with the Rule on an after-the-fact 
basis. The Commission believes that this information currently is 
available and understands that such information currently is maintained 
by at least one industry vendor. The Commission believes that the cost 
to each trading center to access this database will be incremental in 
relation to the cost of other services provided by the vendor. The 
Commission estimates that each trading center will incur an average 
annual ongoing compliance cost of $30,144 for a total annual cost of 
$18,357,696 for all trading centers.\787\
---------------------------------------------------------------------------

    \787\ This estimate was included in the Reproposing Release. The 
Commission continues to estimate that each trading center will incur 
an average annual ongoing compliance cost of $30,144 for a total 
annual cost of $18,357,696 for all trading centers. This figure was 
calculated as follows: (16 compliance hours x $103) + (8 information 
technology hours x $67) + (4 legal hours x $82) x 12 months = 
$30,144 per trading center x 609 trading centers = $18,357,696. See 
supra, notes 732 to 735 for notation as to hourly rates.
---------------------------------------------------------------------------

    In assessing the costs of systems changes that may be required by 
the Order Protection Rule, it is important to recognize that much, if 
not all, of the connectivity among trading centers necessary to 
implement intermarket price protection has already been put in place. 
For example, trading centers for exchange-listed securities already are 
connected through the ITS. The Commission understands that, at least as 
an interim solution, ITS facilities and rules can be modified 
relatively easily and at low cost to provide the current ITS 
participants a means of complying with the provisions of Rule 611. With 
respect to Nasdaq stocks, connectivity among many trading centers 
already is established through private linkages. Routing out to other 
trading centers when necessary to obtain the best prices for Nasdaq 
stocks is an integral part of the business plan of many trading 
centers, even when not affirmatively required by best execution 
responsibilities. Moreover, a variety of private vendors currently 
offer connectivity to NMS trading centers for both exchange-listed and 
Nasdaq stocks. Many of the broker-dealers that are non-SRO trading 
centers that will be subject to the Rule already employ smart order 
routing technology, either their own systems or those of outside 
vendors, which should limit the cost of implementing systems changes. 
The Commission also understands that the cost to the Plan processors to 
incorporate the Order Protection Rule and its exceptions will be 
minimal.
    In determining these estimates the Commission also has considered 
that many market participants are already making changes to their 
systems to become more competitive. Many of the changes being made will 
assist the market participants in preparing for implementation of the 
Order Protection Rule. For example, Nasdaq, which previously did not 
have an order routing system, purchased Brut, LLC last year in order to 
acquire access to such a system. The Commission believes that this 
acquisition should reduce the costs that will be incurred by Nasdaq to 
implement the Order Protection Rule. The Commission also notes that the 
NYSE is in the process of modifying its Direct+ System to make more 
quotations available on an automated basis.\788\ These changes that the 
NYSE has undertaken should reduce the cost of additional systems 
changes needed to implement the Order Protection Rule.
---------------------------------------------------------------------------

    \788\ See Securities Exchange Act Release Nos. 50173 (Aug. 10, 
2004), 69 FR 50407 (Aug. 16, 2004), 50277 (Aug. 26, 2004), 69 FR 
53759 (Sept. 2, 2004) and 50667 (Nov. 15, 2004), 69 FR 67980 (Nov. 
22, 2004) (SR-NYSE-2004-05).
---------------------------------------------------------------------------

    Overall, the Commission believes that the Order Protection Rule 
will produce significant benefits that justify the costs of 
implementation of the Rule.

B. Access Rule

    Rule 610 of Regulation NMS sets forth new standards governing means 
of access to quotations in NMS stocks. These standards will prohibit 
trading centers from imposing unfairly discriminatory terms that would 
prevent or inhibit the efficient access of any person through members, 
subscribers, or customers of such trading center, and enable access to 
NMS quotations through private linkages, rather than mandating a 
collective intermarket linkage facility. In addition, the Rule is 
designed to ensure the fairness and accuracy of displayed quotations by 
establishing an outer limit on the cost of accessing protected 
quotations and any other quotations at the best bid and offer of no 
more than $0.003 per share (or 0.3% of the quotation price per share 
for quotations priced less than $1). Rule 610 also requires SROs to 
establish, maintain, and enforce rules that would, among other things, 
prohibit their members from engaging in a pattern or practice of 
displaying quotations that lock or cross the automated quotations of 
other trading centers. Finally, the adopted amendment to Rule 301 of 
Regulation ATS lowers the threshold that triggers the Regulation ATS 
fair access requirements from 20% to 5% of average daily volume in a 
security.
1. Benefits
    The Commission believes that the adopted Access Rule will help 
achieve the statutory objectives for the NMS by promoting fair and 
efficient access to each individual market. By enabling reliance on 
private linkages, rather than mandating a collective intermarket 
linkage facility, the access provisions of Rule 610(a) and (b) allow 
market centers to connect through flexible and cost effective 
technologies widely used in the markets today, particularly in the 
market for Nasdaq-listed stocks. This will allow firms to capitalize on 
the dramatic improvements in communications and processing technologies 
in recent years, and thereby enhance the linking of all markets for the 
future NMS. Private linkages also will provide flexibility to meet the 
needs of different market participants and allow competitive forces to 
determine the specific nature and cost of connectivity. The access 
provisions of Rule 610(a) and (b) thus should allow market participants 
to fairly and efficiently route orders to execute against the best 
displayed quotations for a stock, wherever such quotations are 
displayed in the NMS. The Commission believes that fair and efficient 
access to the best displayed quotations of all trading centers is 
critical to achieving best execution of those orders.
    The access provisions of Rule 610(a) and (b) also will promote fair 
and efficient means of access to quotations by prohibiting a trading 
center from unfairly discriminating against non-members or non-
subscribers that attempt to access its quotations through a member or 
subscriber of such trading center. Such fair access to the quotations 
of other trading centers is critical for access to all displayed 
quotations and compliance with the adopted Order Protection Rule and 
broker-dealers' duty of best execution.
    The fee limitation of Rule 610(c) will address the potential 
distortions caused by substantial, disparate fees. The wider the 
disparity in the level of access fees among different market centers, 
the less useful and accurate are the prices of displayed quotations. As 
a result of the adopted fee limitation, displayed prices will more 
closely reflect actual costs to trade, thereby enhancing the usefulness 
of market information. The fee limitation also will establish a level 
playing field across all market participants and trading centers. The 
rule promotes the NMS objective of equal regulation of markets and 
broker-

[[Page 37584]]

dealers by applying equally to all types of trading centers and all 
types of market participants.\789\ As noted above in Section III.A.2, 
although ECNs and other types of trading centers, including SROs, may 
currently charge access fees, market makers have not been permitted to 
charge any fee for counterparties accessing their quotations. The 
Commission believes, however, that it is consistent with the Quote Rule 
for market makers to charge fees for access to their quotations 
pursuant to Rule 610(c), so long as such fees meet the requirements of 
Rule 610(c).
---------------------------------------------------------------------------

    \789\ Section 11A(c)(1)(F) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1)(F).
---------------------------------------------------------------------------

    The fee limitation also will address ``outlier'' trading centers 
that otherwise might charge high fees to other market participants 
required to access their quotations by the Order Protection Rule. In 
the absence of a fee limitation, the adoption of the Order Protection 
Rule and private linkages could significantly boost the viability of 
the outlier business model. Outlier markets might well try to take 
advantage of intermarket price protection by acting essentially as a 
toll booth between price levels. Even though high fee markets likely 
would be the last market to which orders would be routed, prices could 
not move to the next level until someone routed an order to take out 
the displayed price at the outlier market. Such a business model would 
detract from the usefulness of quotation information and impede market 
efficiency and competition. The fee cap will limit the outlier business 
model. It will place all markets on a level playing field in terms of 
the fees they can charge and ultimately the rebates they can pass on to 
liquidity providers. Some markets might choose to charge lower fees, 
thereby increasing their ranking in the preferences of order routers. 
Others might charge the full $0.003 and rebate a substantial proportion 
to liquidity providers.\790\ Competition will determine which strategy 
is most successful.\791\ The Rule also precludes a trading center from 
charging high fees selectively to competitors, practices that have 
occurred in the market for Nasdaq stocks.\792\
---------------------------------------------------------------------------

    \790\ Nothing in Rule 610(c) will preclude an SRO or other 
trading center from taking action to limit fees beyond what is 
required by the rule, and trading centers will have flexibility in 
establishing their fee schedules to comply with Rule 610(c), 
consistent with existing requirements of the Exchange Act and the 
rules and regulations thereunder.
    \791\ The Commission believes that the fee limitation on 
protected quotations priced less than $1.00 will provide the same 
benefits.
    \792\ Rule 610(c).
---------------------------------------------------------------------------

    Moreover, the fee limitation is necessary to achieve the purposes 
of the Exchange Act. If outlier markets are allowed to charge high fees 
and pass most of them through as rebates, the published quotations of 
such markets would not reliably indicate the true price that is 
actually available to investors or that would be realized by liquidity 
providers. Section 11A(c)(1)(B) of the Exchange Act authorizes the 
Commission to adopt rules assuring the fairness and usefulness of 
quotation information. For quotations to be fair and useful, there must 
be some limit on the extent to which the true price for those who 
access quotations can vary from the displayed price. Consequently, the 
$0.003 fee limitation will further the statutory purposes of the NMS by 
harmonizing quotation practices and precluding the distortive effects 
of exorbitant fees. Moreover, the fee limitation is necessary to 
further the statutory purpose of enabling broker-dealers to route 
orders in a manner consistent with the operation of the NMS.\793\ To 
protect limit orders, orders must be routed to those markets displaying 
the best-priced quotations. This purpose would be thwarted if market 
participants were allowed to charge exorbitant fees that distort quoted 
prices.
---------------------------------------------------------------------------

    \793\ Section 11A(c)(1)(E) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1)(E), authorizes the Commission to adopt rules assuring that 
broker-dealers transmit orders for NMS stocks in a manner consistent 
with the establishment and operation of a national market system.
---------------------------------------------------------------------------

    As discussed above in Section III.A.2, the Commission agrees that 
the access fee limitation should apply to manual quotations that are 
best bids and offers to the same extent it applies to protected 
quotations, to preclude any incentive for trading centers to display 
manual quotations as a means to charge a higher access fee. In 
addition, the Commission recognizes that at present a trading center's 
execution quality statistics will be evaluated against the NBBO, 
whether that quotation is a manual or automated quotation. The 
Commission therefore has modified the proposed fee limitation in Rule 
610(c) to apply to any quotation that is the best bid or best offer of 
an exchange, the ADF, or The NASDAQ Market Center, in addition to any 
protected quotations as defined in Rule 600(b)(57).\794\
---------------------------------------------------------------------------

    \794\ In addition, the Commission notes that the access 
standards in Rule 610(a) and (b) apply to all quotations, not just 
automated quotations.
---------------------------------------------------------------------------

    The restrictions on locking or crossing quotations in Rule 610(d) 
will promote fair and orderly markets. Locked and crossed markets can 
cause confusion among investors concerning trading interest in a stock. 
Restricting the practice of submitting locking or crossing quotations 
therefore will enhance the usefulness of quotation information. 
Consistent with the approach to trade-through protection, however, Rule 
610(d) will allow automated quotations to lock or cross manual 
quotations. Rule 610(d) thereby addresses the concern that manual 
quotations may not be fully accessible and recognizes that allowing 
automated quotations to lock or cross manual quotations may provide 
useful market information regarding the accessibility of quotations. 
The Commission believes, however, that an automated quotation is 
entitled to protection from locking or crossing quotations. When two 
market participants are willing to trade at the same quoted price, 
giving priority to the first-displayed automated quotation will 
encourage posting of quotations and contribute to fair and orderly 
markets. The basic principle underlying the NMS is to promote fair 
competition among markets, but within a system that also promotes 
interaction between all of the buyers and sellers in a particular NMS 
stock. Allowing market participants simply to ignore accessible 
quotations in other markets and routinely display locking and crossing 
quotations is inconsistent with this principle. The restrictions on 
locking or crossing quotations, in conjunction with the Order 
Protection Rule, should encourage trading against displayed quotations 
and enhance the depth and liquidity of the markets.
    Finally, lowering of the fair access threshold of Rule 301(b)(5) 
under Regulation ATS \795\ from 20% to 5% of average daily trading 
volume in a security will further strengthen access to the full range 
of services of ATSs with significant trading volume in NMS stocks. Such 
access is particularly important for the success of the private linkage 
approach adopted for access to quotations. The lowering of the fair 
access threshold also will make its coverage consistent with the 
existing 5% threshold triggering the order display and execution access 
requirements of Rule 301(b)(3) of Regulation ATS.\796\ As a result, 
each ATS that is required to disseminate its quotations in the 
consolidated data stream also will be prohibited from unfairly 
prohibiting or limiting market participants from becoming a subscriber 
or customer.
---------------------------------------------------------------------------

    \795\ 17 CFR 242.301(b)(5).
    \796\ 17 CFR 242.301(b)(3).
---------------------------------------------------------------------------

    In adopting Rule 610 and the amendment to Rule 301 of Regulation 
ATS, the Commission seeks to help

[[Page 37585]]

ensure that securities transactions can be executed efficiently, at 
prices established by vigorous and fair competition among market 
centers. By enabling fair access and transparent pricing among diverse 
marketplaces within a unified national market, the Commission believes 
that the access provisions will foster efficiency, enhance competition, 
and contribute to the best execution of orders for NMS securities.
2. Costs
    The Commission believes that Rule 610 and the amendment to Rule 301 
of Regulation ATS will not impose significant costs on most trading 
centers and market participants. When assessing the costs of access, it 
is important to recognize that much, if not all, of the connectivity 
among trading centers has already been put in place. For example, 
trading centers for exchange-listed securities already are connected 
through the ITS. The Commission understands that the ITS facilities and 
rules that currently provide intermarket access for exchange-listed 
stocks could be modified relatively easily and at low cost to provide 
the current ITS participants a means of access, at least as an interim 
measure until private linkages are fully established for exchange-
listed stocks. In addition, private linkages already are widely used in 
the equity markets, particularly for trading in Nasdaq-listed stocks. 
Moreover, a variety of private vendors currently offer connectivity to 
NMS trading centers for both exchange-listed and Nasdaq stocks, and 
many broker-dealers already employ smart order routing technology. The 
Commission also notes that trading centers already are making changes 
to their systems to become more competitive. The changes being made 
will assist those trading centers in preparing for implementation of 
the Access Rule.\797\ The Commission therefore believes that the system 
changes necessary to meet the new access standards will be minor.\798\
---------------------------------------------------------------------------

    \797\ For example, Nasdaq, which previously did not have an 
order routing system, purchased Brut, LLC last year in order to 
acquire access to such a system. The Commission believes that this 
acquisition should reduce the costs that will be incurred by Nasdaq 
to implement the Access Rule.
    \798\ One commenter, however, felt that the bilateral links 
required for private linkages would be particularly burdensome to 
smaller market centers compared to an ITS-type structure. Letter 
from Donald E. Weeden to Jonathan G. Katz, Secretary, Commission, 
dated June 30, 2004, at 9-10.
---------------------------------------------------------------------------

    While commenters were generally supportive of the Commission's 
proposal to employ private linkages to provide access between markets, 
some commenters (both those supporting and those opposing the 
reproposed access standards) voiced their concerns about the potential 
need to develop, and the costs of developing, connections to numerous 
small trading centers in the ADF.\799\ Several commenters felt that 
non-SRO trading centers should make their quotations available through 
the automatic execution facilities of an SRO, thereby requiring other 
market participants to only have to maintain access to six or seven 
markets, rather than potentially dozens.\800\ In contrast, one 
commenter that is an ADF participant stated its belief that the 
proposal to require ADF participants to establish the necessary 
connectivity that would facilitate efficient access to their quotations 
would create a cost barrier that discriminates against smaller firms in 
the ADF.\801\
---------------------------------------------------------------------------

    \799\ See supra, section III.A.1.
    \800\ See, e.g., Knight Trading Group Reproposal Letter at 5; 
Nasdaq Reproposal Letter at 17-18 (expressing the view that trading 
facilities with less than a five percent volume should be required 
to make their quotations available through an SRO trading facility); 
STA Reproposal Letter at 6; Type N Reproposal Letter at 1.
    \801\ NexTrade Reproposal Letter at 4-6.
---------------------------------------------------------------------------

    The Commission does not believe that its adopted access approach in 
Rule 610(b)(1) discriminates against smaller firms or creates a barrier 
to access for innovative new market entrants. Rather, smaller firms and 
new entrants have a range of alternatives from which to choose that 
will allow them to avoid incurring any costs to meet the connectivity 
requirements of Rule 610(b)(1) if they wish to do so. This approach is 
fully consistent with Congressional policy set forth in the Regulatory 
Flexibility Act, which directs the Commission to consider significant 
alternatives to regulations that accomplish the stated objectives of 
the Exchange Act and minimize the economic impact on small 
entities.\802\
---------------------------------------------------------------------------

    \802\ 5 U.S.C. 603(c). In the Reproposing Release, the 
Commission noted that only two of the approximately 600 broker-
dealers (including ATSs) that would be subject to Rule 610 are 
considered small (total capital of less than $500,000) for purposes 
of the Regulatory Flexibility Act. 69 FR at 77493. The adopted 
access approach provides alternatives that will benefit a wider 
range of smaller ATSs than the two that are considered small 
entities.
---------------------------------------------------------------------------

    Small ATSs are exempt from participation in the consolidated 
quotation system and, therefore, from the connectivity requirements of 
Rule 610. Under Rule 301(b)(3) of Regulation ATS, an ATS is required to 
display its quotations in the consolidated quotation stream only in 
those securities for which its trading volume reaches 5% of total 
trading volume. Consequently, smaller ATSs are not required to provide 
their quotations to any SRO (whether an SRO trading facility or the 
NASD's ADF) and thereby trigger the access requirements of Rule 610. 
Moreover, potential new entrants with innovative trading mechanisms can 
commence business without having to incur any costs associated with 
participation in the consolidated quotation system.
    Some smaller ATSs, however, may wish to participate voluntarily in 
the consolidated quotation system. Such participation can benefit 
smaller firms and promote competition among markets by enabling smaller 
firms to obtain wide distribution of their quotations among all market 
participants.\803\ Here, too, such firms will have alternatives that 
would not obligate them to comply with the connectivity requirements of 
Rule 610(b)(1). ATSs and market makers that wish to trade NMS stocks 
can choose from a number of options for quoting and trading. They can 
become a member of a national securities exchange and quote and trade 
through the exchange's trading facilities. They can participate in The 
NASDAQ Market Center and quote and trade through that facility. By 
choosing either of these options, an ATS or market maker would not 
create a new connectivity point that all other market participants must 
reach and would not be subject to Rule 610(b)(1). Some firms, however, 
may not want to participate in an SRO trading facility. These ATSs and 
market makers can quote and trade in the OTC market. The existence of 
the NASD's ADF makes this third choice possible by providing a facility 
for displaying quotations and reporting transactions in the 
consolidated data stream.\804\
---------------------------------------------------------------------------

    \803\ See supra, note 566 (the Commission's Advisory Committee 
on Market Information recommended retention of the consolidated 
display requirement because, among other things, it ``may promote 
market competition by assuring that information from newer or 
smaller exchanges is widely distributed.'').
    \804\ Under Rule 301(b)(3) of Regulation ATS, 17 CFR 
242.301(b)(3), an ATS is required to display its quotations in the 
consolidated data stream only in those securities for which its 
trading volume reaches 5% of total trading volume.
---------------------------------------------------------------------------

    As noted above in Section III.A.1, however, the NASD is not 
statutorily required to provide an order execution functionality in the 
ADF. The Commission believes that market makers and ECNs should 
continue to have the option of operating in the OTC market, rather than 
on an exchange or The NASDAQ Market Center. As noted in the 
Commission's order approving Nasdaq's SuperMontage trading facility, 
this ability to operate in the ADF is an

[[Page 37586]]

important competitive alternative to Nasdaq or exchange 
affiliation.\805\ Therefore, the Commission has determined not to 
require small trading centers to make their quotations accessible 
through an SRO trading facility.
---------------------------------------------------------------------------

    \805\ See Securities Exchange Act Release No. 43863 (Jan. 19, 
2001), 66 FR 8020 (Jan. 26, 2001).
---------------------------------------------------------------------------

    Instead, Rule 610(b)(1) requires all trading centers that choose to 
display quotations in an SRO display-only quotation facility 
(currently, the ADF) to provide a level and cost of access to such 
quotations that is substantially equivalent to the level and cost of 
access to quotations displayed by SRO trading facilities. Rule 
610(b)(1) therefore may cause trading centers that display quotations 
in the ADF to incur additional costs to enhance the level of access to 
their quotations and to lower the cost of connectivity for market 
participants seeking to access their quotations. The extent to which 
these trading centers in fact incur additional costs to comply with the 
adopted access standard will be largely within the control of the 
trading center itself. As noted above, ATSs and market makers that wish 
to trade NMS stocks can choose from a number of options for quoting and 
trading, including quoting and trading in the OTC market. As a result, 
the additional connectivity requirements of Rule 610(b) will be 
triggered only by a trading center that displays its quotations in the 
consolidated data stream and chooses not to provide access to those 
quotations through an SRO trading facility.
    Currently, nine SROs operate trading facilities in NMS stocks. 
Market participants throughout the securities industry generally have 
established connectivity to these nine points of access to quotations 
in NMS stocks. By choosing to display quotations in the ADF, a trading 
center effectively could require the entire industry to establish 
connectivity to an additional point of access. Potentially, many 
trading centers could choose to display quotations in the ADF, thereby 
significantly increasing the overall costs of connectivity in the NMS. 
Such an inefficient outcome would become much more likely if an ADF 
trading center were not required to assume responsibility for the 
additional costs associated with its decision to display quotations 
outside of an established SRO trading facility.
    Although the Exchange Act envisions an individual broker-dealer 
having the option of trading in the OTC market,\806\ it does not 
mandate that the securities industry in general must subsidize the 
costs of accessing a broker-dealer's quotations in the OTC market if 
the NASD chooses not to provide connectivity. The Commission believes 
that it is reasonable and appropriate to require those ATSs and market 
makers that choose to display quotations in the ADF to bear the 
responsibility of providing a level and cost of access to their 
quotations that is substantially equivalent to the level and cost of 
access to quotations displayed by SRO trading facilities. Under Rule 
610(b)(1), therefore, ADF participants will be required to bear the 
costs of the necessary connectivity to facilitate efficient access to 
their quotations.\807\ This standard will help ensure that additional 
connectivity burdens are not imposed on the securities industry each 
time an additional ADF participant necessitates a new connectivity 
point by choosing to begin displaying quotations in the consolidated 
quotation stream. The Commission believes that this requirement will 
help reduce overall industry costs by more closely aligning the burden 
of additional connectivity with those entities whose choices have 
created the need for additional connectivity.
---------------------------------------------------------------------------

    \806\ See Sections 11A(c)(3)(A) and (4) of the Exchange Act, 15 
U.S.C 78k-1(c)(3)(A) and (4).
    \807\ Thus, although market participants may still be required 
to access numerous trading centers in the ADF, the Rule should 
reduce the cost of access to each such trading center by requiring 
the ADF trading center to provide a cost and level of access 
substantially equivalent to the level and cost of access to 
quotations displayed by SRO trading facilities.
---------------------------------------------------------------------------

    As just discussed, the Commission recognizes that trading centers 
subject to Rule 610(b)(1) may incur costs associated with providing 
access to their quotations, although the costs will vary depending upon 
the manner in which each trading center provides such access. The 
Commission notes that to meet the standard contained in Rule 610(b)(1), 
a trading center will be allowed to take advantage of the greatly 
expanded connectivity options that have been offered by competing 
access service providers in recent years.\808\ These industry access 
providers have extensive connections to a wide array of market 
participants through a variety of direct access options and private 
networks. A trading center potentially could meet the requirement of 
Rule 610(b)(1) by establishing connections to and offering access 
through such vendors. The option of participation in existing market 
infrastructure and systems should reduce a trading center's cost of 
compliance.\809\
---------------------------------------------------------------------------

    \808\ As noted in the Commission's order approving the pilot 
program for the ADF, the reduction in communications line costs in 
recent years and the advent of competing access providers offer the 
potential for multiple competitive means of access to the various 
trading centers that trade NMS stocks. Securities Exchange Act 
Release No. 46249, supra note 390.
    \809\ As the self-regulatory authority responsible for the OTC 
market, the NASD must act as ``gatekeeper'' for the ADF, and, as 
such, will need to closely assess the extent to which ADF 
participants meet the requirements of Rule 610.
---------------------------------------------------------------------------

    Two commenters raised concerns about reliance on third party 
private vendors to provide access, since they may not be regulated by 
the Commission and thus could deny access to a trading center they 
viewed as a competitor, or because utilizing their services to link to 
other trading centers is outside the control of a trading center.\810\ 
The Commission believes that the requirement in Rule 610(b)(1) that ADF 
participants provide a substantially equivalent level of access will 
preclude the ADF participant from providing access only through a 
narrow range of private access providers. The range of access providers 
must be sufficient to provide access substantially equivalent to SRO 
trading facilities. In these circumstances, and given the significant 
number and variety of entities that currently provide access services 
and the competitive nature of the market for these services, the 
Commission believes that competition will be sufficient to provide 
services for any trading center choosing to utilize an outside 
vendor.\811\
---------------------------------------------------------------------------

    \810\ NexTrade Reproposal Letter at 6; STANY Reproposal Letter 
at 4.
    \811\ For example, one large ECN can be accessed through five 
extranets and at least 21 other access providers, as well as through 
direct connections. See supra, note 366 and accompanying text.
---------------------------------------------------------------------------

    Several commenters, including some that otherwise supported the 
proposal, expressed concern that requiring non-discriminatory access to 
markets might undermine the value of SRO membership.\812\ The 
Commission does not believe that adoption of a private linkage approach 
will seriously undermine the value of membership in SROs that offer 
valuable services to their members. First, the fact that markets will 
not be allowed to impose unfairly discriminatory terms on non-members 
who obtain indirect access to quotations through members does not mean 
that non-members will obtain free access to quotations. Members who 
provide piggyback access will be providing a useful service and 
presumably will charge a fee for such service. The fee will be subject 
to competitive forces and likely will reflect the costs of SRO 
membership, plus some element of profit to the SRO's members. As a 
result,

[[Page 37587]]

non-members that frequently make use of indirect access are likely to 
contribute indirectly to the costs of membership in the SRO market. 
Moreover, the unfair discrimination standard of Rule 610(a) will apply 
only to access to quotations, not to the full panoply of services that 
markets generally provide only to their members. These other services 
will be subject to the more general fair access provisions applicable 
to SROs and large ECNs, as well as the statutory provisions that govern 
SRO rules.
---------------------------------------------------------------------------

    \812\ Alliance of Floor Brokers Letter at 10; Amex Letter, 
Exhibit A at 25-26; BSE Letter at 12; CHX Letter at 14; Citigroup 
Letter at 12; Phlx Letter at 2; STANY Letter at 9.
---------------------------------------------------------------------------

    For the reasons discussed below, the Commission does not believe 
that the fee limitation of Rule 610(c), including the fee limitation on 
non-protected quotations at the best bid and offer, will impose 
significant new costs on most trading centers. First, a few commenters 
were concerned about the costs to market participants of administering 
a fee program.\813\ The adopted provision, by imposing a single 
accumulated fee limitation of $0.003 (when the price of the protected 
quotation is $1 or more), greatly simplifies the fee limitation and 
likely will leave existing fee practices largely intact. For trading 
centers that currently charge and collect fees and that will continue 
to do so, the costs of imposing and collecting fees are already 
incurred. The fee limitation does not require trading centers that do 
not currently charge fees to begin charging fees. If market makers 
determine to begin charging fees, they likely will collect fees through 
an SRO trading facility or ECN through which they display limit orders 
or quotations, and the administration of such fee program likely will 
be handled by the SRO or ECN. Therefore, the adopted fee limitation 
likely will not impose significant new administrative costs.
---------------------------------------------------------------------------

    \813\ Brokerage America Letter at 1; NexTrade Reproposal Letter 
at 8; Oppenheimer Letter at 2; SIA Reproposal Letter at 22; STANY 
Letter at 11.
---------------------------------------------------------------------------

    Two commenters expressed a concern with the ability to determine 
after-the-fact whether a quotation against which an incoming order 
executed was subject to an access fee cap, given that under the Rule a 
market participant could be charged different fees based on whether or 
not a quotation was protected.\814\ The Commission acknowledges these 
concerns, but notes that market participants will be able to control 
the extent to which their orders interact with protected and non-
protected quotations. First, under the Order Protection Rule, the 
definition of intermarket sweep order requires market participants to 
route orders to interact only with protected quotations. The objective 
can be achieved by routing an IOC, marketable limit order with a limit 
price that equals the price of the protected quotation. The extent to 
which they route to non-protected quotations will be subject to the 
full range of competitive forces, including the fees that trading 
centers choose to charge for access to non-protected quotations.
---------------------------------------------------------------------------

    \814\ Bloomberg Reproposal Letter at 8, note 6; SIA Reproposal 
Letter at 22.
---------------------------------------------------------------------------

    The Commission recognizes, however, the concern that a market 
participant could intend to interact only with a protected quotation 
but in fact execute against a non-protected quotation. For example, at 
the time a market participant routes an order to a trading center, it 
may be attempting to execute against only that trading center's best 
bid or offer, which will be subject to the fee cap under adopted Rule 
610(c) (for instance, by sending an intermarket sweep order with a 
limit price equal to the price of the protected quotation). By the time 
the order arrives at the trading center, the incoming order may, if a 
better bid or offer has been displayed at the trading center for a size 
smaller than the size of the incoming order, execute against both the 
new best bid or offer and the quotation that previously was the trading 
center's best bid or offer. To meet the requirements of Rule 610(c), 
however, a trading center must ensure that it never charges a fee in 
excess of the cap for executions of an order against its quotations 
that are subject to the fee cap. The operation of this limitation will 
be based on quotations as they are displayed in the consolidated 
quotation stream. Thus, the trading center is responsible for ensuring 
that any time lag between prices in its internal systems and its 
quotations in the consolidated quotation system do not cause fees to be 
charged that violate the limitation of Rule 610(c). Compliance with 
this requirement obviously will not be a problem for trading centers 
that do not charge any fees in excess of the cap. Given the often rapid 
updating of quotations in NMS stocks, however, the Commission does not 
believe a trading center that charges fees above the cap for quotations 
that are not subject to the fee cap could comply with the Rule unless 
it provides a functionality that enables market participants to assure 
that they will never inadvertently be charged a fee in excess of the 
cap. For example, such a trading center could provide a ``top-of-book 
only'' or ``limited-fee only'' order functionality. By using this 
functionality, market participants themselves could assure that they 
were never required to pay a fee in excess of the levels set forth in 
Rule 610(c).
    Although the fee limitation is consistent with current business 
practices, the fee limitation of Rule 610(c) will affect the few 
markets that currently impose access fees of greater than $0.003 per 
share that apply to a wide range of NMS stocks.\815\ These markets will 
be required to re-evaluate their business models in light of the 
adopted fee limitation. In particular, they likely will need to reduce 
the rebates they currently pay to liquidity providers. The adopted 
limitation also will affect a few trading centers that charge 
significant access fees for large transactions in specific types of NMS 
stocks, such as ETFs. It is unlikely, however, that such fees currently 
generate a large amount of revenues.\816\
---------------------------------------------------------------------------

    \815\ See supra, note 423 and accompanying text.
    \816\ The Commission believes that the same analysis would apply 
to the fee limitation on protected quotations priced less than 
$1.00.
---------------------------------------------------------------------------

    We do not believe that the locked and crossed provisions of Rule 
610(d) will impose significant additional costs for the SROs. All SROs 
currently have rules restricting locking and crossing quotations in 
exchange-listed stocks to comply with the provisions of the ITS Plan. 
Such SROs also collect the data and related information required to 
monitor locked and crossed markets, and the Commission believes that 
the additional surveillance and enforcement costs related to the 
provisions will be minor. The Commission recognizes, however, that Rule 
610(d), by restricting locked markets with respect to automated 
quotations, could prohibit the display of an order that would otherwise 
have been displayed and reduced the quoted spread to zero. Although 
locked markets do occur a certain percentage of the time, they do not 
occur all the time, even in extremely active stocks, and thus the 
average effective spread in these stocks typically is between one-half 
cent and one cent (one cent being the minimum pricing increment for all 
but a very few stocks). Thus, the Commission believes that any widening 
of average effective spreads caused solely by the adopted rule will be 
limited to the difference between a sub-penny and penny spread. In 
addition, a locked market currently may not actually represent two 
market participants willing to buy and sell at the same price. Often 
the locking market participant is not truly willing to trade at the 
displayed locking price, but instead chooses to lock rather than 
execute against the already-displayed quotation to receive a liquidity 
rebate.\817\
---------------------------------------------------------------------------

    \817\ See supra, notes 435 and 442.

---------------------------------------------------------------------------

[[Page 37588]]

    Finally, reducing the fair access thresholds of Regulation ATS will 
require ATSs that exceed the 5% threshold level to comply with Rule 
301(b)(5) under Regulation ATS. Rule 301(b)(5) requires ATSs, among 
other things, to establish written standards for granting access to 
trading on its system, to not unreasonably prohibit or limit access to 
its services, to keep records of all grants or denials of access, and 
to report such information on Form ATS-R. The Commission believes that 
the costs to meet these requirements are justified by the need to 
promote fair and efficient access to trading centers with significant 
volume.
    Overall, the Commission believes that the benefits of Rule 610 and 
the amendment to Rule 301 of Regulation ATS justify the costs of 
implementation.

C. Sub-Penny Rule

    Rule 612 will prohibit market participants from displaying, 
ranking, or accepting quotations in NMS stocks that are priced in an 
increment less than $0.01 per share, except for quotations priced less 
than $1.00 per share, which may extend to four decimal places.
1. Benefits
    The Commission believes that the markets' conversion to decimal 
pricing has benefited investors by, among other things, clarifying and 
simplifying pricing for investors, making the U.S. securities markets 
more competitive internationally, and reducing trading costs by 
narrowing spreads. The Commission is concerned, however, that if the 
MPV decreases beyond a certain point, some of the benefits of decimals 
could be lost while some of the negative effects would be exacerbated. 
The Commission believes that Rule 612, which will prohibit an MPV of 
less than $0.01 for the vast majority of NMS stocks, will have several 
benefits. The majority of the commenters supported the proposal and 
noted various benefits of this approach.\818\
---------------------------------------------------------------------------

    \818\ See supra, section IV.C.1.
---------------------------------------------------------------------------

    The Commission believes that sub-penny quoting impedes transparency 
by reducing market depth at the NBBO and increasing quote flickering. 
In an environment where the NBBO can change very quickly, broker-
dealers have more difficulty in carrying out their duties of best 
execution and complying with other regulatory requirements that require 
them to identify the best bid or offer available at a particular moment 
(such as the Commission's short sale rule \819\ and NASD's Manning rule 
\820\). Rule 612 should increase market depth at the NBBO and help 
reduce quote flickering.
---------------------------------------------------------------------------

    \819\ Rule 10a-1 under the Exchange Act, 17 CFR 240.10a-1.
    \820\ NASD IM-2110-2.
---------------------------------------------------------------------------

    In addition, the Commission agrees with the many commenters who 
believed that prohibiting sub-penny quoting would deter the practice of 
stepping ahead of exposed trading interest by an economically 
insignificant amount. Limit orders provide liquidity to the market and 
perform an important price-setting function. If a quotation or order 
can lose execution priority because of economically insignificant price 
improvement from a later-arriving quotation or order, liquidity could 
diminish and some market participants could incur greater execution 
costs. As one commenter, the Investment Company Institute, stated, 
``[t]his potential for the increased stepping-ahead of limit orders 
would create a significant disincentive for market participants to 
enter any sizeable volume into the markets and would reduce further the 
value of displaying limit orders.'' \821\ Improved liquidity should 
decrease the costs of trading, especially for large orders.\822\ Market 
participants may be more likely to place limit orders if they know that 
other market participants cannot quote ahead of them by a sub-penny 
amount.
---------------------------------------------------------------------------

    \821\ ICI Letter at 20.
    \822\ One commenter argued that a prohibition on sub-penny 
quoting should not affect institutional investors' trading costs 
because improvements in trading technology (such as auto-execution 
and VWAP trading algorithms) allow them to fill large orders at 
minimal cost. See Tower Research Letter at 9-10. While the 
Commission agrees that such improvements have been useful, it 
believes that this commenter did not consider the costs involved in 
having to develop these technologies in response, at least in part, 
to insufficient liquidity. Moreover, the Commission believes that 
this commenter also did not consider the positive externalities that 
limit orders have on price discovery and price competition; orders 
that execute without being displayed do not contribute to price 
discovery and price competition.
---------------------------------------------------------------------------

2. Costs
    The Commission recognizes that Rule 612 will impose certain costs 
on the U.S. securities markets. Currently, a few NMS stocks are 
quoted--and in the absence of the rule, others in the future could be 
quoted--in sub-penny increments. For these NMS stocks, quoted spreads 
will be wider than they otherwise would be, because Rule 612 will 
prohibit market participants from narrowing the spread by a sub-penny 
amount.
    A few commenters argued that investors would incur costs from 
artificially widened spreads as a result of Rule 612.\823\ One 
commenter analyzed trading in six high-volume securities and concluded 
that Rule 612 would have costs of over $400 million in these securities 
alone due to wider spreads.\824\ Another commenter stated that, if all 
markets traded QQQQ solely in sub-pennies, the savings would be 
approximately $150 million per year.\825\ A third commenter argued that 
allowing sub-penny quoting in ``23 of the most appropriate securities'' 
would generate annual savings of anywhere between $342 million and $1.9 
billion.\826\ No other commenters provided any quantitative analysis of 
the costs that a sub-penny quoting rule would impose by widening 
spreads to at least a full penny.\827\
---------------------------------------------------------------------------

    \823\ See Chakrabarty and Chung Study at 24 (stating that, for 
high volume stocks, ``the spread reduction in the absence of binding 
constraints * * * translates into savings of millions of dollars''); 
INET Reproposal Letter at 3; Instinet Letter at 50; Mercatus Center 
Letter at 9; Tower Research Letter at 9.
    \824\ Tower Research Letter at 9.
    \825\ Instinet Letter at 50.
    \826\ INET Reproposal Letter at 3.
    \827\ However, one commenter stated: ``When analyzed in terms of 
costs and benefits, we believe that the costs of sub-penny quoting 
(i.e., less liquidity at quotes, more transactions required to fill 
large orders, increased quote flickering, and increased ability to 
displace orders through minimal price improvement) far exceed any 
incremental benefits that market participants might enjoy through 
additional pricing conventions for their limit orders.'' Deutsche 
Bank Reproposal Letter at 3. This commenter did not provide 
empirical evidence to justify that assertion.
---------------------------------------------------------------------------

    The commenters who attempted to quantify the costs appear to assume 
that all trading activity in the securities they discuss would occur at 
narrower sub-penny spreads if Rule 612 did not exist. The Commission 
does not believe that these commenters provided any evidence to justify 
that assumption. Currently, Nasdaq and the national securities 
exchanges generally do not permit quoting in sub-pennies; this practice 
exists on only a small number of ATSs, and only for a small number of 
securities. Because spreads on Nasdaq and the exchanges already cannot 
be smaller than $0.01, Rule 612 will not require these markets to take 
any action that would cause spreads to widen. Therefore, the lack of 
sub-penny spreads on these markets should not be considered costs of 
Rule 612. With respect to the ATSs that currently do permit some NMS 
stocks to be quoted in sub-pennies, Commission staff performed a study 
to better assess and respond to commenters' claims.\828\ Based on that 
study, Commission staff estimated that the costs of widened spreads in 
these securities would be approximately $48 million annually (or

[[Page 37589]]

approximately $33 million if the Commission were to exempt QQQQ from 
Rule 612).\829\
---------------------------------------------------------------------------

    \828\ See OEA December 2004 Sub-Penny Analysis.
    \829\ The Commission believes that INET overstated the potential 
costs of Rule 612. INET's methodology for computing the potential 
savings to investors from quoting in sub-pennies appears to be based 
on the incorrect assumption that all of the stocks selected for 
their sample would trade with the same price-point distribution as 
the average of JDSU, SIRI, and QQQQ.
---------------------------------------------------------------------------

    In this study, Commission staff obtained public data from NYSE's 
``Trade and Quote'' files for all NYSE-listed and Amex-listed stocks, 
and public data from the Nastraq trade file for Nasdaq-listed stocks, 
for the period June 7-10, 2004. Based on trading activity of the 
Nasdaq-listed securities, Commission staff estimated that 1.5% of all 
trades executed at a per-share price over $1.00 were reported in a sub-
penny increment.\830\ These trades accounted for 4.7% of share volume. 
However, not all trades that were reported as having a sub-penny price 
resulted from a sub-penny quotation. Commission staff excluded VWAP 
trades which were marked as such in the Nastraq file.\831\ Based on 
this screened dataset, Commission staff estimated that 1.4% of trades 
were reported in sub-penny increments, accounting for 2.4% of share 
volume. Commission staff then calculated the dollar cost if all such 
trades executed at the near-side penny rather than at a sub-penny 
amount. This price difference, multiplied by the executed volume, 
produced a dollar cost per trade.\832\ Summed across all sub-penny 
trades, the average daily cost in this sample was $80,973. At 252 
trading days per year, this resulted in an estimate of $20,400,235 on 
an annual basis.
---------------------------------------------------------------------------

    \830\ Trades executed at a per-share price below $1.00 were 
excluded from the sample as Rule 612 will not prohibit sub-penny 
quotations priced less than $1.00.
    \831\ Executions occurring at a sub-penny price resulting from a 
midpoint, VWAP, or similar volume-weighted pricing algorithm are not 
prohibited by Rule 612. For purposes of this study, Commission staff 
excluded all other trades that had a condition code other than 
``regular way'' (e.g., trades reported after normal trading hours, 
bunched trades, next-day trades, previous reference price trades, 
and late trades).
    \832\ For example, the cost to a sub-penny trade at price 
$25.248 for 300 shares is as follows. The assumption is that, 
without sub-penny quotations, this trade would have occurred at 
$25.25--a difference of $0.002 per share. At 300 shares, this trade 
incurs a cost of $0.60 ($0.002 x 300). A sub-penny trade at $25.242 
would incur a cost of $0.002 per share under the assumption that, 
under Rule 612, it would execute at $25.24.
---------------------------------------------------------------------------

    Commission staff performed a similar analysis on the trade data for 
Amex-listed stocks, except that the dataset did not permit VWAP trades 
to be excluded. Commission staff estimated that, on an annualized 
basis, the gross costs resulting from slightly wider spreads would be 
$16 million (or only $1.2 million if QQQQ were excluded). Similarly, 
Commission staff estimated that the gross costs from wider spreads 
would be approximately $12 million annually for NYSE-listed stocks.
    Another potential cost of Rule 612 is that market participants that 
have developed systems allowing their users to quote in sub-pennies 
will, for most NMS stocks, lose the ability to gain any market 
advantage from such enhancements. In addition, any market participant 
that currently allows its users to display, rank, or accept orders or 
quotations in sub-pennies will incur costs in reprogramming its systems 
to prevent the entry of sub-penny orders or quotations. The Commission 
believes, however, that these costs are not significant. Currently, 
only a few ATSs--but not Nasdaq or any of the national securities 
exchanges--permit sub-penny quoting, and then only in a small number of 
securities. These ATSs will have to make only minor adjustments to 
their systems to comply with Rule 612. One commenter, a technology firm 
that develops software and systems for electronic securities trading, 
stated, ``we do not believe that there are significant technological or 
structural impediments to immediate implementation'' of Rule 612.\833\ 
No commenter indicated that the compliance costs of ATSs that currently 
permit sub-penny quoting would be significant.
---------------------------------------------------------------------------

    \833\ ATD Reproposal Letter at 4.
---------------------------------------------------------------------------

    Finally, the Commission believes that paragraph (b) of Rule 612, 
which prohibits quotations below $1.00 per share from extending beyond 
four decimal places, will have negligible systems costs. The Commission 
currently is not aware of any market that quotes and trades NMS stocks 
in increments beyond four decimal places and believes, therefore, that 
no market will incur systems costs to limit such quotations to a 
maximum of four decimal places.
    After carefully considering all the comments received, the 
Commission believes that, on balance, the benefits of Rule 612 will 
justify the costs.

D. Market Data Rules and Plan Amendments

    The Commission is adopting amendments to the rules relating to the 
dissemination of market information to the public. In particular, the 
Commission is adopting amendments to the Plans to modify the current 
formulas for allocating market data revenues to the SROs, and to 
require the establishment of non-voting advisory committees comprised 
of interested parties other than SROs. In addition, the Commission is 
rescinding the current prohibition in Exchange Act Rule 11Aa3-1 
(redesignated as Rule 601) on SROs and their members from independently 
distributing their own trade reports, and is adopting an amendment to 
Exchange Act Rule 11Ac1-2 (redesignated as Rule 603) to incorporate 
uniform standards pursuant to which they may independently distribute 
their own trade reports and quotations (outside of providing the 
requisite information to Plan processors). The Commission is further 
amending Exchange Act Rule 11Ac1-2 (redesignated as Rule 603) to make 
explicit that all SROs must act jointly through the Plans and through a 
single processor per security to disseminate consolidated market 
information in NMS stocks to the public. Finally, the Commission is 
adopting amendments to Exchange Act Rule 11Ac1-2 (redesignated as Rule 
603) to streamline and simplify the consolidated display requirements 
by reducing the data required to be displayed under the Rule, and by 
limiting the range of the Rule to the display of such data in trading 
and order-routing contexts.
1. Revenue Allocation Formula
a. Benefits
    The Commission believes, and a number of commenters agreed, that 
the adopted amendment to the Plans modifying the current formulas for 
allocating market data revenues will be beneficial to the marketplace 
because the new formula will allocate revenues to SROs based on the 
value of their quotations in addition to their trades.\834\ The current 
formulas allocate Plan revenues based solely on the number or share 
volume of an SRO's reported trades, and do not allocate revenues to 
those market centers that generate quotations with the best prices and 
the largest sizes that are an important source of public price 
discovery. The new allocation formula also should help to reduce the 
economic and regulatory distortions caused by the current formulas, 
including wash sales, trade shredding, and SRO print facilities. 
Because the adopted formula will address these distortive practices and 
would allocate revenues to those market centers that provide the most 
useful market information, the Commission

[[Page 37590]]

believes that the NMS will be benefited as a whole.
---------------------------------------------------------------------------

    \834\ See, e.g., Bloomberg Tradebook Letter at 7-8; BSE 
Reproposal Letter at 8; ICI Letter at 21; STA Reproposal Letter I at 
8; Vanguard Letter at 6.
---------------------------------------------------------------------------

    The adopted new revenue allocation formula will encompass a two-
step process. The initial step of the adopted formula, the ``Security 
Income Allocation,'' allocates a Network's distributable revenues among 
the many different securities that are included in the Network's data 
stream primarily based on the square root of the dollar volume of 
trading in each security. Of those that commented on this aspect of the 
formula, many generally agreed with the benefits of the Commission's 
use of square roots.\835\ Some commenters, however, believed that the 
use of the square root function overly rewards illiquid stocks at the 
expense of liquid stocks.\836\ To address this concern, the adopted 
formula modifies the square root allocation with respect to very 
inactively traded stocks by limiting the revenues that can be allocated 
to a single Network security to an amount that is no greater than $4 
per qualified transaction report.\837\ The amount that exceeds this 
limitation will be reallocated among all Network securities in direct 
proportion to their dollar volume of trading.
---------------------------------------------------------------------------

    \835\ Amex Letter, Exhibit A at 15; Nasdaq Letter II at 32; NYSE 
Reproposal Letter II at 3; Specialist Assoc. Letter at 16, note 21.
    \836\ See, e.g., ArcaEx Reproposal Letter at 11; CBOE Letter at 
11; Instinet Reproposal Letter at 13.
    \837\ The limit of $4 per qualified transaction report is 
analogous to the reproposal's limit on Trading Shares to $2 per 
qualified transaction report. Whereas the reproposed limit of $2 
applied to the 50% Trading Share allocation (described below), the 
adopted limit of $4 applies to the 100% Security Income Allocation. 
See supra section V.A.3.
---------------------------------------------------------------------------

    Following this initial distribution of revenues, the next step in 
the process is to allocate the revenues distributed to an individual 
security among the various SROs that trade the security based on each 
SRO's trading and quoting activity. Specifically, under the ``Trading 
Share'' criterion, fifty percent of the revenues allocated to a 
particular security will be allocated to SROs based on their proportion 
of the total dollar volume and number of qualified trades (transactions 
that have a dollar volume of $5,000 or greater) in that security. A few 
commenters on the original proposal stated that small trades 
(transactions that have a dollar value of less than $5000) should be 
entitled to partial credit under this criterion because these trades 
also contribute to public price discovery.\838\ The Commission 
acknowledged the benefits of small trades and provided for a 
proportional allocation of revenues for such trades under the 
reproposed formula. The adopted formula also includes this provision. 
The Trading Share measure is intended to allocate revenue to those SROs 
that actively trade in the security, thereby providing liquidity and 
price discovery, while reducing the potential for the shredding of 
trade volume.
---------------------------------------------------------------------------

    \838\ See, e.g., BSE Letter at 16; CHX Letter at 19-20; E*Trade 
Letter at 11-12.
---------------------------------------------------------------------------

    Under the ``Quoting Share'' criterion, fifty percent of the 
revenues allocated to a particular security under the Security Income 
Allocation measure will be allocated to an SRO based on the SRO's 
proportion of credits earned for each second of time and dollar value 
of size that the SRO's automated best bid or offer during regular 
trading hours equals the price of the NBBO in that security. The 
Quoting Share criterion of the adopted formula is intended to do what 
the current formulas do not--allocate revenue to those markets whose 
quotations frequently equal the best prices and for the largest sizes. 
Many commenters agreed with the Commission that, if the Networks were 
to continue allocating revenues to the SROs, the current allocation 
formulas needed to be updated.\839\ In particular, some of these 
commenters noted the benefits of adding a quoting component to the new 
formula,\840\ especially if revenues are allocated only for automated 
and accessible quotations.
---------------------------------------------------------------------------

    \839\ See, e.g., Bloomberg Tradebook Letter at 7; BSE Letter at 
15; Deutsche Bank Reproposal Letter at 4; Harris Reproposal Letter 
at 11; ICI Letter at 21; JP Morgan Reproposal Letter at 2; NYSE 
Reproposal Letter II at 3; STA Letter at 7; UBS Letter at 10; 
Vanguard Letter at 6.
    \840\ See, e.g., Bloomberg Tradebook Letter at 7-8; Morgan 
Stanley Letter at 22-23; NYSE Reproposal Letter II at 3; STA Letter 
at 7; Vanguard Letter at 6.
---------------------------------------------------------------------------

    In sum, the Commission believes that the greatest benefit of 
allocating Plan revenues to the SROs based equally on the Trading Share 
and Quoting Share measures is that such measures will allocate revenues 
to an SRO for its overall contribution of both quotations and trades, 
while reducing the incentive for distortive trade reporting practices 
caused by the current formulas. Investors will benefit from the adopted 
new formula because these broad-based measures will allocate revenues 
to those SROs that provide investors with the most useful market 
information, and thus that contribute to public price discovery, by 
allocating them a larger portion of Plan revenues.
b. Costs
    The Commission recognizes that the current allocation formulas have 
been used since the creation of the Plans and Networks in the 1970s, 
and that the SROs and the Network processors have become familiar with 
those formulas for purposes of allocating revenues and structuring 
their businesses. Because the adopted allocation formula is more 
detailed than the current formulas, the Network processors will have to 
learn the particular features of the new formula and will have to 
consider SRO quotations in addition to reported trades as a measure for 
allocating Plan revenues. Accordingly, the Network processors, or some 
other entity retained by the Networks, will be required to develop a 
program to calculate the Security Income Allocation, Trading Shares, 
and Quoting Shares of the SRO participants. All of the data necessary 
for implementation of the formula will be disseminated through the 
consolidated data stream on a real-time basis. If a single entity were 
retained to handle the task for all three Networks, the Commission 
estimates that it will cost approximately $1 million annually to make 
the requisite calculations under the proposed new formula and to 
disseminate the results to the SRO participants on a daily basis. This 
estimated cost of implementation and compliance represents only \1/4\ 
of one percent of the total revenues collected and distributed through 
the Plans for 2004.
    The Commission received a number of comments regarding the 
potential cost and complexity of the originally proposed revenue 
allocation formula.\841\ The Commission notes that, consistent with the 
approach of the Order Protection Rule and the Access Rule, it 
eliminated in the reproposed formula the most complex elements of the 
proposed allocation formula that were intended primarily to address the 
problem of manual quotations--the ``NBBO Improvement Share'' criterion 
and the automatic cut-off for manual quotations left at the NBBO under 
the Quoting Share criterion. The adopted amendment also eliminates 
these two elements. Because the adopted formula will allocate revenues 
for only automated quotations, and manual quotations will be excluded 
from any revenue allocation, the Commission believes that an NBBO 
Improvement Share criterion and automatic cut-off for manual quotations 
are not necessary in the new formula. As a result, the adopted formula 
is substantially less complex than originally proposed.
---------------------------------------------------------------------------

    \841\ See, e.g., Angel Letter I at 11; BSE Letter at 15, 18; 
Brut Letter at 22-23; Callcott Letter at 4; CBOE Letter at 2, 9; 
Instinet Letter at 42; ISE Letter at 9; Nasdaq Letter II at 31; NSX 
Letter at 7; NYSE Letter, Attachment at 11; Phlx Letter at 3-4.
---------------------------------------------------------------------------

    Some commenters argued that it would be overly costly and complex 
to calculate the other elements of the

[[Page 37591]]

proposed formula.\842\ The Commission does not agree. An SRO's Trading 
Share, for example, will not be materially more difficult to calculate 
than the current Network C formula, which is based on an average of an 
SRO's proportion of trades and share volume. The Security Income 
Allocation uses the square root function which is a simple arithmetic 
calculation. In addition, some commenters believed that the Quoting 
Share, which incorporates the total dollar size of the NBBO in a stock 
throughout the trading year, would result in astronomically high 
numbers that would be extremely difficult to calculate.\843\ In fact, 
the largest number of quote credits in a year for even the highest 
price stock with the greatest displayed depth at the NBBO is very 
unlikely to reach beyond the trillions, a number well within the 
capabilities of even the most basic spreadsheet program.\844\ Moreover, 
the allocation is determined by the proportion of an SRO's quote 
credits in relation to other SROs, not the absolute amount of quote 
credits.
---------------------------------------------------------------------------

    \842\ See, e.g., Brut Letter at 22-23; CBOE Letter at 2, 9; NSX 
Letter at 7.
    \843\ See, e.g., CBOE Letter at 14 (calculation of Quote Credits 
will ``yield astronomical numbers'' that ``can be expressed only in 
exponential terms''); NSX Letter at 7 (calculation of large number 
of Quote Credits is ``particularly ludicrous'').
    \844\ For example, assume a stock with an average price of $100 
per share has an unusually large average quoted size of 200,000 
shares at both the national best bid and the national best offer 
throughout every second of the trading year. Over an average 252 
trading days during a year, the total Quote Credits in this stock 
would be 235.9 trillion ($100*400,000*252*23,400 seconds per trading 
day). Quote Credits are only calculated for individual Network 
stocks and are not totaled across all Network stocks.
---------------------------------------------------------------------------

    Some commenters were concerned that the inclusion of quotations in 
the proposed new allocation formula could lead new types of ``gaming'' 
of the formula, such as flashing quotations with no real intention to 
trade at those prices simply to earn more quote credits--and thereby 
more revenues--under the Quoting Share measure.\845\ Commenters also 
were concerned that such practices would increase quotation traffic and 
bandwidth costs, but with little or no benefit for the quality of the 
consolidated data stream.\846\ Because the Commission recognizes that 
abusive quoting behavior is a legitimate concern, the adopted formula 
incorporates a number of modifications to minimize the potential for 
abusive or costly quoting behavior. First, the adopted formula 
clarifies that a quotation must be displayed by the Network processor 
for a minimum of one full second of time before it is entitled to earn 
any quote credits.\847\ Second, the adopted formula clarifies that, 
consistent with the approach of the Order Protection Rule, each SRO 
participant in a Network is entitled to earn quote credits only for the 
SRO's best bid and best offer.\848\ By limiting the number of separate 
quotations that are entitled to earn quote credits, the adopted formula 
both reduces the ability of market participants to ``shred'' their 
quotes among many different markets and promotes equal regulation of 
exchange SROs, Nasdaq, and the NASD. Third, the adopted formula 
modifies the language of the reproposed formula to clarify that a 
quotation cannot earn Quote Credits while it locks or crosses a 
previously displayed automated quotation. This limitation is needed to 
remove any potential financial incentive for abusive quoting behavior 
that would be contrary to the purposes of the provisions on locking and 
crossing quotations set forth in the Access Rule. Fourth, the formula 
limits the revenues that can be allocated to a single Network security 
to an amount that is no greater than $4 per qualified transaction 
report, in order to achieve an appropriately balanced allocation among 
Network stocks by allowing room for a significant increase in the 
amounts currently allocated for many less active stocks, while also 
preventing unjustifiably high allocations for the most extremely 
inactive stocks that might create an inappropriate incentive for 
abusive quoting behavior.
---------------------------------------------------------------------------

    \845\ See, e.g., ArcaEx Reproposal Letter at 13; CHX Letter at 
19; Instinet Reproposal Letter at 14; SIA Reproposal Letter at 30.
    \846\ See, e.g., Financial Information Forum Reproposal Letter 
at 4; Nasdaq Reproposal Letter at 13; SIA Reproposal Letter at 30.
    \847\ See supra, section V.A.3.b.
    \848\ See supra, section V.A.3.b.
---------------------------------------------------------------------------

    In addition, the Commission recognizes that some SROs are likely to 
be allocated a smaller portion of Plan revenues under the new 
allocation formula than they would have received under the prior 
formulas, while other SROs will receive a larger portion of revenues. 
This will result if certain SROs are currently reporting a large number 
of trades or share volume of trades, but are not necessarily providing 
the best quotations or trades with larger sizes. A few commenters 
expressed concern that certain business models would be adversely 
impacted by the proposed new allocation formula,\849\ particularly for 
those markets that primarily handle small retail order flow.\850\ The 
Commission recognizes that reforming formulas that have remained 
unchanged for many years may affect the competitive position of various 
markets. Given the severe deficiencies of these formulas, however, it 
does not believe that the interests of any particular business model 
should preclude updating the formulas to reflect current market 
conditions. The adopted formula is designed to reflect more 
appropriately the contributions of the various SROs to the consolidated 
data stream and thereby better align the interests of individual 
markets with the interests of investors. Moreover, by representing a 
much more broad-based measure of an SRO's contribution to the 
consolidated data stream, the adopted formula will be less subject to 
any particular type of gaming and distortion than the narrowly-focused 
current Plan formulas.\851\ The Commission therefore believes that the 
benefits of the adopted new allocation formula justify the costs of 
implementation.
---------------------------------------------------------------------------

    \849\ See, e.g., Brut Letter at 22; CHX Reproposal Letter at 5; 
CHX Letter at 19, 21-22; NSX Letter at 6-7. See also BSE Reproposal 
Letter at 2, 3, 8 (suggesting a pilot approval process to address 
any unintended consequences on individual markets).
    \850\ See, e.g., BSE Letter at 16; CHX Letter at 19, 21-22; 
E*Trade Letter at 11. The adopted formula will provide a partial 
allocation of revenues for smaller trades that have a dollar value 
of less than $5000. This provision should lessen impact of the 
formula on exchanges that handle small retail orders.
    \851\ Two commenters on the reproposal suggested adopting an 
allocation formula based solely on the dollar volume of trading. 
ArcaEx Reproposal Letter at 13; Nasdaq Reproposal Letter at 14. 
Dollar volume alone, however, is not a broad-based measure and would 
miss important aspects of an SRO's contribution to the public data 
stream. It would, for example, allocate a disproportionately large 
amount to block trades. Block trades often are internalized by 
securities dealers at prices based, at least partly, on current 
public quotations. A formula based solely on dollar volume would not 
adequately allocate revenues to the source of quotations relied on 
in pricing block trades.
---------------------------------------------------------------------------

2. Plan Governance
a. Benefits
    The Commission believes that the adopted amendment to the Plans 
requiring the creation of Plan advisory committees will improve Plan 
governance. Most commenters generally supported the adopted amendment 
to the Plans, generally believing that expanding the participation of 
non-SROs parties in Plan governance would be a constructive step.\852\ 
Under the Plans, a representative of each SRO participating in the Plan 
is a member of the operating committee that governs that Plan. The 
adopted amendment to the Plans will require the establishment of non-
voting advisory committees

[[Page 37592]]

comprised solely of persons not employed by or affiliated with an SRO 
participant. This adopted amendment is intended to broaden 
participation in the governance of the Plans.
---------------------------------------------------------------------------

    \852\ See, e.g., Amex Letter at 10; Citigroup Letter at 17; 
Financial Information Forum Letter at 4; Financial Services 
Roundtable Letter at 6-7; ICI Letter at 4 and 21 n. 35; Nasdaq 
Letter II at 33; Reuters Letter at 3; SIIA/FISD Reproposal Letter at 
2.
---------------------------------------------------------------------------

    The adopted amendment will require the SRO participants to select 
the members of the advisory committee comprised, at a minimum, of one 
or more representatives associated with: (1) A broker-dealer with a 
substantial retail investor base; (2) a broker-dealer with a 
substantial institutional investor customer base; (3) an ATS; (4) a 
data vendor; and (5) an investor. In addition, each SRO participant 
will be entitled to select an additional committee member. The 
Commission believes that the composition of the advisory committee will 
give interested parties other than the SROs a voice in matters that 
affect them.
    The members of the advisory committee will have the right to submit 
their views to the operating committee on Plan business (other than 
matters determined to be confidential by a majority of Plan 
participants), prior to any decision made by the operating committee, 
and will have the right to attend operating committee meetings. Broader 
participation in the Plans through the creation of Plan advisory 
committees will be beneficial to the administration of the Plans 
because it will provide transparency to the Plan governance process and 
can promote the formation of industry consensus on disputed issues.
b. Costs
    The adopted amendment to the Plans requiring the formation of 
advisory committees can potentially result in costs to the SRO 
participants who will be required to engage in a selection process for 
purposes of establishing such committees. A Plan's operating committee 
as a whole will be required to select a minimum of five committee 
members, while each SRO participant will also have the right to select 
an additional committee member. This selection process can potentially 
result in added costs and administrative burden and expense to the SRO 
participants.
    The adopted Plan amendment also can potentially disrupt the current 
governance of the Plans by their participants. Since the creation of 
the Plans, representatives from the SROs have been the sole 
participants in the Plans and have been responsible for their 
administration. A few commenters believed that the additional 
participation of non-SRO parties could potentially increase the 
difficulty of reaching a consensus on Plan business, stating that too 
many members on an advisory committee could complicate and disrupt, 
rather than assist, Plan operations due to differing party 
agendas.\853\ Although such a result may occur at times, the Commission 
believes that this cost would be justified by the benefits that can be 
gained by increasing the transparency of Plan operations and giving 
parties other than SROs an opportunity to submit their views. In the 
past, the Plans may not have adequately considered the viewpoints of 
non-SRO parties on important issues such as fees and administrative 
burdens. Establishing advisory committees will address this problem and 
thereby potentially make the Plans more responsive to the needs of 
market participants and investors.
---------------------------------------------------------------------------

    \853\ See, e.g., Amex Letter, Exhibit A at 21-22; Reuters Letter 
at 3.
---------------------------------------------------------------------------

3. Amendments to Rules 11Aa3-1 and 11Ac1-2 (Redesignated as Rules 601 
and 603)

a. Independent Distribution of Information
i. Benefits
    The Commission is adopting as proposed the amendment to Rule 11Aa3-
1 (redesignated as Rule 601), which rescinds the prohibition on SROs 
and their members from disseminating their trade reports 
independently.\854\ Under adopted Rule 601, members of an SRO will 
continue to be required to transmit their trades to the SRO (and SROs 
will continue to transmit trades to the Networks pursuant to the 
Plans), but such members also will be free to distribute their own data 
independently, with or without fees. The Commission believes that 
independently distributed information can be beneficial to investors 
and other information users because depth-of-book quotations have 
become increasingly important as decimal trading has spread displayed 
depth across a greater number of price points. Similarly, commenters 
that discussed this aspect of the proposal generally agreed that the 
proposal would benefit investors and vendors by giving them greater 
freedom to make their own decisions regarding the data they need.\855\ 
Other commenters believed that the proposal would lead to increased 
competition, the provision of more data products, and/or lower costs, 
thus benefiting market participants.\856\ In addition, one commenter 
agreed with the Commission that market centers would benefit from 
additional revenues and stated that the prospect of additional revenues 
would encourage markets to provide better markets.\857\
---------------------------------------------------------------------------

    \854\ Regulation NMS removed the definitions in paragraph (a) of 
Exchange Act Rule 11Aa3-1 (redesignated as Rule 601) and placed them 
in Rule 600. Subparagraphs (c)(2) and (c)(3) of Exchange Act Rule 
11Aa3-1 are being rescinded. As a result, subparagraph (c)(4) of 
Exchange Act Rule 11Aa3-1 is redesignated as subparagraph (b)(2) of 
Rule 601.
    \855\ See, e.g., CBOE Letter at 17; Financial Information Forum 
Letter at 3-4; Reuters Letter at 3.
    \856\ See, e.g., Brut Letter at 23; Financial Services 
Roundtable Letter at 6; Nasdaq Reproposal Letter at 15-16.
    \857\ Specialist Assoc. Letter at 16-17.
---------------------------------------------------------------------------

    Adopted Rule 603(a) establishes uniform standards for distribution 
of both quotations and trades. The standards require an exclusive 
processor, or a broker or dealer with respect to information for which 
it is the exclusive source, that distributes quotation and transaction 
information in an NMS stock to a securities information processor 
(``SIP'') to do so on terms that are fair and reasonable. In addition, 
those SROs, brokers, or dealers that distribute such information to a 
SIP, broker, dealer, or other persons are required to do so on terms 
that are not unreasonably discriminatory. Furthermore, these uniform 
standards are based, in part, on similar requirements found in Sections 
3 and 11A of the Exchange Act \858\ for SROs and entities that 
distribute SRO information on an exclusive basis. The Commission 
believes that extending these requirements to non-SRO market centers, 
including ATSs and market makers, will help assure equal regulation of 
all markets that trade NMS stocks.
---------------------------------------------------------------------------

    \858\ 15 U.S.C. 78c and 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

ii. Costs
    The Commission recognizes that the rescission of the prohibition on 
independent distribution of trade reports under adopted Rule 601 may 
potentially lead to market centers incurring costs associated with the 
independent distribution of their market data if they choose to 
distribute such data without charging a fee. In addition, investors may 
have to pay for additional data if market centers choose to charge a 
fee for the additional data. Furthermore, a corollary to one 
commenter's assertion that market centers could benefit from additional 
revenues if market centers choose to distribute their own quotation 
information,\859\ is that the data from one or more other market 
centers can potentially become more or less valuable than another 
market center's data, and thereby increase or reduce that market 
center's overall income. The Commission does not believe that there 
will be any costs associated with

[[Page 37593]]

establishment of uniform standards for the distribution of trades and 
quotations pursuant to adopted Rule 603(a). The Commission did not 
receive any comments on this issue.
---------------------------------------------------------------------------

    \859\ Specialist Assoc. Letter at 16-17.
---------------------------------------------------------------------------

b. Consolidation of Information
i. Benefits
    All SROs currently participate in Plans that provide for the 
dissemination of consolidated information for the NMS stocks that they 
trade. Adopted Rule 603(b) confirms by Exchange Act rule that both 
existing and any new SROs will be required to continue to participate 
in joint-industry plans to disseminate consolidated information in NMS 
stocks to the public. Adopted Rule 603 provides the benefit of 
clarifying that all SROs--whether existing or new--will be required to 
participate jointly in one or more Plans to disseminate consolidated 
information in NMS stocks. Adopted Rule 603 also requires that all 
quotation and trade information for an individual NMS stock be 
disseminated through a single processor (currently, SIAC or Nasdaq). 
The Commission believes that requiring a single processor for a 
particular security will help to ensure that investors continue to 
receive the benefits of obtaining consolidated information from a 
single source.
ii. Costs
    Given that consolidated market information currently is 
disseminated through a single processor per stock, the Commission does 
not foresee any new costs associated with adopted Rule 603(b).
c. Display of Consolidated Information
i. Benefits
    The Commission is adopting as proposed the amendment to Rule 11Ac1-
2 (redesignated as Rule 603(c)) that substantially revises the 
consolidated display requirement by limiting its scope. It incorporates 
a new definition of ``consolidated display'' (set forth in adopted Rule 
600(b)(13)) that is limited to the prices, sizes, and market center 
identifications of the NBBO and the ``consolidated last sale 
information.'' Beyond disclosure of this basic information, market 
forces, rather than regulatory requirements, will be allowed to 
determine what, if any, additional data from other market centers is 
displayed. In particular, investors and other information users 
ultimately will be able to decide whether they need additional 
information in their displays.
    As amended, Rule 603(c) also eliminates the burden on vendors and 
broker-dealers to display a complete montage of quotations from all 
market centers trading a particular security, which would include the 
price of quotations that may be far away from the current NBBO. 
Furthermore, vendors and broker-dealers will have the ability to decide 
what, if any, additional data from other market centers beyond this 
basic disclosure to display. Vendors, broker-dealers, and investors 
will benefit from this reduced consolidated display requirement through 
a more efficient use of system capacity and because the costs of 
obtaining necessary data may be lowered. The Commission believes that 
giving investors the ability to choose (and pay for) only the data they 
need and use will be beneficial.
    Rule 603(c) narrows the contexts in which a consolidated display is 
required to those when it is most needed--a context in which a trading 
or order-routing decision could be implemented. For example, the 
consolidated display requirement will continue to cover broker-dealers 
who provide on-line data to their customers in software programs from 
which trading decisions can be implemented. Similarly, the requirement 
will continue to apply to vendors who provide displays that facilitate 
order routing by broker-dealers. It will not apply, however, when 
market data is provided on a purely informational website that does not 
offer any trading or order-routing capability. Rule 603(c) also 
simplifies the rule language to require that consolidated data be made 
available in an equivalent manner as other data and rescinds 
unnecessary provisions in order to update the Rule.\860\ We expect Rule 
603(c) to benefit broker-dealers and vendors by making compliance with 
the adopted Rule's more tailored requirements easier and more 
efficient.
---------------------------------------------------------------------------

    \860\ The provisions being rescinded include requirements 
relating to moving tickers, categories of market information, and 
representative bids and offers.
---------------------------------------------------------------------------

ii. Costs
    A potential cost attributable to Rule 603(c) is that there 
currently may be individuals who use the displayed montage of 
quotations from all market centers trading a particular security. If 
vendors and broker-dealers determined not to display this additional 
information, these investors would be required to obtain the additional 
data at additional cost. Rule 603(c) also may potentially result in an 
administrative cost or burden for vendors and broker-dealers that will 
be required to assess in what circumstances they are displaying market 
data information for trading and order-routing purposes and in what 
circumstances they are displaying such information for other purposes. 
The Commission believes that such a cost will be minimal.

E. Regulation NMS

    The Commission is redesignating the current NMS rules adopted under 
Section 11A of the Exchange Act \861\ as Regulation NMS, making non-
substantive conforming changes to various rules, and creating a 
separate definitional rule, Rule 600, which will contain all of the 
defined terms used in Regulation NMS. Currently, each NMS rule includes 
its own set of definitions, and some identical terms, such as ``covered 
security,'' ``reported security,'' and ``subject security,'' are 
defined inconsistently. Although Rule 600 retains, unchanged, most of 
the definitions used in the existing NMS rules, it deletes or revises 
obsolete definitions and eliminates the use of inconsistent definitions 
for identical terms. Rule 600 does not alter the requirements or 
operation of the existing NMS rules.
---------------------------------------------------------------------------

    \861\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

1. Benefits
    The Commission believes that Rule 600 and the related amendments to 
various Commission rules will benefit all entities that are and will be 
subject to the requirements of the rules contained in Regulation NMS, 
including brokers, dealers, national securities exchanges, the NASD, 
ECNs, SIPS, and vendors. By eliminating or revising obsolete and 
inconsistent definitions and adopting a single set of definitions that 
will be used throughout Regulation NMS, Rule 600 should make Regulation 
NMS clearer and easier to understand, thereby facilitating compliance 
with the Rules' requirements and potentially easing the compliance 
burden on entities subject to Regulation NMS. Increased compliance with 
Regulation NMS will, in turn, benefit investors and the public 
interest. Similarly, the related non-substantive amendments to various 
Commission rules will ensure that those rules use the definitions 
provided in Rule 600 and refer accurately to the redesignated NMS 
rules.
2. Costs
    Rule 600 will update and clarify the definitions used in existing 
NMS rules. Neither Rule 600 nor the related conforming amendments to 
various rules will alter the existing requirements of the NMS rules or 
other Commission rules. Accordingly, the Commission believes that Rule 
600 and the related

[[Page 37594]]

amendments will impose few additional costs on entities subject to 
Regulation NMS. Although some additional personnel costs may be 
incurred in reviewing the changes, the Commission believes that these 
costs will be minimal.

X. Consideration of Burden on Competition, and Promotion of Efficiency, 
Competition, and Capital Formation

    Section 3(f) of the Exchange Act \862\ requires the Commission, 
when engaging in rulemaking that requires the Commission to consider or 
determine whether an action is necessary or appropriate in the public 
interest, to consider whether the action will promote efficiency, 
competition and capital formation. Section 23(a)(2) prohibits the 
Commission from adopting any rule that would impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act.\863\ To assist the Commission in evaluating the 
costs and benefits of Regulation NMS, the Commission solicited comment 
in the Proposing Release and the Reproposing Release on whether any of 
the proposals discussed therein would have an adverse effect on 
competition that was neither necessary nor appropriate in furtherance 
of the purposes of the Exchange Act, and whether they would promote 
efficiency, competition and capital formation. The Commission also 
requested commenters to provide empirical data and other factual 
support for their views on these subjects. The Commission has 
considered comments received and has adopted the rules as discussed 
above, taking into account these comments.
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    \862\ 15 U.S.C. 78c(f).
    \863\ 15 U.S.C. 78w(a)(2).
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A. Order Protection Rule

    The Commission agrees with commenters that supported the Reproposed 
Rule \864\ that the price protection that will be provided by the Order 
Protection Rule will encourage greater use of limit orders, which will 
help improve the price discovery process, and contribute to increased 
liquidity and depth in the markets. The more limit orders available at 
better prices and greater size, the more liquidity available to fill 
incoming marketable orders. Greater depth and liquidity will, at a 
minimum, lower the search costs associated with trying to find 
liquidity and should lead to improved execution quality, particularly 
for larger-sized institutional orders. The Commission also believes 
that the Order Protection Rule, by providing intermarket price 
protection for accessible, automated orders (but not requiring 
automated markets to wait for responses from non-automated markets), 
will help promote efficiency in the markets by more effectively linking 
markets together and integrating trading centers with different market 
structures into the NMS, and by providing an incentive for non-
automated markets to automate. Rule 611 also will promote investor 
confidence in the markets by helping to assure, on an order-by-order 
basis, that customer orders are executed at the best price available 
and providing protection against limit orders being bypassed by 
inferior priced executions. In particular, the Commission believes that 
the providing enhanced protection for the best bids and offers of each 
exchange, The NASDAQ Stock Market, and the ADF will represent a major 
step toward achieving the objectives of intermarket price protection. 
The Order Protection Rule thus will promote best execution for retail 
investors on an order-by-order basis, given that most retail investors 
justifiably expect that their orders will be executed at the NBBO.
---------------------------------------------------------------------------

    \864\ See supra, section II.A.1.
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    The Commission believes that Rule 611 will promote intermarket 
competition by leveling the playing field between automated and non-
automated markets and, to the extent that the existing trade-through 
rule serves to constrain competition, by removing this barrier to 
competition. The Commission recognizes the vital importance of 
preserving competition among market centers,\865\ but continues to 
believe that commenters have overstated the risk that such competition 
will be eliminated by adoption of an order protection rule without an 
opt-out exception. The Commission believes that markets likely will 
have strong incentives to compete and innovate to attract both 
marketable orders and limit orders. Market participants and 
intermediaries responsible for routing marketable orders, consistent 
with their desire to achieve the best price and their duty of best 
execution, will continue to rank trading centers according to the total 
range of services provided by such markets. The most competitive 
trading center will be the first choice for routing marketable orders, 
thereby enhancing the likelihood of execution for limit orders routed 
to that trading center. Because likelihood of execution is very 
important to limit orders, routers of limit orders likely will be 
attracted to this preferred trading center. More limit orders will 
enhance the depth and liquidity offered by the preferred trading 
center, thereby increasing its attractiveness for marketable orders, 
and beginning the cycle over again. In addition, Rule 611 will not 
require that limit orders be routed to any particular market. 
Consequently, the Commission believes that competitive forces will be 
fully operative to discipline markets that offer poor services to limit 
orders, such as limiting the extent to which limit orders can be 
cancelled in changing market conditions or providing slow speed of 
cancellation.
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    \865\ Many commenters believed that an opt-out exception would 
be necessary to promote competition among trading centers, 
particularly competition based on factors other than price, such as 
speed of response. See supra, section II.A.4.a.
---------------------------------------------------------------------------

    Conversely, trading centers that offer poor services, such as slow 
response times, will likely rank near the bottom in order-routing 
preferences of market participants and intermediaries. Whenever a 
least-preferred trading center is merely posting the same price as 
other trading centers, orders will be routed to the other trading 
centers. Competitive forces will continue to dictate that the lowest 
ranked trading center in order-routing preference will suffer from 
offering a poor range of services to the routers of marketable orders. 
The Commission therefore does not believe that Rule 611 will eliminate 
competition among markets.
    Commenters have, however, identified a troubling potential for 
intermarket price protection to lessen the competitive discipline that 
market participants now can impose on inefficient trading centers.\866\ 
The Order Protection Rule generally requires that trading centers match 
the best quoted prices, cancel orders without an execution, or route 
orders to the trading centers quoting the best prices. This is good for 
investors generally, but may not be if the quoting market is 
inefficient. For example, a market center may have poor systems that do 
not process orders quickly and reliably. Or a low-volume market may not 
be nearly as accessible as a high-volume market.
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    \866\ See, e.g., Fidelity Reproposal Letter at 2; MFA Reproposal 
Letter at 2; Morgan Stanley Reproposal Letter at 2; TIAA-CREF 
Reproposal Letter at 2.
---------------------------------------------------------------------------

    Currently, consistent with their best execution and other agency 
responsibilities, participants in the market for Nasdaq stocks can 
choose not to deal with any trading center that they believe provides 
unsatisfactory services. Under the Order Protection Rule, market 
participants can limit their involvement with any trading center to 
routing IOC orders to access only the best bid or best

[[Page 37595]]

offer of the trading center. Nevertheless, even this limited 
involvement potentially could lessen the competitive discipline that 
otherwise will be imposed on an inefficient trading center. The 
Commission therefore believes that this potentially serious effect must 
be addressed at multiple levels in addition to the specific exceptions 
included in the Rule that were discussed above.
    First, trading centers themselves have a legal obligation to meet 
their responsibilities under the Exchange Act to provide venues for 
trading that is orderly and efficient.\867\ Through registration and 
other requirements, the Exchange Act regulatory regime is designed to 
preclude entities that are not capable of meeting high standards of 
conduct from doing business with the public. This critically important 
function will be undermined by a trading center that displayed 
quotations in the consolidated data stream, but could not, because of 
poor systems or otherwise, provide efficient access to market 
participants and efficient handling of their orders. In addition, a 
trading center will violate its Exchange Act responsibilities if it 
failed to comply fully with the requirements set forth in Rule 
600(b)(3) and (4) for automated quotations and automated trading 
centers. In particular, an automated trading center must implement such 
systems, procedures, and rules as are necessary to render it capable of 
meeting the requirements for automated quotations and must immediately 
identify its quotations as manual whenever it has reason to believe 
that it is not capable of displaying automated quotations. These 
requirements place an affirmative and vitally important legal duty on 
trading centers to identify their quotations as manual at the first 
sign of a problem, not after a problem has fully manifested itself and 
thereby caused a rippling effect at other trading centers that damages 
investors and the public interest.
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    \867\ See, e.g., Exchange Act Sections 6(b)(1) and 6(b)(5); 
Exchange Act Section 15; Exchange Act Sections 15A(b)(2) and 
15A(b)(6); Exchange Act Section 11A(a)(1)(C); Regulation ATS.
---------------------------------------------------------------------------

    Second, those responsible for the regulatory function at SROs have 
an affirmative responsibility to examine for and enforce all Exchange 
Act requirements and the SRO rules that apply to the trading centers 
that fall within their regulatory authority. One of the key policy 
justifications for a self-regulatory system is that industry regulators 
will have close proximity to, and significant expertise concerning, 
their particular trading centers. In addition, industry regulators 
typically have greater flexibility to address problems than 
governmental authorities. Implementation of the Order Protection Rule 
will heighten the importance of effective self-regulation. Those 
responsible for the market operation functions of an SRO may have 
business incentives that militate against dealing with potential 
problems in an effective and forthright manner. Regulatory personnel 
are expected to be independent of such business concerns and have an 
affirmative responsibility to prevent improper factors from interfering 
with an SRO's full compliance with regulatory requirements.
    Finally, the Commission itself plays a critical role in the 
Exchange Act regulatory regime. Effective implementation of the Order 
Protection Rule also will depend on the Commission taking any action 
that is necessary and appropriate to address problem trading centers 
that fail to meet fully their regulatory requirements. The Commission 
and its staff must continue to monitor the markets closely for signs of 
problems and listen to the concerns of market participants as they 
arise, especially with regard to the new requirements imposed by the 
Order Protection Rule. Quick and effective action will be needed to 
assure that all responsible parties do not feel that inattention to 
problems is an acceptable course of action.
    The Commission therefore believes that Rule 611 will not impose any 
competitive burden that is not necessary and appropriate in furtherance 
of the purposes of the Exchange Act. The Commission believes that the 
Order Protection Rule will help create an NMS that more fully meets the 
needs of a wide spectrum of investors, particularly long-term investors 
and publicly traded companies, by providing increased efficiency and 
improved depth and liquidity to our capital markets. By providing 
increased efficiency and promoting investor confidence in quality 
executions, investors may be more willing to invest in our capital 
markets, thus promoting the ability of listed companies to raise 
capital at lower cost.

B. Access Rule

    Rule 610 establishes standards governing access to quotations in 
NMS stocks that: (1) Prohibit trading centers from unfairly 
discriminating against non-members members or non-subscribers that 
attempt to access their quotations through a member or subscriber of 
the trading center, and enable access to NMS quotations through private 
linkages; (2) establish an outer limit on the cost of accessing such 
quotations of no more than $0.003 per share; and (3) require SROs to 
establish, maintain, and enforce rules that, among other things, 
prohibit their members from engaging in a pattern or practice of 
displaying quotations that lock or cross the automated quotations of 
other trading centers. The amendment to Rule 301(b)(5) under Regulation 
ATS lowers the threshold that triggers the Regulation ATS fair access 
requirements from 20% to 5% of average daily volume in a security.
    The access provisions are intended to bolster investor confidence 
in the markets by helping to assure investors that their orders will be 
executed at the best prices and will not subject to hidden fees, 
regardless of the market on which the execution takes place. By 
generally imposing a uniform fee limitation of $0.003 per share, the 
Rule will promote equal regulation of different types of trading 
centers, where currently some are permitted to charge fees and some are 
not, thereby leveling the playing field among diverse market centers. 
Moreover, the Commission believes that, by prohibiting a trading center 
from imposing unfairly discriminatory terms that would prevent or 
inhibit the efficient access of any person through members, 
subscribers, or customers of such trading center, the Rule will promote 
competition among trading centers.
    The Commission believes that Rule 610 also will increase 
transparency and efficiency in the market, thereby enhancing investor 
confidence, and thus capital formation. Specifically, the Rule will 
permit private linkages between markets, rather than mandating a 
collective intermarket linkage facility. Private linkages will permit 
market centers to connect through cost effective and technologically 
advanced communications networks. Such systems are widely utilized in 
the market for Nasdaq-listed stocks today and likely will provide speed 
and flexibility to trading centers and their market participants. The 
use of private linkages can encourage interaction between the markets 
and reduce fragmentation by removing impediments to the execution of 
orders between and among marketplaces, thereby increasing efficiency 
and competition.
    Several commenters expressed concerns regarding the impact that the 
access fee proposal could have on

[[Page 37596]]

competition.\868\ As discussed in detail in Section III above, the 
Commission believes that the flat limitation on access fees of $0.003 
per share is the fairest and most appropriate solution to what has been 
a longstanding and contentious issue. A single accumulated fee cap will 
apply equally to all types of trading centers and all types of market 
participants, thereby promoting the NMS objective of equal regulation 
of markets and broker-dealers, and allowing those entities to compete 
on equal footing.\869\
---------------------------------------------------------------------------

    \868\ See, e.g., Amex Letter, Exhibit A at 23-24; ArcaEx 
Reproposal Letter at 10; BGI Reproposal Letter at 3; Bloomberg 
Summary of Intended Testimony at 3; BrokerageAmerica Letter at 1; 
Brut Letter at 14; CHX Letter at 15; Domestic Securities Summary of 
Intended Testimony; Instinet Reproposal Letter at 10; NexTrade 
Reproposal Letter at 7-8; Phlx Reproposal Letter at 4 (stating its 
belief that the proposal is not justified under Section 23(a)(2) of 
the Exchange Act); TrackECN Letter at 3.
    \869\ Section 11A(c)(1)(F) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1)(F).
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    A fee limitation also is necessary to preclude individual trading 
centers from raising their fees substantially in an attempt to take 
improper advantage of strengthened protection against trade-throughs 
and the adoption of a private linkage regime. In particular, the fee 
limitation is necessary to address ``outlier'' trading centers that 
otherwise might charge high fees to other market participants required 
to access their quotations by the Order Protection Rule. It also 
precludes a trading center from charging high fees selectively to 
competitors, practices that have occurred in the market for Nasdaq 
stocks. In the absence of a fee limitation, the adoption of the Order 
Protection Rule and private linkages could significantly boost the 
viability of the outlier business model. Outlier markets might well try 
to take advantage of intermarket price protection by acting essentially 
as a toll booth between price levels. The high fee market likely would 
be the last market to which orders would be routed, but prices could 
not move to the next level until someone routed an order to take out 
the displayed price at the outlier market. Therefore, the outlier 
market might see little downside to charging exceptionally high fees, 
such as $0.009, even if it is last in priority. While markets would 
have significant incentives to compete to be near the top in order-
routing priority,\870\ there might be little incentive to avoid being 
the least-preferred market if fees were not limited.
---------------------------------------------------------------------------

    \870\ See supra, section II.A.4.a (discussion of competitive 
implications of trade-through protection).
---------------------------------------------------------------------------

    The $0.003 cap will limit the outlier business model. It will place 
all markets on a level playing field in terms of the fees they can 
charge and the rebates they can pass on to liquidity providers. Some 
markets may choose to charge lower fees, thereby increasing their 
ranking in the preferences of order routers. Others may charge the full 
$0.003 and rebate a substantial proportion to liquidity providers. 
Competition will determine which strategy is most successful.
    The Commission notes that the $0.003 fee limitation is consistent 
with current business practices, as very few trading centers currently 
charge fees that exceed this amount.\871\ It appears that only two ECNs 
currently charges fees that exceed $0.003, charging $0.005 for access 
through the ADF. These ECNs currently do not account for a large 
percentage of trading volume. In addition, while a few SROs have large 
fees on their books for transactions in ETFs that exceed a certain size 
(e.g., 2100 shares), it is unlikely that these fees generate a large 
amount of revenues. Accordingly, the adopted fee limitation will not 
impair the agency market business model. The Commission recognizes that 
agency trading centers perform valuable agency services in bringing 
buyers and sellers together, and that their business model historically 
has relied, at least in part, on charging fees for execution of orders 
against their displayed quotations. Under current conditions, 
prohibiting access fees entirely would unduly harm this business model.
---------------------------------------------------------------------------

    \871\ Cf. Instinet Letter at 35 (``there is no basis for 
adopting any limitation other than at the prevailing $0.003 per 
share level, which was arrived at through open competition among 
ATSs, ECNs, and SRO markets in the Nasdaq market'') and Instinet 
Reproposal Letter at 11 (``as for an appropriate amount for such an 
accumulated fee limitation, the Reproposal sets the cap at the 
prevailing $0.003 per share level for stocks priced above $1.00, 
which was arrived at through open competition among marketplaces'').
---------------------------------------------------------------------------

    In addition, the Rule is designed to reduce the instances of locked 
and crossed quotations, which will promote capital formation by 
providing market participants a clear picture of the true trading 
interest in a stock. Moreover, the Commission believes that the access 
provisions will encourage interaction between the markets and reduce 
fragmentation by removing impediments to the execution of orders 
between and among marketplaces, thereby increasing efficiency and 
competition. Finally, the Commission believes that the access 
provisions likely will assist broker-dealers in evaluating and 
complying with their best execution obligations. The Commission 
therefore believes that Rule 610 will not impose any competitive burden 
that is not necessary and appropriate in furtherance of the purposes of 
the Exchange Act.

C. Sub-Penny Rule

    The Commission has considered Rule 612 in light of Sections 3(f) 
and 23(a)(2) of the Exchange Act and believes that the Rule will not 
impose a burden on competition not necessary or appropriate in 
furtherance of the purposes of the Exchange Act. To the contrary, by 
preserving the benefits of decimalization and guarding against the less 
desirable effects of further reducing the MPV, Rule 612 should promote 
fair and vigorous competition. The Commission acknowledges that the 
rule will, in some circumstances, prevent market participants from 
offering marginally better prices (through quoting or placing orders in 
sub-pennies). Some commenters argued that a prohibition on quoting in 
sub-pennies, at least in some NMS stocks, would inhibit price 
competition and artificially widen spreads.\872\ Nevertheless, the 
Commission is concerned that sub-penny quoting may be used by market 
participants more as a means of stepping ahead of competing limit 
orders for an economically insignificant amount than of promoting 
genuine price competition.
---------------------------------------------------------------------------

    \872\ See, e.g., Instinet Letter at 47; Mercatus Center Letter 
at 9-10; Tower Research Letter at 8-11.
---------------------------------------------------------------------------

    The Commission believes that Rule 612 will assist broker-dealers in 
evaluating and complying with their best execution obligations and 
other rules premised on identifying the price of a security at a 
particular moment in time. The Commission also believes that Rule 612 
will enhance market depth and improve transparency by preventing 
trading interest from being spread across an unnecessarily large number 
of price points. Therefore, we believe Rule 612 will encourage market 
participants to use limit orders, an important source of liquidity, and 
thereby promote market efficiency, competition, and capital formation. 
The Commission also believes that the new Rule will bolster investor 
confidence by helping ensure that their orders, especially large 
orders, can be executed without incurring large transaction costs. This 
increase in investor confidence also will promote market efficiency, 
competition, and capital formation.
    Rule 612 will establish common quoting conventions that will 
increase transparency in the securities markets. Moreover, the 
Commission believes that the Rule will encourage interaction between 
the markets and reduce

[[Page 37597]]

fragmentation by removing impediments to the execution of orders 
between and among markets. The increased transparency in the markets 
and reduction of fragmentation between the markets will bolster 
investor confidence, thereby promoting capital formation.

D. Market Data Rules and Plan Amendments

    The Commission believes that the adopted Plan amendment updating 
the current revenue allocation formulas will promote efficiency in the 
marketplace by eliminating incentives for market participants to engage 
in distortive trading practices such as wash trades, trade shredding, 
and SRO print facilities to obtain market data revenues. Similarly, 
commenters supported the need to update the current allocation 
formulas.\873\ In addition, the Commission believes, and several 
commenters concurred, that the adopted Plan amendment requiring the 
creation of non-voting advisory committees will promote efficiency in 
the administration of the Plans by allowing interested parties other 
than SROs to have a voice in Plan matters,\874\ which can, in turn, 
contribute to the resolution of potential disputes that SRO 
participants will otherwise bring before the Commission. Furthermore, 
we expect Rule 603(a) will promote efficiency and competition among 
market centers by helping to assure that independently reported trade 
and quotation information is distributed on terms that are fair and 
reasonable and not unreasonably discriminatory. Commenters that 
discussed this Rule generally agreed that adopted Rule 603(a) would 
allow investors and vendors greater freedom to make their own decisions 
regarding the data they need and that the proposal should lead to lower 
costs to investors.\875\ The Commission agrees with these commenters 
and notes that efficiency is promoted when broker-dealers who do not 
need the data beyond the prices, sizes, market center identifications 
of the NBBO and consolidated last sale information are not required to 
receive (and pay for) such data. The Commission also believes that 
efficiency is promoted when broker-dealers may choose to receive (and 
pay for) additional market data based on their own internal analysis of 
the need for such data. Adopted Rule 603(b) also likely will promote 
efficiency in the dissemination of consolidated market information by 
requiring that all SROs act jointly through the Plans to disseminate 
such information to the public.
---------------------------------------------------------------------------

    \873\ See, e.g., BGI Reproposal Letter at 3; Citigroup 
Reproposal Letter at 9; Deutsche Bank Reproposal Letter at 4; Harris 
Reproposal Letter at 11; JP Morgan Reproposal Letter at 2; STA 
Letter at 7; UBS Letter at 10; Vanguard Letter at 6.
    \874\ See, e.g., Financial Services Roundtable Letter at 7; 
Reuters Letter at 3; SIIA/FISD Reproposal Letter at 2.
    \875\ See, e.g., Brut Letter at 23; Financial Services 
Roundtable Letter at 6; Nasdaq Reproposal Letter at 16. In addition, 
two commenters believed that the proposal would reduce some 
regulatory burdens imposed on market participants. Financial 
Information Forum Reproposal Letter at 4-5; Instinet Reproposal 
Letter at 16.
---------------------------------------------------------------------------

    The Commission believes that the adopted Plan amendments will 
assist in capital formation through a more appropriate allocation of 
the Networks' revenues to those SROs that contribute most to public 
price discovery. Rule 603(c) also will eliminate the requirement to 
display a complete montage of quotations from all market centers and 
will therefore promote capital formation by reducing the costs to 
vendors and broker-dealers that are currently required to display 
quotations that may be far away from the NBBO. One commenter stated 
that broker-dealers currently are discouraged from making quotation and 
price information on a stock available because, under the current rule, 
this information must be accompanied by consolidated information for 
which they must pay market data fees.\876\ Accordingly, the Commission 
believes that, in certain circumstances, Rule 603(c) will result in 
additional market data information being provided, which will assist 
capital formation.
---------------------------------------------------------------------------

    \876\ Reuters Letter at 2-3.
---------------------------------------------------------------------------

    The Commission further believes that the adopted amendments to the 
Plans and to Rules 601 and 603 will not impose any competitive burden 
that is not necessary and appropriate in furtherance of the purposes of 
the Exchange Act. One regional exchange urged the Commission to 
consider the impact of the formula on competition, because, according 
to this commenter, most regional market centers rely on market data 
revenues to fund a significant portion of their budgets and thus a 
material decrease in such revenues could affect their financial plans, 
making it infeasible to compete with listing markets, which can survive 
on listing revenues.\877\ Although any change to the current formulas 
may result in a competitive advantage for some SROs and in a 
competitive disadvantage for other SROs, the Commission does not 
believe that this should preclude the adoption of an allocation formula 
that would provide a more useful distribution of market data revenues 
based on the quality of an SROs contribution of quotations and trades 
to the consolidated data stream. The Commission also believes that the 
adopted Plan amendment requiring the Plans to form non-voting advisory 
committees will enhance and promote competition by broadening Plan 
governance to include non-SRO parties, and thereby provide greater 
transparency in the administration of such Plans. Furthermore, we 
expect adopted Rules 601 and 603 to lessen the burden on vendors and 
broker-dealers from having to comply with certain consolidated display 
requirements. A few commenters generally noted that allowing market 
centers to independently disseminate certain market data information 
could increase competition among markets.\878\ The Commission agrees 
that the competition among market centers will be enhanced when such 
markets also choose to independently distribute their own market data. 
In addition, the amendment providing that all SROs consolidate 
information in each NMS stock and disseminate such information through 
a single processor per security will clarify that SROs are on an equal 
competitive footing with each other. Thus, the Commission believes that 
the amendments will enhance rather than burden competition by creating 
a more equal competitive environment for market centers and others.
---------------------------------------------------------------------------

    \877\ CHX Reproposal Letter at 5.
    \878\ See, e.g., Amex Letter at 10; Specialist Assoc. Letter at 
16-17; see also Brut Letter at 23.
---------------------------------------------------------------------------

E. Regulation NMS

    Rule 600, the redesignation of the existing NMS rules as Regulation 
NMS, and the related conforming changes to other Commission rules will 
help to promote efficiency and capital formation by making the NMS 
rules easier to understand, thereby helping to reduce compliance costs 
for entities subject to the rules. Enhanced clarity in the definitions 
used in Regulation NMS also will benefit investors and the public 
interest by facilitating compliance with the requirements of Regulation 
NMS. Because Rule 600 will clarify the existing definitions used in 
Regulation NMS without imposing new requirements, and because the 
redesignation of the NMS rules as Regulation NMS and the conforming 
changes to other Commission rules will create no new substantive 
requirements, Rule 600 and the related changes will not impose a burden 
on competition or alter the competitive standing of entities subject to 
Regulation NMS.

[[Page 37598]]

XI. Regulatory Flexibility Act

A. Order Protection Rule

    The Commission certified, pursuant to Section 605(b) of the 
Regulatory Flexibility Act, that the Order Protection Rule will not 
have a significant economic impact on a substantial number of small 
entities.\879\ This certification was incorporated into the Reproposing 
Release.\880\ The Commission did not receive any comments on this 
certification.
---------------------------------------------------------------------------

    \879\ 5 U.S.C. 605(b).
    \880\ Reproposing Release, 69 FR at 77492.
---------------------------------------------------------------------------

B. Access Rule

    The Commission certified, pursuant to Section 605(b) of the 
Regulatory Flexibility Act, that Rule 610 and the amendments to Rule 
301 of Regulation ATS will not have a significant economic impact on a 
substantial number of small entities.\881\ This certification was 
incorporated into the Reproposing Release.\882\ The Commission received 
one comment discussing the certification. The commenter, an ADF 
participant, believed that the Commission in the certification 
recognized that Rule 610 could result in a significant economic impact 
on small firms, just not a substantial number of small firms.\883\ This 
commenter continued to express its concerns with the proposed access 
requirements, stating its belief that the proposal to require ADF 
participants to establish the necessary connectivity that would 
facilitate efficient access to their quotations would create a cost 
barrier that discriminates against smaller firms in the ADF.\884\
---------------------------------------------------------------------------

    \881\ 5 U.S.C. 605(b).
    \882\ Reproposing Release, 69 FR at 77493.
    \883\ In the Reproposing Release, the Commission noted that only 
two of the approximately 600 broker-dealers (including ATSs) that 
would be subject to the Rule are considered small for purposes of 
the Regulatory Flexibility Act. See Section XII.B of the Reproposing 
Release, 69 FR at 77493.
    \884\ NexTrade Reproposal Letter at 4-6.
---------------------------------------------------------------------------

    The Commission does not believe that its adopted access approach in 
Rule 610(b)(1) discriminates against smaller firms or creates a barrier 
to access for innovative new market entrants. Rather, smaller firms and 
new entrants have a range of alternatives from which to choose that 
will allow them to avoid incurring any costs to meet the connectivity 
requirements of Rule 610(b)(1) if they wish to do so. This approach is 
fully consistent with Congressional policy set forth in the Regulatory 
Flexibility Act, which directs the Commission to consider significant 
alternatives to regulations that accomplish the stated objectives of 
the Exchange Act and minimize the economic impact on small 
entities.\885\
---------------------------------------------------------------------------

    \885\ 5 U.S.C. 603(c). The adopted access approach provides 
alternatives that will benefit a wider range of smaller ATSs than 
the two that are considered small entities. See supra note 385.
---------------------------------------------------------------------------

    Small ATSs are exempt from participation in the consolidated 
quotation system and, therefore, from the connectivity requirements of 
Rule 610. Under Rule 301(b)(3) of Regulation ATS, an ATS is required to 
display its quotations in the consolidated quotation stream only in 
those securities for which its trading volume reaches 5% of total 
trading volume. Consequently, smaller ATSs are not required to provide 
their quotations to any SRO (whether an SRO trading facility or the 
NASD's ADF) and thereby trigger the access requirements of Rule 610. 
Moreover, potential new entrants with innovative trading mechanisms can 
commence business without having to incur any costs associated with 
participation in the consolidated quotation system.
    Some smaller ATSs, however, may wish to participate voluntarily in 
the consolidated quotation system. Such participation can benefit 
smaller firms and promote competition among markets by enabling smaller 
firms to obtain wide distribution of their quotations among all market 
participants.\886\ Here, too, such firms will have alternatives that 
would not obligate them to comply with the connectivity requirements of 
Rule 610(b)(1). ATSs and market makers that wish to trade NMS stocks 
can choose from a number of options for quoting and trading. They can 
become a member of a national securities exchange and quote and trade 
through the exchange's trading facilities. They can participate in The 
NASDAQ Market Center and quote and trade through that facility. By 
choosing either of these options, an ATS or market maker would not 
create a new connectivity point that all other market participants must 
reach and would not be subject to Rule 610(b)(1). Some firms, however, 
may not want to participate in an SRO trading facility. These ATSs and 
market makers can quote and trade in the OTC market. The existence of 
the NASD's ADF makes this third choice possible by providing a facility 
for displaying quotations and reporting transactions in the 
consolidated data stream.\887\
---------------------------------------------------------------------------

    \886\ See supra, note 566 (the Commission's Advisory Committee 
on Market Information recommended retention of the consolidated 
display requirement because, among other things, it ``may promote 
market competition by assuring that information from newer or 
smaller exchanges is widely distributed.'').
    \887\ Under Rule 301(b)(3) of Regulation ATS, 17 CFR 
242.301(b)(3), an ATS is required to display its quotations in the 
consolidated data stream only in those securities for which its 
trading volume reaches 5% of total trading volume.
---------------------------------------------------------------------------

    As noted above in Section III.A.1, however, the NASD is not 
statutorily required to provide an order execution functionality in the 
ADF. The Commission believes that market makers and ECNs should 
continue to have the option of operating in the OTC market, rather than 
on an exchange or The NASDAQ Market Center. As noted in the 
Commission's order approving Nasdaq's SuperMontage trading facility, 
this ability to operate in the ADF is an important competitive 
alternative to Nasdaq or exchange affiliation.\888\ Therefore, the 
Commission has determined not to require small trading centers to make 
their quotations accessible through an SRO trading facility.
---------------------------------------------------------------------------

    \888\ See Securities Exchange Act Release No. 43863 (Jan. 19, 
2001), 66 FR 8020 (Jan. 26, 2001).
---------------------------------------------------------------------------

    Instead, Rule 610(b)(1) requires all trading centers that choose to 
display quotations in an SRO display-only quotation facility 
(currently, the ADF) to provide a level and cost of access to such 
quotations that is substantially equivalent to the level and cost of 
access to quotations displayed by SRO trading facilities. Rule 
610(b)(1) therefore may cause trading centers that display quotations 
in the ADF to incur additional costs to enhance the level of access to 
their quotations and to lower the cost of connectivity for market 
participants seeking to access their quotations. The extent to which 
these trading centers in fact incur additional costs to comply with the 
adopted access standard will be largely within the control of the 
trading center itself. As noted above, ATSs and market makers that wish 
to trade NMS stocks can choose from a number of options for quoting and 
trading, including quoting and trading in the OTC market. As a result, 
the additional connectivity requirements of Rule 610(b) will be 
triggered only by a trading center that displays its quotations in the 
consolidated data stream and chooses not to provide access to those 
quotations through an SRO trading facility.
    Currently, nine SROs operate trading facilities in NMS stocks. 
Market participants throughout the securities industry generally have 
established connectivity to these nine points of access to quotations 
in NMS stocks. By choosing to display quotations in the ADF, a trading 
center effectively could require the entire industry to establish

[[Page 37599]]

connectivity to an additional point of access. Potentially, many 
trading centers could choose to display quotations in the ADF, thereby 
significantly increasing the overall costs of connectivity in the NMS. 
Such an inefficient outcome would become much more likely if an ADF 
trading center were not required to assume responsibility for the 
additional costs associated with its decision to display quotations 
outside of an established SRO trading facility.
    Although the Exchange Act envisions an individual broker-dealer 
having the option of trading in the OTC market,\889\ it does not 
mandate that the securities industry in general must subsidize the 
costs of accessing a broker-dealer's quotations in the OTC market if 
the NASD chooses not to provide connectivity. The Commission believes 
that it is reasonable and appropriate to require those ATSs and market 
makers that choose to display quotations in the ADF to bear the 
responsibility of providing a level and cost of access to their 
quotations that is substantially equivalent to the level and cost of 
access to quotations displayed by SRO trading facilities. Under Rule 
610(b)(1), therefore, ADF participants will be required to bear the 
costs of the necessary connectivity to facilitate efficient access to 
their quotations.\890\ This standard will help ensure that additional 
connectivity burdens are not imposed on the securities industry each 
time an additional ADF participant necessitates a new connectivity 
point by choosing to begin displaying quotations in the consolidated 
quotation stream. The Commission believes that this requirement will 
help reduce overall industry costs by more closely aligning the burden 
of additional connectivity with those entities whose choices have 
created the need for additional connectivity.
---------------------------------------------------------------------------

    \889\ See Sections 11A(c)(3)(A) and (4) of the Exchange Act, 15 
U.S.C 78k-1(c)(3)(A) and (4).
    \890\ Thus, although market participants may still be required 
to access numerous trading centers in the ADF, the Rule should 
reduce the cost of access to each such trading center by requiring 
the ADF trading center to provide a cost and level of access 
substantially equivalent to the level and cost of access to 
quotations displayed by SRO trading facilities.
---------------------------------------------------------------------------

    As just discussed, the Commission recognizes that trading centers 
subject to Rule 610(b)(1) may incur costs associated with providing 
access to their quotations, although the costs will vary depending upon 
the manner in which each trading center provides such access. The 
Commission notes that to meet the standard contained in Rule 610(b)(1), 
a trading center will be allowed to take advantage of the greatly 
expanded connectivity options that have been offered by competing 
access service providers in recent years.\891\ These industry access 
providers have extensive connections to a wide array of market 
participants through a variety of direct access options and private 
networks. A trading center potentially could meet the requirement of 
Rule 610(b)(1) by establishing connections to and offering access 
through such vendors. The option of participation in existing market 
infrastructure and systems should reduce a trading center's cost of 
compliance.\892\
---------------------------------------------------------------------------

    \891\ As noted in the Commission's order approving the pilot 
program for the ADF, the reduction in communications line costs in 
recent years and the advent of competing access providers offer the 
potential for multiple competitive means of access to the various 
trading centers that trade NMS stocks. Securities Exchange Act 
Release No. 46249, supra note 390.
    \892\ As the self-regulatory authority responsible for the OTC 
market, the NASD must act as ``gatekeeper'' for the ADF, and, as 
such, will need to closely assess the extent to which ADF 
participants meet the requirements of Rule 610.
---------------------------------------------------------------------------

    Section 3(a) of the Regulatory Flexibility Act \893\ requires the 
Commission to undertake an Initial Regulatory Flexibility Analysis of 
proposed rules on small entities unless the Commission certifies that 
the proposed rules, if adopted, would not have a significant economic 
impact on a substantial number of small entities. The Commission 
continues to believe that the Access Rule will not have a significant 
economic impact on a substantial number of small entities.
---------------------------------------------------------------------------

    \893\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

C. Sub-Penny Rule

    This Final Regulatory Flexibility Act Analysis (``FRFA'') relating 
to Rule 612 of Regulation NMS has been prepared in accordance with the 
Regulatory Flexibility Act.\894\
---------------------------------------------------------------------------

    \894\ 5 U.S.C. 604.
---------------------------------------------------------------------------

1. Need for and Objective of Rule 612
    Although the conversion from fractional to decimal trading 
benefited investors by clarifying and simplifying prices, making our 
markets more competitive internationally, and reducing trading costs by 
narrowing spreads, these benefits could be diluted if market 
participants could quote NMS stocks in increments less than a penny. 
The Commission is particularly concerned that sub-penny orders may be 
used to step ahead of competing limit orders for an economically 
insignificant amount.
    New Rule 612 prohibits an exchange, association, vendor, ATS, or 
broker-dealer from accepting, ranking, or displaying an order, 
quotation, or indication of interest in an NMS stock priced in a sub-
penny increment (except for an order, quotation, or indication of 
interest priced less than $1.00 per share, in which case the price may 
not extend beyond four decimal places). The rule is designed to improve 
market depth by preventing quotations from spreading across an unduly 
large number of price points, while also encouraging the use of limit 
orders--an important source of liquidity--by preventing competing 
market participants from stepping ahead of a limit order by an 
economically insignificant amount. We expect the rule to reduce the 
instances of quote flickering and to facilitate broker-dealers' efforts 
to meet their best execution and other regulatory duties premised on 
identifying a security's prevailing market price.
2. Significant Issues Raised by Public Comment
    The IRFA appeared in the Proposing Release and in the Reproposing 
Release.\895\ The Commission requested comment in the IRFA on the 
impact the proposals would have on small entities and how to quantify 
the impact. The Commission did not receive any comment letters 
addressing the IRFA.
---------------------------------------------------------------------------

    \895\ Proposing Release, 69 FR at 11174-75; Reproposing Release, 
69 FR 77493-94.
---------------------------------------------------------------------------

3. Small Entities Subject to the Rule
    Rule 612 applies to every national securities exchange, national 
securities association, ATS, vendor, and broker-dealer. Each type of 
market participant that will be affected by the new Rule 612 is 
discussed below.
a. National Securities Exchanges and National Securities Associations
    Rule 0-10(e) under the Exchange Act \896\ provides that the term 
``small business'' or ``small organization,'' when referring to an 
exchange, means any exchange that: (1) Has been exempted from the 
reporting requirements of Rule 601 under the Exchange Act; and (2) is 
not affiliated with any person (other than a natural person) that is 
not a small business or small organization, as defined by Rule 0-10. No 
national securities exchange meets these criteria; therefore, no 
national securities exchange is a small entity. Currently, there is one 
national securities association (NASD) that is subject to Rule 612. 
NASD is not a small entity as defined by 13 CFR 121.201.
---------------------------------------------------------------------------

    \896\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

b. Broker-Dealers
    Commission rules generally define a broker-dealer as a small entity 
for

[[Page 37600]]

purposes of the Exchange Act and the Regulatory Flexibility Act if the 
broker-dealer had total capital (net worth plus subordinated 
liabilities) of less than $500,000 on the date in the prior fiscal year 
as of which its audited financial statements were prepared, and the 
broker-dealer is not affiliated with any person (other than a natural 
person) that is not a small entity.\897\ The Commission estimates that, 
as of the end of 2003, there were approximately 6,565 Commission-
registered broker-dealers,\898\ of which approximately 905 are 
considered small entities pursuant to Rule 0-10(c) under the Exchange 
Act.\899\
---------------------------------------------------------------------------

    \897\ See 17 CFR 240.0-10(c).
    \898\ This number reflects the number of FOCUS filings. ATSs 
that are not registered as exchanges are required to register as 
broker-dealers. Accordingly, an ATS would be considered a small 
entity if it fell within the definition of ``small entity'' as it 
applies to broker-dealers.
    \899\ 17 CFR 240.0-10(c).
---------------------------------------------------------------------------

c. Vendors
    A vendor is any securities information processor engaged in the 
business of disseminating transaction reports or last sale data with 
respect to transactions in reported securities to brokers, dealers, or 
investors on a real-time or other current and continuing basis, whether 
through an ECN, moving ticker, or interrogation device.\900\ Rule 0-
10(g) \901\ provides that the term ``small business'' or ``small 
organization,'' when referring to a securities information processor, 
means any securities information processor that: (1) Had gross revenues 
of less than $10 million during the preceding fiscal year (or in the 
time it has been in business, if shorter); (2) provided service to 
fewer than 100 interrogation devices or moving tickers at all times 
during the preceding fiscal year (or in the time that it has been in 
business, if shorter); and (3) is not affiliated with any person (other 
than a natural person) that is not a small business or small 
organization under this section. The Commission estimates that there 
are approximately 80 vendors, 16 of which are considered small 
entities.
---------------------------------------------------------------------------

    \900\ See 17 CFR 11Aa3-1(a)(11).
    \901\ 17 CFR 240.0-10(g).
---------------------------------------------------------------------------

4. Reporting, Recordkeeping, and Other Compliance Requirements
    Rule 612 will not impose any new reporting, recordkeeping, or other 
compliance requirements on any entities subject to the rule, including 
small entities.
5. Agency Action To Minimize Effect on Small Entities
    Rule 612 establishes a uniform pricing increment for NMS stocks. 
All entities subject to the rule generally are prohibited from 
displaying, ranking, or accepting an order, quotation, or indication of 
interest priced in a sub-penny increment. Imposing different compliance 
requirements for small entities would be impractical and undermine the 
goal of uniformity. Furthermore, the Commission does not believe it 
necessary or appropriate to consider whether small entities should be 
permitted to use performance rather than design standards to comply 
with Rule 612. The rule already establishes performance standards and 
does not dictate any particular design standard that must be employed 
to achieve the rule's objectives.

D. Market Data Rules and Plan Amendments

1. Regulatory Flexibility Act Certification for the Plan Amendments
    The Commission certified, pursuant to Section 605(b) of the 
Regulatory Flexibility Act, that amending the Plans to: (1) Modify the 
current formulas for allocating market data revenues, and; (2) require 
the establishment of non-voting advisory committees will not have a 
significant economic impact on a substantial number of small 
entities.\902\ This certification was incorporated into the Proposing 
Release and Reproposing Release.\903\ The Commission did not receive 
any comments on this certification.
---------------------------------------------------------------------------

    \902\ 5 U.S.C. 605(b).
    \903\ Proposing Release, 69 FR at 11190-91; Reproposing Release, 
69 FR at 77495-96.
---------------------------------------------------------------------------

2. Final Regulatory Flexibility Analysis for Amendments to Rules 11Aa3-
1 and 11Ac1-2 (Redesignated as Rules 601 and 603)
    This FRFA has been prepared in accordance with the Regulatory 
Flexibility Act.\904\ This FRFA relates to Exchange Act Rules 11Aa3-1 
and 11Ac1-2 (redesignated as Rules 601 and 603).
---------------------------------------------------------------------------

    \904\ 5 U.S.C. 604.
---------------------------------------------------------------------------

a. Need for and Objectives of Rules 601 and 603
    The Commission believes that an overall modernization of the rules 
for disseminating market data to the public is necessary to address 
problems posed by the current market data rules. In adopting Rules 601 
and 603 as reproposed, the Commission retains the core elements of the 
existing rules--price discovery and mandatory consolidation--which 
provide important benefits to investors and to others who use market 
information, but amends other parts of the existing rules that have 
resulted in serious economic and regulatory distortions. More 
specifically, adopted Rules 601 and 603 reduce the burden on, and 
provide simplification and uniformity for, those market centers, 
broker-dealers, and data vendors that have to comply with requirements 
under the Rules.
    Adopted Rules 601 and 603 are designed to fulfill several 
objectives, including: (1) Providing market centers, including ATSs and 
market makers, with flexibility to independently distribute their own 
trade reports, aside from their obligation to provide their trade 
reports and best quotations to an SRO or to the Networks (depending on 
the type of market center); (2) providing uniform standards for all 
market centers, including non-SRO market centers and entities that are 
exclusive processors of SRO market data, for the independent 
distribution of market data; (3) providing that all SROs act jointly 
through the Plans and disseminate their consolidated information 
through a single processor, to clarify the practice among the SROs and 
to require continued participation in the Plans and dissemination 
through one processor per security; (4) reducing consolidated display 
requirements on broker-dealers and vendors and limiting their 
consolidated display obligations to the disclosure of the NBBO and 
consolidated last sale information and to the display of market 
information in a trading or order-routing context; and (5) easing the 
burden of compliance by simplifying the current consolidated display 
requirements under the Rule and by rescinding old provisions in the 
Rule that are outdated and no longer necessary.
b. Significant Issues Raised by Public Comment
    The IRFA appeared in the Proposing Release and in the Reproposing 
Release.\905\ The Commission requested comment in the IRFA on the 
impact the proposals would have on small entities and how to quantify 
the impact. The Commission did not receive any comment letters 
addressing the IRFA.
---------------------------------------------------------------------------

    \905\ Proposing Release, 69 FR at 11190-91; Reproposing Release, 
69 FR 77495-96.
---------------------------------------------------------------------------

c. Small Entities Subject to the Rule
    Adopted Rules 601 and 603 affect ATSs, market makers, broker-
dealers, and SIPs that could potentially be small entities. Paragraph 
(c) of Rule 0-10

[[Page 37601]]

under the Exchange Act \906\ defines the term ``small business'' or 
``small organization,'' when referring to a broker-dealer, to mean a 
broker or dealer that had total capital of less than $500,000 on the 
date in the prior fiscal year as of which its audited financial 
statements were prepared, or, if not required to file such statements, 
that had total capital of less than $500,000 on the last business day 
of the preceding fiscal year; and is not affiliated with any person 
(other than a natural person) that is not a small business or small 
organization. ATSs and market makers would be considered broker-dealers 
for purposes of this definition. Paragraph (g) of Rule 0-10 \907\ 
defines the term ``small business'' or ``small organization,'' when 
referring to a SIP, to mean a SIP that had gross revenues of less than 
$10 million during the preceding fiscal year and provided service to 
fewer than 100 interrogation devices or moving tickers at all times 
during the preceding fiscal year; and is not affiliated with any person 
(other than a natural person) that is not a small business or small 
organization.
---------------------------------------------------------------------------

    \906\ 17 CFR 240.0-10(c).
    \907\ 17 CFR 240.0-10(g).
---------------------------------------------------------------------------

    In the IRFA included in the Reproposing Release, the Commission 
estimated that, as of December 31, 2003, there were approximately 905 
registered broker-dealers, including ATSs and market makers that would 
be considered small entities. In addition, approximately 16 SIPs would 
be considered small entities. In the Proposing Release and in the 
Reproposing Release, the Commission requested comment on the number of 
small entities that would be impacted by adopted Rules 601 and 603, 
including any available empirical data. No commenters responded with 
cost estimates pertaining to the requested data listed above. Adopted 
Rule 601 enables small market centers, including ATSs and market 
makers, that contribute to consolidated information, if they so choose, 
to also independently distribute their own trade reports. Adopted Rule 
603 reduces the compliance burden on small broker-dealers and SIPs by 
limiting the data required to be displayed under the Rule.\908\
---------------------------------------------------------------------------

    \908\ Adopted Rule 603, providing that all SROs act jointly 
through the Plans and disseminate their consolidated information 
through a single processor, would only apply to the SROs, which are 
not ``small entities'' for purposes of the Regulatory Flexibility 
Act.
---------------------------------------------------------------------------

d. Reporting, Recordkeeping and Other Compliance Requirements
    Adopted Rules 601 and 603 do not impose any new reporting, 
recordkeeping or other compliance requirements on ATSs, market makers, 
broker-dealers, and SIPs that are small entities. SROs that would be 
subject to these proposed amendments are not considered small 
entities.\909\
---------------------------------------------------------------------------

    \909\ See supra, section XI.C.3.a.
---------------------------------------------------------------------------

e. Agency Action To Minimize Effects on Small Entities
    As required by the Regulatory Flexibility Act, the Commission has 
considered alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. As 
discussed in the Proposing Release and in the Reproposing Release, the 
Commission has considered the following alternative models for 
disseminating market data to the public: (1) A competing consolidators 
model under which each SRO would be allowed to sell its market data 
separately to any number of consolidators; (2) a rescission of the 
consolidated display requirement and allowing all SROs and other market 
centers to distribute their market data individually; and (3) a hybrid 
model that would retain the consolidated display requirement and 
existing Networks solely for the dissemination of the NBBO, but allow 
the SROs to distribute their own quotations and trades independently 
and without a consolidated display requirement.
    The primary goal of the adopted amendments to Rules 11Aa3-1 and 
11Ac1-2 (redesignated as Rules 601 and 603) is to retain the benefits 
of the consolidated display requirement, which provides a uniform, 
consolidated stream of data and is the single most important tool for 
unifying all of the market centers trading NMS Stocks, while providing 
market centers that contribute to consolidated information with the 
ability to independently distribute their own market data and reducing 
the consolidated display requirements on broker-dealers and SIPs. As 
stated in the Proposing Release and in the Reproposing Release and in 
Section V.A.1 above, the Commission believes that these potential 
alternative models pose an unacceptable risk of losing important 
benefits that investors and other information users receive under the 
current system--an affordable and highly reliable stream of quotations 
and trades that is consolidated from all significant market centers 
trading an NMS Stock.
    The Commission believes that different compliance or reporting 
requirements for small entities, and further clarification, 
consolidation, or simplification of Rules 601 and 603, is not necessary 
because adopted Rules 601 and 603 do not establish any new reporting, 
recordkeeping or other compliance requirements for small entities and, 
in fact, adopted Rule 603 should reduce the compliance burden on small 
broker-dealers and SIPs by limiting the data required to be 
consolidated and displayed under the Rule. The Commission also notes 
that the amendments contain performance standards and do not dictate 
for entities of any size any particular design standards (e.g., 
technology) that must be employed to achieve the objectives of the 
adopted amendments.

E. Regulation NMS

    The Commission certified, pursuant to Section 605(b) of the 
Regulatory Flexibility Act, that Rule 600 and the redesignation of the 
NMS rules as Regulation NMS will not have a significant economic impact 
on a substantial number of small entities.\910\ This certification was 
incorporated into the Reproposing Release.\911\ The Commission did not 
receive any comments on this certification.
---------------------------------------------------------------------------

    \910\ 5 U.S.C. 605(b).
    \911\ Reproposing Release, 69 FR at 77496.
---------------------------------------------------------------------------

XII. Response to Dissent

    The Commission has added this section to its release to respond 
directly to the dissent's claims that the Commission's ``statutory 
interpretations and policy changes are arbitrary, unreasonable and 
anticompetitive'' and that they are ``not supported by substantial 
evidence that, notwithstanding their anti-competitive effect, they are 
necessary or appropriate to further the purposes of the Exchange Act.'' 
\912\ Previous sections of this release discuss in greater detail the 
basis of the Commission's decision to adopt Regulation NMS. By 
modernizing and strengthening the regulatory structure of the U.S. 
equity markets, Regulation NMS will protect investors, promote fair 
competition, and enhance market efficiency. Because the dissent appears 
to have misconstrued a number of the Commission's policy positions and 
the reasoning underlying them, we are including this section to clarify 
the record.
---------------------------------------------------------------------------

    \912\ Dissent of Commissioners Cynthia A. Glassman and Paul S. 
Atkins to the Adoption of Regulation NMS (``Dissent''), 
Introduction.
---------------------------------------------------------------------------

    We understand that reasonable minds can disagree with the policy 
decisions reflected in Regulation NMS. In light of

[[Page 37602]]

the substantial record, however, the Commission rejects any assertion 
that this rulemaking is arbitrary, unreasonable, anticompetitive, or 
otherwise outside the agency's authority. In making this claim, the 
dissent appears to ignore the clear statutory authority for the 
Commission's action, the many public comments strongly supporting the 
adoption of Regulation NMS, and the extensive and comprehensive 
rulemaking process undertaken by the Commission. As discussed below, 
the drafters of the Exchange Act itself repeatedly affirmed the basic 
principles that underlie Regulation NMS. In particular, they 
specifically contemplated and endorsed the Commission's authority to 
adopt an intermarket price protection rule.\913\ In addition, the 
comments supporting Regulation NMS were submitted by a broad spectrum 
of investors, listed companies, academics, market centers, and other 
market participants, many of which have extensive experience and 
expertise regarding the inner workings of the equity markets.\914\
---------------------------------------------------------------------------

    \913\ See infra, notes 920-922 and accompanying text.
    \914\ See supra, notes 56-59 and accompanying text; infra, notes 
939-941, 957-960, and accompanying text.
---------------------------------------------------------------------------

    Moreover, Regulation NMS is the culmination of a long and open 
process that included the original proposals, a public hearing, a 
supplemental request for comment, the reproposals, eight in-depth 
analyses of relevant trading data, and more than 2000 public comments. 
The issues raised by Regulation NMS undoubtedly are multifaceted. 
Reaching decisions in this complex area requires an understanding of 
the relevant facts and of the often subtle ways in which the markets 
work, and the balancing of policy objectives that sometimes may not 
point in precisely the same direction. Perhaps not surprisingly, there 
continue to be differences of opinion, even after this long process, 
among Commissioners, investors, market participants, and the public in 
general concerning the most appropriate future regulatory structure for 
the U.S. equity markets.
    In sum, the Regulation NMS rulemaking process has required the 
Commission to grapple with many difficult and contentious issues that 
have lingered unresolved for many years. The Commission has devoted a 
great deal of effort to studying these issues, assessing the views of 
all commenters, and modifying its proposals to respond appropriately to 
their comments. Indeed, this release discusses at length our response 
to commenters, particularly those that disagree with the proposals. 
However, decisions must be made and contentious issues must be resolved 
so that the markets can move forward with certainty concerning their 
future regulatory environment and appropriately respond to fundamental 
economic and competitive forces. The Commission always seeks to achieve 
a consensus, but when positions have become entrenched after many years 
of study and debate, waiting for consensus can mean indefinite gridlock 
that ultimately could damage the competitiveness of the U.S. equity 
markets, both at home and internationally. The Commission believes that 
further delay is not warranted and that the time has come to make the 
difficult decisions necessary to modernize and strengthen the national 
market system.

A. Statutory Authority for Order Protection Rule

    The dissent suggests that the Commission is exceeding its authority 
by attempting to impose an ``optimal market structure.'' \915\ This 
claim misconstrues the nature and impact of the Order Protection Rule 
and ignores the clear mandate provided to the Commission by Congress in 
Section 11A(a)(2) of the Exchange Act to facilitate the establishment 
of a national market system. Regulation NMS does not dictate any 
particular structure for the markets; rather, it establishes basic 
``rules-of-the-road'' for all markets that will promote competition on 
terms that benefit investors. In particular, competition will be guided 
by three basic principles--price transparency, open access, and best 
price. As a result, all investors will be able to ascertain the best 
prices for NMS stocks, obtain fair and non-discriminatory access to the 
markets displaying such prices, and have assurance that their orders 
will be executed at the best prices that are immediately and 
automatically accessible. Within this regulatory framework of 
transparency, access, and best price, competitive forces will determine 
the optimal market structure.
---------------------------------------------------------------------------

    \915\ Dissent, text accompanying note 27.
---------------------------------------------------------------------------

1. Intermarket Price Protection Rule
    The dissent cites a selected few passages from the legislative 
history of the 1975 Amendments \916\ to the Exchange Act as support for 
the claim that an intermarket price protection rule is inconsistent 
with the Exchange Act.\917\ A more complete review of the legislative 
history, however, makes it clear that the Order Protection Rule is 
squarely consistent with the policy determinations made by Congress in 
1975--indeed, it may be the dissent's disagreement with those 
Congressional policy determinations that explains its opposition to the 
Order Protection Rule. In particular, the national market system is 
premised on promoting fair competition among individual markets, while 
at the same time assuring that these markets are linked together in a 
unified system that promotes competition among the orders of buyers and 
sellers in individual NMS stocks. The most succinct statement of order 
competition is found in the House Report on the 1975 Amendments: 
``Investors must be assured that they are participants in a system 
which maximizes the opportunities for the most willing seller to meet 
the most willing buyer.'' \918\ This Congressional mandate for the 
national market system is not achieved when trades occur at prices 
inferior to the best quotations that are immediately and automatically 
accessible.
---------------------------------------------------------------------------

    \916\ Pub. L. No. 94-29, 89 Stat. 97 (1975).
    \917\ See, e.g., Dissent, notes 3-5, 51-52.
    \918\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975) (``House 
Report'').
---------------------------------------------------------------------------

    The dissent appears to focus on the NMS objective of fair 
competition among markets, without giving appropriate weight to the 
important Congressional objective of integrating markets into a system 
that promotes order interaction and the best execution of investor 
orders.\919\ The House Report gives the following overview of the 
``goals and principles to serve as a guide'' to the Commission that 
specifically endorses price protection for investor orders:
---------------------------------------------------------------------------

    \919\ See supra, section I.B (discussion of NMS principles and 
objectives).

    Briefly stated, these embrace the principles of competition in 
which all buying and selling interests are able to participate and 
be represented. The objective is to enhance competition and to allow 
economic forces, interacting within a fair regulatory field, to 
arrive at appropriate variations of practices and services. Neither 
the markets themselves nor the broker-dealer participant in these 
markets should be forced into a single mold. Market centers should 
compete and evolve according to their own natural genius and all 
actions to compel uniformity must be measured and justified as 
necessary to accomplish the salient purposes of the Securities 
Exchange Act, assure the maintenance of fair and orderly markets and 
to provide price protection for the orders of investors.\920\
---------------------------------------------------------------------------

    \920\ House Report at 51.

The establishment of a ``fair regulatory field'' that will ``provide 
price protection for the orders of investors'' is

[[Page 37603]]

precisely what the Order Protection Rule is designed to do.
    Similarly, the Senate Report on the 1975 Amendments emphasizes both 
competition among markets and integration of those markets into a 
unified system:

    S. 249 would lay the foundation for a new and more competitive 
market system, vesting in the SEC power to eliminate all unnecessary 
or inappropriate burdens on competition while at the same time 
granting to that agency complete and effective powers to pursue the 
goal to centralized trading of securities in the interest of both 
efficiency and investor protection.\921\
---------------------------------------------------------------------------

    \921\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 2 (1975) 
(``Senate Report'').

    By ``centralized trading,'' the Senate Report did not mean a single 
market, but rather NMS rules and facilities that link the markets into 
a unified system to assure best execution of investor orders--the 
approach incorporated in Regulation NMS. For example, the Senate Report 
---------------------------------------------------------------------------
specifically addresses the importance of intermarket price protection:

    [A] limited price order is presently ``protected'' as to price 
priority on the exchange on which it is held but it is not protected 
in any way [with] respect to trading on another exchange or in the 
third market. As a consequence, a limit order for a listed security 
held in only one of several markets for that security need not be 
executed before a transaction is effected at the same price or at a 
price less favorable to the other party in another market. In the 
Committee's view this is the basic problem caused by fragmentation 
of the securities markets: the lack of a mechanism by which all 
buying and selling interest in a given security can be centralized 
and thus assure public investors best execution.\922\
---------------------------------------------------------------------------

    \922\ Senate Report at 17.

    Consequently, the Commission's challenge in meeting its NMS 
responsibilities is to promote both competition among markets and 
competition among orders, as well as to assure a regulatory structure 
that is workable and minimizes regulatory costs. Notably, Congress 
chose not to mandate any particular NMS rules in order to give the 
Commission greater flexibility to use its expertise in achieving NMS 
---------------------------------------------------------------------------
objectives:

    The Committee considered mandating certain minimum components of 
the national market system but rejected this approach. The nation's 
securities markets are in dynamic change and in some respects are 
delicate mechanisms; the sounder approach appeared to the Committee, 
therefore, to be to establish a statutory scheme clearly granting 
the Commission broad authority to oversee the implementation, 
operation, and regulation of the national market system and at the 
same time to charging it with the clear responsibility to assure 
that the system develops and operates in accordance with 
Congressionally determined goals and objectives. Section 11A(a) and 
11A(c), taken together, would establish such an arrangement.\923\
---------------------------------------------------------------------------

    \923\ Senate Report at 8-9. See also H.R. Rep. No. 94-229, 94th 
Cong., 1st Sess. 92 (1975) (``Conference Report'') (adopting Senate 
approach to ``provide maximum flexibility to the Commission and the 
securities industry in giving specific content to the general 
concept of the national market system'').

    Although the dissent may disagree with the policy of an intermarket 
price protection rule, there is no basis for the claim that Regulation 
NMS is at odds with the Commission's statutory mandate to facilitate 
the establishment of a national market system.
2. Long-Term Investors
    The dissent questions the Commission's authority to give precedence 
to the interests of long-term investors in those limited contexts where 
their interests conflict with the interests of short-term traders.\924\ 
As is discussed elsewhere in this release,\925\ the interests of long-
term investors and short-term traders in fair and efficient markets 
coincide most of the time. In those few contexts where the interests of 
long-term investors directly conflict with short-term trading 
strategies, we believe that, in implementing regulatory structure 
reform, the Commission has both the authority and the responsibility to 
further the interests of long-term investors, and that the record 
provides substantial support for the Commission's determination to 
further their interests.
---------------------------------------------------------------------------

    \924\ Dissent, section IV. Many short-term trading strategies 
are conducted by registered broker-dealers, such as specialists and 
market makers. Despite the dissent's repeated references in section 
IV to both short-term investors and market intermediaries, we do not 
believe the dissent means to suggest that the Commission lacks 
authority under the Exchange Act to give precedence to the interests 
of long-term investors over market intermediaries.
    \925\ Supra, section I.B.2.
---------------------------------------------------------------------------

    As discussed above, intermarket price protection will significantly 
benefit the more than 84 million individual investors in the U.S. 
equity markets by reducing their transaction costs and thereby 
enhancing their long-term investment returns.\926\ Price protection 
may, however, interfere to some extent with the extremely short-term 
trading strategies that can depend on millisecond response times from 
markets for orders taking displayed liquidity. It also may interfere 
with short-term trading strategies that benefit from volatile and 
illiquid markets. The dissent claims that the ``length of time an 
individual owns a stock is not a relevant factor in distinguishing 
among groups of investors'' and that the distinction between long-term 
investors and short-term traders is arbitrary and unreasonable.\927\ 
But in those limited contexts where the interests of long-term 
investors conflict with short-term trading strategies, the conflict 
cannot be reconciled by stating that the NMS should benefit all 
investors. In particular, failing to adopt a price protection rule 
because short-term trading strategies can be dependent on millisecond 
response times would be unreasonable in that it would elevate such 
strategies over the interests of millions of long-term investors--a 
result that would be directly contrary to the purposes of the Exchange 
Act.\928\
---------------------------------------------------------------------------

    \926\ See supra, text accompanying notes 25-26 (survey finding 
that more than 84 million individuals representing more than 50% of 
American households own equity securities, directly or indirectly, 
and that nearly all view their equity investments as savings for the 
long-term).
    \927\ Dissent, section IV.
    \928\ See, e.g., Exchange Act Section 11A(a)(1)(C) (``It is in 
the public interest and appropriate for the protection of investors 
and the maintenance of fair and orderly markets to assure,'' among 
other things, ``the economically efficient execution of securities 
transactions'' and ``the practicability of brokers executing 
investors' orders in the best market.'').
---------------------------------------------------------------------------

    As discussed earlier in this release,\929\ the legislative history 
of the Exchange Act from its adoption in 1934 emphasizes the 
Congressional concern to protect the interests of the many average 
investors who are not active traders or market intermediaries, but who 
depend on their equity investments, whether directly in corporate 
stocks or indirectly through their investment in mutual funds and 
retirement accounts, to meet their long-term financial goals. The 
dissent suggests that these statements of Congressional concern for 
millions of average investors were no longer relevant when Congress 
adopted the 1975 Amendments, but the legislative history of the 1975 
Amendments does not support this proposition.\930\
---------------------------------------------------------------------------

    \929\ Supra, section I.B.2.
    \930\ See, e.g., Conference Report at 91 (``The securities 
markets of the United States are an important national asset. Under 
the system of Federal regulation established in the 1930s, these 
markets have flourished. They have provided a means for millions of 
Americans to share in the profits of our free enterprise system and 
have facilitated the raising of capital by new and growing 
businesses.'').
---------------------------------------------------------------------------

    The dissent also argues that short-term traders often provide 
liquidity to the market and thereby benefit long-term investors. The 
Commission certainly agrees with this statement as a general matter, 
but believes that, in the specific context of an intermarket price 
protection rule, directly promoting the display of limit orders, which 
directly

[[Page 37604]]

provide liquidity to the market, rather than promoting short-term 
trading strategies that require millisecond response times for orders 
that take displayed liquidity, is the most appropriate approach to 
protect investors and enhance market efficiency. Many commenters agreed 
with this policy decision. For example, T. Rowe Price stated that ``we 
do not believe that speed of access considerations should drive market 
structure issues if to do so would jeopardize legitimate market linkage 
initiatives. Connected markets provide the opportunity for information 
gathering, block trading, and improved price discovery, as well as the 
legitimacy of the `last-sale' price. While speed of access and 
execution are crucial, there is a limit to how fast such linkages need 
to be in order to protect and enhance our markets.'' \931\ Similarly, 
the Committee on Investment of Employee Benefit Assets, which 
represents 110 of the nation's largest corporate retirement funds 
managing $1.1 trillion on behalf of 15 million plan participants and 
beneficiaries, stated that ``it is unclear with the advance of 
automation why we would need or should allow anything other than the 
best price requirement for investors. Our constituency is concerned 
with long-term growth and market stability and the ability to opt-out 
[of the best price requirement] could place long-term investors at a 
disadvantage.'' \932\ Finally, the National Association of Investors 
Corporation emphasized that ``[m]ake no mistake, the best price best 
serves investors. It is part of the value equation when buying and 
selling stock. Please keep in mind that individual investors are long-
term investors and price is of utmost importance to them.'' \933\ 
Although the dissent may disagree with the policy views of these 
commenters on the best means to protect investors and to promote market 
integrity and liquidity, it does not provide a basis for concluding 
that the commenters' views, which the Commission shares, are arbitrary 
or unreasonable.
---------------------------------------------------------------------------

    \931\ T. Rowe Price Reproposal Letter at 2.
    \932\ Letter from Gary A. Glynn, Chairman, Committee on 
Investment of Employee Benefit Assets, to Jonathan G. Katz, 
Secretary, Commission, dated June 24, 2004 (``CIEBA Letter'') at 1.
    \933\ Letter from Kenneth S. Janke, Chairman, National 
Association of Investors Corporation, to Jonathan G. Katz, 
Secretary, Commission, dated June 24, 2004 (``NAIC Letter'') at 1.
---------------------------------------------------------------------------

B. Basis for Adoption of Order Protection Rule

    A prior section of this release discusses at length the 
Commission's basis for adopting the Order Protection Rule.\934\ This 
section responds to certain specific claims made in the dissent where 
the dissent appears to have misconstrued the Commission's decision-
making process and conclusions, and highlights the critical policy 
issues on which the views expressed in the dissent simply conflict with 
the considered views of the Commission and many commenters.
---------------------------------------------------------------------------

    \934\ Supra, section II.A.
---------------------------------------------------------------------------

    The dissent asserts that the Commission's objectives for the Order 
Protection Rule have been ``a moving target, morphing from the 
protection of limit orders, to the need to increase market depth and 
liquidity, to the reduction of transaction costs for long-term 
investors and issuers.'' \935\ In fact, the Commission's objectives 
have remained consistent throughout the NMS rulemaking.\936\ While 
certain details in the original proposal have been modified to respond 
appropriately to public comment, the policies underlying the Rule as 
proposed, reproposed, and adopted have remained the same. Indeed, the 
dissent seems not to appreciate that the ``moving targets'' it 
identifies--the objectives of protecting limit orders, increasing 
market depth and liquidity, and reducing investor transaction costs--
are all quite closely inter-related. As the Commission has explained 
quite consistently in this release and in the proposing releases, 
protecting limit orders contributes to market depth, which in turn 
reduces investor transaction costs. In addition, the Commission has 
consistently emphasized that intermarket price protection will promote 
the best execution of investor orders and fair and orderly 
markets.\937\
---------------------------------------------------------------------------

    \935\ Dissent, section I. The dissent asserts that the 
Commission has sought to reduce transaction costs for issuers. 
Stated more accurately, the Commission has sought to reduce 
transaction costs for investors, which would thereby help reduce the 
cost of capital for the listed companies in which they invest. See 
supra, note 15 and accompanying text.
    \936\ For example, the Proposing Release emphasized that one of 
the three overarching objectives of the proposals was to ``promote 
greater order interaction and displayed depth,'' thereby reducing 
the price impact costs of large, institutional investors. Proposing 
Release, 69 FR at 11129.
    \937\ Id. at 11132.
---------------------------------------------------------------------------

1. Investor Protection
    As discussed previously in this release,\938\ the Commission 
believes that the Order Protection Rule is needed to strengthen the 
protection of investors in the U.S. equity markets. Many commenters 
agreed with the Commission on the need for strengthened price 
protection to protect investors. For example, the Consumer Federation 
of America believed that ``the brokers'' duty of best execution is 
simply too vague to serve as an effective deterrent to abuse. It is too 
vague for the broker to know with certainty that it has satisfied its 
best execution obligation and too vague to be enforced consistently and 
effectively. In fact, one of the real benefits of the proposed trade-
through rule is that it has the potential to simplify compliance with 
best execution rules.'' \939\ The Committee on Investment of Employee 
Benefit Assets also recognized the vital importance of maintaining 
equity markets in which all investors can participate with confidence: 
``[I]n light of the scandals in the securities and mutual fund 
industries, our first priority should be to restore investor confidence 
in our capital markets. To allow trading to take place outside of the 
best price will continue to raise questions of fairness and could 
diminish investor confidence.'' \940\ Other commenters shared these 
concerns about the impact of trade-throughs on investor confidence in 
the fairness of the U.S. equity markets.\941\
---------------------------------------------------------------------------

    \938\ See supra, section II.A.1.
    \939\ Consumer Federation Letter at 4.
    \940\ CIEBA Letter at 2.
    \941\ See, e.g., BSE Reproposal Letter at 2 (``The Exchange 
believes that the reproposed Trade-Through Rule is critical to the 
protection of customer limit orders through `protected quotes' for 
all securities.* * * Minimum investor protection principles should 
not be bifurcated on the basis of whether a security trades in 
either a listed or NASDAQ environment.''); Letter from James W. 
Vitalone, Chair, U.S. Advocacy Committee, and Linda L. Rittenhouse, 
CFA Institute--Advocacy, to Jonathan G. Katz, Secretary, Commission, 
dated Sep. 22, 2004 (``CFA Institute Letter'') at 1 (``We believe 
that the current way of doing business has become a system permeated 
with trading practices that often obfuscate the manner in which best 
price is determined or how some limit orders are filled. Thus, we 
strongly support and urge reforms that will bring uniformity and 
transparency to the current system, ultimately leveling the playing 
field as much as possible among market participants. To this end, we 
support a trade-through rule that applies to all securities.''); 
Letter from Lawrence E. Harris, Marshall School of Business, 
University of Southern California, to Jonathan G. Katz, Secretary, 
Commission, dated Feb. 5, 2005 (``Harris Reproposal Letter'') at 7 
(``The proposed trade-through rule would prevent exchanges from 
trading through exposed electronically accessible orders at another 
exchange. In principle, such rules should not be necessary because 
traders generally will access liquidity wherever it is cheapest. In 
practice, dealers, brokers, and exchanges sometimes do trade through 
other orders since it is generally in their self-interest to control 
an execution rather than share it. Accordingly, the primary benefit 
of the proposed trade-through regulation will be to promote investor 
protection.''); NAIC Letter at 1 (``Having confidence that one is 
receiving the best price in stock transactions contributes greatly 
to the confidence that investors have in the fairness and integrity 
of the marketplace.''); Phlx Reproposal Letter at 1 (``Phlx believes 
that intermarket protection of firm and accessible quotes is not 
only necessary, but should foster a more efficient marketplace, 
which is consistent with protecting investors and the public 
interest.'').

---------------------------------------------------------------------------

[[Page 37605]]

    The dissent, however asserts that the Trade-Through Study prepared 
by Commission staff to estimate trade-through rates does not 
substantiate investor protection concerns.\942\ The dissent further 
suggests that the Commission has ``cherry-picked'' statistics that 
support its position, while ignoring, or even failing to disclose, 
statistics that do not support its position.\943\ While the Commission 
believes that the total number of trade-throughs should not be the sole 
consideration in making its policy choices, an earlier section of this 
release discusses in detail the data demonstrating the significance of 
trade-through rates found in the Study,\944\ and that discussion makes 
clear that the Commission has not ignored or failed to disclose the 
findings of the Trade-Through Study. Indeed, at the time the 
Reproposing Release was published, the Study was placed in the public 
file specifically to assure that all commenters had a full opportunity 
to evaluate its data and methodologies.
---------------------------------------------------------------------------

    \942\ The Trade-Through Study is described in note 66 above.
    \943\ Dissent, section II.A.
    \944\ Supra, section II.A.1.a.ii. As discussed above, different 
measures of trade-through rates are relevant for assessing the 
extent to which the Order Protection Rule is needed to achieve the 
objectives of best execution of market orders, fair and orderly 
treatment of limit orders, and greater depth and liquidity for NMS 
stocks, respectively.
---------------------------------------------------------------------------

    The Study used a variety of calculation methodologies that 
generated many different statistics on trade-through rates, but 
summarized its findings as follows: ``Depending on the methodology 
applied, the overall trade-through rate ranged from 2% to 10% of trades 
and from 2% to 13% of share volume. Using the more conservative of 
these methods, we estimate that 2% to 3% of all trades and 2% to 8% of 
all share volume are trade-throughs.'' \945\ The Reproposing Release 
explained why the Commission believed that the most relevant measure is 
2.5% of total trades, representing more than 7% of total share volume, 
that trade through the best displayed prices. The Reproposing Release 
also explained the deficiency of the dissent's preferred measure--the 
displayed size of quotations that are traded through. This measure 
primarily reflects the current shortage of displayed size, which is a 
symptom of one of the primary problems that the Order Protection Rule 
is designed to address.\946\ It therefore is not a useful means to 
assess the potential upside of strengthened price protection.
---------------------------------------------------------------------------

    \945\ Trade-Through Study at 1 (emphasis in original).
    \946\ Reproposing Release, 69 FR at 77443.
---------------------------------------------------------------------------

    The dissent also asserts that the Trade-Through Study did not 
indicate ``that investors are not obtaining best execution, that their 
orders are being unfairly treated, or that investors are otherwise 
suffering economic harm.'' \947\ The Study, however, found that 2.5% of 
trades in Nasdaq stocks do not receive the best prices that are 
immediately and electronically accessible and that the average amount 
by which such trades miss the best prices is 2.3 cents per share.\948\ 
In addition, Nasdaq submitted statistics with its comment letter on the 
reproposal indicating that the trade-through rate for dealers that 
internalize customer orders in Nasdaq stocks was 3.2% in 2003. The 
dissent attempts to minimize the seriousness of these statistics on a 
variety of grounds, but it concedes that the trade-through rate for 
customers in Nasdaq stocks was between 1% and 2% in 2004 and states 
that ``these numbers speak for themselves'' that customers are not 
being treated unfairly.\949\
---------------------------------------------------------------------------

    \947\ Dissent, section II.A.
    \948\ Trade-Through Study at 3.
    \949\ Dissent, text following note 47.
---------------------------------------------------------------------------

    Even if the Commission accepted the dissent's focus on a limited 
portion of the rulemaking record, we strongly believe that the evidence 
contained in this record would raise serious investor protection 
concerns. Because of the enormous volume of trading in the U.S. equity 
markets, even small percentages can translate into significant harm to 
investors. For example, even a 1.5% trade-through rate for customers in 
Nasdaq stocks in 2004 would mean that 14.3 million customer orders 
received a price that was inferior to an immediately and automatically 
accessible quotation.\950\ Because of the difficulties faced by retail 
investors in monitoring whether their orders receive the best prices, 
it is likely that a great many of these customers were not aware that 
they in fact received an inferior price for their order.\951\ We 
suspect that the millions of customers who received inferior prices, 
had they known, would believe that they had been treated unfairly.
---------------------------------------------------------------------------

    \950\ More than 955 million trades were reported in 2004 by the 
consolidated market data network for Nasdaq stocks.
    \951\ The difficulties faced by retail investors in monitoring 
the execution quality of their market orders are discussed further 
above in the text accompanying note 53.
---------------------------------------------------------------------------

    Moreover, the dissent does not appear to take into account the 
practical difficulties faced by retail customers in monitoring and 
obtaining best execution of their orders. Such difficulties vary 
depending on the type of order. As discussed previously in this 
release,\952\ retail customers who submit market and marketable limit 
orders seeking the best available market price generally can ascertain 
the best quotations at the time they submit their orders, but 
quotations can change rapidly, thereby making it quite difficult for 
customers to know whether their orders were in fact executed at the 
best quotations at the time of order execution.\953\ In contrast, 
retail customers who display non-marketable limit orders at the best 
prices can readily see when their orders are traded through--the 
inferior trade prices will be disseminated in the consolidated trade 
stream.\954\ These customers legitimately may feel that their orders 
have not been treated in a fair and orderly fashion. By establishing 
strong intermarket price protection, the Order Protection Rule will 
benefit investors who use both types of orders. It will promote the 
execution of investor market orders at the best prices on an order-by-
order basis,\955\ as well as protect displayed limit orders, no matter 
how small or large their displayed size, from trade throughs. In both 
contexts, the Rule will significantly enhance the protection of 
investors in all NMS stocks.
---------------------------------------------------------------------------

    \952\ See supra, text accompanying note 53. See also J.P. Morgan 
Reproposal Letter at 3 (``[P]rincipal agent conflicts can lead to 
less than best execution, particularly for retail investors who may 
not have the sophistication or resources to assess the quality of 
the trades provided by their agents. By prohibiting the execution of 
orders at prices inferior to those displayed, a trade-through rule 
can therefore help provide protection to limit orders and further 
encourage their use.'')
    \953\ Cf. Dissent, note 42 (``the majority fails to acknowledge 
that retail investors have access to consolidated information that 
allows them to monitor their executions'').
    \954\ Cf. Dissent, note 44 (questioning the basis for the 
Commission's assertion that retail investors are not given a level 
playing field when their displayed limit orders are bypassed by 
large, block trades and stating that the assertion is ``also 
inconsistent with the majority's previous assertion that investors 
have difficulty monitoring execution quality'').
    \955\ See supra, notes 341-344 and accompanying text (duty of 
best execution not interpreted as requiring order-by-order routing 
by brokers with large volume of customer orders).
---------------------------------------------------------------------------

2. Improved Depth and Liquidity in Nasdaq Stocks
    The dissent asserts that there is no evidence of a need for greater 
depth in Nasdaq stocks that would warrant application of the Order 
Protection Rule.\956\ In making this assertion, the

[[Page 37606]]

dissent does not address the views of many commenters that intermarket 
price protection is needed to improve depth and liquidity in all NMS 
stocks, including those listed on Nasdaq. For example, the Investment 
Company Institute, whose members account for more than 95% of all U.S. 
mutual fund assets, noted that ``[b]y affirming the principle of price 
priority, a trade-through rule should encourage the display of limit 
orders, which in turn would improve the price discovery process and 
contribute to increased market depth and liquidity.'' \957\ It 
therefore ``strongly recommend[ed] that the Commission adopt a uniform 
trade-through rule that applies across all market centers and to all 
types of securities, including Nasdaq-listed securities.'' \958\ 
Similarly, the Bank of New York stated that ``[w]e agree with the 
Commission that a uniform trade-through rule would encourage the use of 
displayed limit orders and aggressive quotation. In the market for 
Nasdaq securities, for example, many investors are reluctant to show 
their full trading interest for fear of having others use that 
information to their detriment. A uniform trade-through rule would 
incentivize these investors to display their interest, knowing their 
order must be filled before the next-priced order. Accordingly, a well-
formulated trade-through rule will promote transparency and liquidity 
in the national market system.'' \959\ Many other commenters similarly 
believed that an intermarket price protection rule is needed to promote 
market depth and liquidity in all NMS stocks.\960\
---------------------------------------------------------------------------

    \956\ Dissent, section II.B. The dissenters imply that a need 
for greater depth was the only basis relied on by the Commission for 
applying the Order Protection Rule to Nasdaq stocks. Dissent, text 
accompanying note 52. As discussed in the preceding section, the 
Commission believes that enhancing investor protection, particularly 
for retail investors, is a compelling reason to apply the Order 
Protection Rule consistently across all NMS stocks.
    \957\ ICI Reproposal Letter at 2.
    \958\ Id. at 3.
    \959\ BNY Letter at 2.
    \960\ See, e.g., American Century Letter at 2 (``[W]e support 
the establishment of a uniform trade-through rule for all securities 
across all market centers within the National Market System.''); 
Letter from Yakov Amihud, New York University, and Haim Mendelson, 
Stanford University, to Jonathan G. Katz, Secretary, Commission, 
dated Jan. 25, 2005 (``Amihud/Mendelson Reproposal Letter''), 
Attachment at 14 (``The BBO Alternative is most potent in protecting 
the interests of small, uninformed investors. This will induce their 
participation in the stock market and thus will make the market more 
liquid.''); Capital Research Letter at 2 (``We believe providing 
price protection will create an incentive for buyers and sellers to 
display their intentions. This will generate a more accurate 
reflection of true supply and demand, which will enhance price 
discovery. We also believe that this will lead to an increased use 
of limit orders outside the best bid and offer which will increase 
depth in the market and dampen volatility. For this reason we favor 
a trade-through rule.''); Consumer Federation Letter at 2 (``The 
lack of a trade-through rule in the Nasdaq market has unquestionably 
contributed significantly to fragmentation in that market, by 
allowing practices such as internalization and payment for order 
flow that prevent substantial pockets of orders from interacting 
with the broader market while leaving limit orders that set the best 
price unfilled * * *. [W]e believe a universal trade-through rule 
will not only benefit the investors who have their limit orders 
filled as a result, but also will benefit the market as a whole, 
through increased liquidity, improved price discovery, and tighter 
spreads.''); Deutsche Bank Reproposal Letter at 1-2 (``DBSI agrees 
with the Commission that limit orders are critically important to 
our markets, and we believe that readily accessible limit orders 
should be protected. In our view, protection means that the first 
mover who commits to offer liquidity at a particular price point 
should be rewarded with the assurance that others in the marketplace 
cannot overlook that price and trade at an inferior price.''); 
Global Electronic Trading Company Reproposal Letter at 2 (``The BBO 
Alternative and electronic efficiencies will have a positive impact 
on the economy by increasing market efficiency and, thereby, 
GDP.''); Interactive Brokers Group Reproposal Letter at 1 (``We 
strongly support adoption of proposed Regulation NMS, which is a 
common sense and long-overdue update of the national market system 
rules in light of the major technological changes that have taken 
place in the equity markets in the last three decades.''); Vanguard 
Reproposal Letter (``We agree with the Commission that an 
intermarket trade-through rule should be applied to Nasdaq stocks to 
strengthen price protection.''); Weaver Reproposal Letter (``I also 
urge the commission to extend the rule to NASDAQ stocks. Clearly 
establishing price as the primary priority rule in markets will 
encourage the submission of limit orders, leading to lower execution 
costs for investors, and consequently lowering the cost of capital 
for traded firms.'').
---------------------------------------------------------------------------

    In addition to not addressing the views of commenters, the dissent 
does not refute the significance of data analyses prepared by 
Commission staff to assess the views of commenters that intermarket 
price protection is needed to promote depth and liquidity in Nasdaq 
stocks. First, the dissent does not mention the staff studies that 
found that short-term price volatility is significantly higher in 
Nasdaq stocks than in NYSE stocks.\961\ Excessive short-term price 
volatility indicates a need for greater depth and liquidity to dampen 
price fluctuations. Although acknowledging that the drafters of the 
1975 Amendments identified ``the maintenance of stable and orderly 
markets with maximum capacity for absorbing trading imbalances without 
undue price movements'' as one of the ``paramount'' objectives for the 
NMS,\962\ the dissent does not address the staff volatility analyses 
indicating the need to address price volatility in Nasdaq stocks.\963\
---------------------------------------------------------------------------

    \961\ The relevant studies are the Volatility Study and the 
Supplemental Volatility Study prepared by the Commission's Office of 
Economic Analysis, described in notes 143-144 above.
    \962\ Dissent, note 30 (quoting Senate Report on 1975 
Amendments).
    \963\ Dissent, section II.B. The dissenters also imply that 
minimizing price volatility and enhancing depth and liquidity are 
not encompassed within the five broad objectives for the NMS 
specified in Exchange Act Section 11A(a)(1)(C). Dissent, text 
accompanying notes 30, 50-52. In fact, both minimizing price 
volatility and enhancing depth and liquidity are essential elements 
for achieving the broad objective of assuring the ``economically 
efficient execution of securities transactions.'' Section 
11A(a)(1)(C)(i). Both elements help reduce investor transaction 
costs and thereby promote efficient trading. See Conference Report 
at 91-92 (``The basic goals of the Exchange Act remain salutatory 
and unchallenged: To provide fair and honest mechanisms for the 
pricing of securities, to assure that dealing in securities is fair 
and without under preferences or advantages among investors, to 
ensure that securities can be purchased and sold at economically 
efficient transaction costs, and to provide, to the maximum degree 
practicable, markets that are open and orderly.'') (emphasis added). 
The implicit costs associated with the prices at which transactions 
are executed represent one of the most significant elements of 
investor transaction costs. See supra, text accompanying notes 300-
302.
---------------------------------------------------------------------------

    Second, the dissent fails to appreciate the significance of staff 
studies examining fill rates and other order execution quality 
statistics for marketable limit orders in Nasdaq stocks.\964\ The 
dissent incorrectly interprets the Commission's evaluation of these 
studies as critical of the trading strategy of submitting ``pinging'' 
orders--orders with sizes greater than the displayed size of 
quotations.\965\ The Commission's evaluation of low fill rates in 
Nasdaq stocks is not a criticism of pinging orders. The use of pinging 
orders is a valid strategy for trading stocks on electronic markets and 
certainly will continue after implementation of the Order Protection 
Rule. Indeed, an important goal of the Rule is to improve the execution 
quality for such orders by increasing their fill rates and, thereby, 
the ability of investors to trade Nasdaq stocks in larger sizes. As 
discussed earlier in this release,\966\ the important consideration is 
not that fill rates in Nasdaq stocks are lower than fill rates in NYSE 
stocks. This difference likely is explained by broad structural 
differences unrelated to market efficiency. Rather, the problem is that 
fill rates, as well as the executed share volume, in Nasdaq stocks for 
orders with sizes ranging from 2,000 to 9,999 shares are very low in 
absolute terms (falling as low as 12% to 27%), even for many active 
stocks included in the Nasdaq-100 Index.\967\ The Commission believes 
that this data supports the views of commenters that intermarket price 
protection is needed

[[Page 37607]]

to promote greater depth and liquidity across the whole range of Nasdaq 
stocks.
---------------------------------------------------------------------------

    \964\ The relevant studies are the Matched Pairs Study, prepared 
by the Commission's Office of Economic Analysis, and the S&P Index 
Study and the Nasdaq-100 Index Supplemental Study, prepared by the 
Commission's Division of Market Regulation, described in notes 114 
and 137 above. The significance of marketable limit orders in the 
market for Nasdaq stocks is addressed at length elsewhere and will 
not be repeated here. See supra, text accompanying notes 121-123.
    \965\ Dissent, text accompanying notes 57-58.
    \966\ Supra, text accompanying notes 132-136.
    \967\ See supra, text accompanying notes 138-139.
---------------------------------------------------------------------------

3. Effectiveness of Order Protection Rule
    The dissent suggests that the Order Protection Rule will not meet 
its goals because some trade-throughs will continue even after 
implementation of the Rule. The dissent notes that the Rule contains 
exceptions for intermarket sweep orders, flickering quotations, trading 
centers that are experiencing a material delay, volume weighted average 
price (``VWAP'') orders, and stopped orders, and questions whether, 
given these exceptions, the Rule will lead to a significant reduction 
in trade-through rates.\968\
---------------------------------------------------------------------------

    \968\ Dissent, section III.A.
---------------------------------------------------------------------------

    The dissent fails to appreciate both the methodology of the staff 
study of trade-through rates and the operation of the Order Protection 
Rule. As explained at length earlier in this release,\969\ the staff 
used a conservative methodology in the Trade-Through Study that did not 
include trade-throughs attributable to intermarket sweep orders, 
flickering quotations, and VWAP trades in its calculation of trade-
through rates. Thus, given the consistency between the Study's 
methodology and the Rule's exceptions, the Commission believes that 
implementation of the Rule will lead to the elimination of the great 
majority of the types of trade-throughs found in the Trade-Through 
Study.\970\
---------------------------------------------------------------------------

    \969\ Supra, section II.A.1.a.
    \970\ See supra, notes 61-63 and accompanying text.
---------------------------------------------------------------------------

    Moreover, the exceptions in the Order Protection Rule are fully 
consistent with the principle of price protection. For example, to 
comply with the exemptions for intermarket sweep orders, VWAP orders, 
and stopped orders as a practical matter, market participants must 
trade with, rather than trade through, the displayed size of protected 
quotations.\971\ Intermarket sweep orders must, by definition, be 
routed to execute against the full displayed size of protected 
quotations, while the dealers that execute VWAP and stopped orders 
typically will execute trades in the public markets to establish the 
positions necessary to fill the orders. In addition, the exceptions for 
flickering quotations and trading centers experiencing a material delay 
are consistent with intermarket price protection because they are 
designed to exclude quotations that are not truly accessible. The 
existence of these exceptions, therefore, will not detract from the 
effectiveness of the Rule in strengthening price protection.
---------------------------------------------------------------------------

    \971\ See supra, notes 220-221, 249-257, and accompanying text.
---------------------------------------------------------------------------

    The dissent also states that the Order Protection Rule will not 
increase market depth and liquidity because the Rule does not provide 
what the dissent views as complete protection of limit orders.\972\ In 
particular, it points to the Commission's decision to protect only 
quotations that are the best bids and offers (``BBOs'') of markets, and 
to the ability of markets to match the best prices displayed in other 
markets. The Commission's reasons for protecting market BBOs are 
discussed in detail earlier in this release.\973\ The practice of price 
matching, by definition, does not cause investors to receive inferior 
prices or result in trade-throughs of displayed quotations. Most 
importantly, the dissent's assertion that the other approaches might 
have given greater protection to limit orders does not dispose of the 
relevant question, which is whether strengthening the current level of 
price protection for market BBOs will lead to greater depth and 
liquidity.\974\
---------------------------------------------------------------------------

    \972\ Dissent, section III.C.
    \973\ Supra, section II.A.5.
    \974\ See, e.g., supra, notes 56-59, 957-960, and accompanying 
text (commenters supporting adoption of Order Protection Rule to 
promote depth and liquidity).
---------------------------------------------------------------------------

4. Promoting Competition
    The dissent claims that the Order Protection Rule will limit 
competition, stifle innovation, and create regulatory barriers to 
entry. The dissent argues that intermarket protection of the best 
accessible prices will ``reduce markets to the lowest common 
denominator.'' \975\ As discussed in an earlier section of this 
release, the Commission believes that markets will continue to have 
strong incentives to compete and innovate, particularly to be the first 
preference of order routers at any given price and thereby maximize 
their share of trading volume.\976\ Liquidity providers will be able to 
compete on both price and size through use of the intermarket sweep 
order exception, which will allow them to execute immediately a large 
transaction at prices outside the best prices by routing orders to 
execute against the displayed size of better-priced quotations.\977\ 
Finally, the Order Protection Rule will promote competition among 
markets by assuring new or smaller markets that, if they display the 
best prices, they will attract order flow, because larger, dominant 
markets will not be allowed to ignore their quotations. New or smaller 
markets also will benefit from the price transparency and open access 
elements of Regulation NMS, which preclude dominant markets from 
unreasonably restricting the availability of their market information 
or unfairly discriminating against competing markets by denying access 
to their displayed quotations.
---------------------------------------------------------------------------

    \975\ Dissent, section V.A.1.
    \976\ Supra, section II.A.4.a. See also Bear Stearns Reproposal 
Letter at 2 (Market BBO alternative ``accomplishes the right balance 
for trade-through protection because it encourages competitive 
quoting behavior both within and among markets, without imposing 
excessive routing obligations and related costs on receiving trading 
centers.''); CHX Reproposal Letter at 3 (``[T]he Market BBO 
Alternative provides an ideal balance; it recognizes the importance 
of preserving essential price protections, while permitting market 
centers to control costs and to preserve intermarket 
competition.''); Letter Type J (Letter submitted by 548 commenters 
stating that protecting the best bid and offer in each market center 
preserves both competition among markets and competition among 
quotations ``in a way that benefits all securities industry 
participants.'').
    \977\ See supra, text accompanying notes 249-250.
---------------------------------------------------------------------------

    The dissent also claims that the Order Protection Rule will create 
barriers to competition and regulatory barriers to entry, largely 
because the Rule protects quotations that are displayed by SROs 
registered under the Exchange Act.\978\ Here, however, the dissent 
appears to take issue with one of the most basic elements of the 
Exchange Act regulatory scheme--the equity market registration 
requirement. Congress enacted this registration requirement in 1934 to 
assure that all significant equity markets have the capacity and 
integrity to meet their responsibilities to protect investors and 
promote the public interest. The Commission strongly believes that this 
basic registration requirement is an essential element of any effective 
scheme of securities regulation. Consistent with this requirement, the 
SROs for many years have been responsible for collecting quotations and 
disseminating them to the public in the consolidated quotation stream. 
Broker-dealers and ATSs can participate in the consolidated quotation 
stream by providing their quotations to an SRO. They will continue to 
be able to do so after implementation of the Order Protection Rule and, 
to the extent their quotations constitute the best bids or offers of 
the SRO, such quotations will be protected. Moreover, small ATSs with 
less than 5% of trading volume are exempted from participation in the 
consolidated quotation stream, thereby reducing barriers to entry for 
new markets.\979\ But these aspects of the U.S. regulatory scheme all 
flow from the basic Exchange Act registration

[[Page 37608]]

requirement for significant equity markets, not Regulation NMS.
---------------------------------------------------------------------------

    \978\ Dissent, sections V.A.3 and V.A.4.
    \979\ See supra, text accompanying notes 385-386.
---------------------------------------------------------------------------

5. Scope of Order Protection Rule
    The dissent argues that the scope of the Order Protection Rule has 
been substantially expanded beyond the reproposal without the benefit 
of the normal notice and comment process, and further states that the 
``practical effect is that market participants must exhaust liquidity 
in reserve prior to moving to the next price level.'' \980\ Both of 
these assertions are incorrect. The scope of the Order Protection Rule 
has not been expanded from the reproposal, nor does the Rule, as 
reproposed or adopted, require market participants to route orders to 
execute against reserve size or any other liquidity that is not 
displayed. As reproposed and adopted, the Rule protects the best 
displayed prices of protected quotations, without regard to their 
sizes,\981\ but provides an exception for transactions at inferior 
prices if intermarket sweep orders simultaneously are routed to execute 
against the ``full displayed size'' of the protected quotations.\982\ 
Therefore, the removal of references to size in the definition of 
quotation has no effect on the operation of the Rule as adopted.
---------------------------------------------------------------------------

    \980\ Dissent, text following note 63.
    \981\ For example, ``trade-through'' is defined in adopted Rule 
600(b)(77), as it was in the reproposal, solely with respect to 
price--``the purchase or sale of an NMS stock during regular trading 
hours, either as principal or agent, at a price that is lower than a 
protected bid or higher than a protected offer.'' This definition is 
unchanged from the reproposal.
    \982\ Rule 600(b)(30) defines an ``intermarket sweep order'' as 
requiring, among other things, that limit orders be ``routed to 
execute against the full displayed size of any protected bid, in the 
case of a limit order to sell, or the full displayed size of any 
protected offer, in the case of a limit order to buy, for the NMS 
stock with a price that is superior to the limit price of the limit 
order identified as an intermarket sweep order.'' This definition is 
unchanged from the reproposal.
---------------------------------------------------------------------------

    Market participants will not be required to route oversized orders 
in an attempt to execute against reserve size, as the dissenters claim. 
While a technical correction to a reproposed Regulation NMS definition 
has been made, it does not raise a notice and comment issue. A clause 
was deleted from the definition of ``quotation'' in reproposed Rule 
600(b)(63), but this clause was not relevant to the Order Protection 
Rule or to any other rule in Regulation NMS, as reproposed or 
adopted.\983\
---------------------------------------------------------------------------

    \983\ Reproposed Rule 600(b)(63) provided that ``quotations and 
quotation information means bids, offers and, where applicable, 
quotation sizes and aggregate quotation sizes.'' As adopted, Rule 
600(b)(62) simply defines ``quotation'' as ``a bid or an offer.'' 
The deleted language currently is found only in a definition from 
Exchange Act Rule 11Ac1-2(a)(5), which Rule has been entirely 
rewritten and redesignated as Rule 603 in Regulation NMS. See supra, 
section V.B.3.c. The new Rule does not use the terms ``quotation 
information,'' ``quotation sizes,'' or ``aggregate quotation 
sizes,'' and therefore the deleted language now is obsolete. The 
language was inadvertently left in the definition of ``quotation'' 
in the reproposal and has been deleted as a technical correction. 
Its deletion does not change the substantive operation of the 
reproposed or adopted Order Protection Rule.
---------------------------------------------------------------------------

    The dissent minimizes the role of the intermarket sweep order 
exception in the operation of the adopted Order Protection Rule. It 
states that, under the Rule as reproposed, ``trading centers could 
route an order to a protected quotation's full displayed size and 
simultaneously execute an order at an inferior price,'' and then 
implies that this practice is no longer allowed under the adopted 
Rule.\984\ But simultaneously executing orders at multiple price levels 
is precisely what the intermarket sweep order exception allows under 
the reproposed and adopted Rule. Regardless of the dissent's position, 
there is no indication that commenters were confused concerning the 
importance of the exception or operation of the Rule.\985\
---------------------------------------------------------------------------

    \984\ Dissent, text following note 63.
    \985\ See, e.g., Letter from Adam Cooper, Senior Managing 
Director and General Counsel, Citadel Investment Group, L.L.C., to 
Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 
(``Citadel Reproposal Letter'') at 2-3 (``The proposed intermarket 
sweep exception addresses most of Citadel's concerns about the 
Commission's initial trade-through proposal, and would have many 
benefits * * *. [T]his exception would increase execution speed and 
reliability because it would allow market participants to 
simultaneously and immediately sweep through multiple price 
levels.''); SIA Reproposal Letter at 20 (``We continue to believe 
that an exception for intermarket sweep orders is imperative for the 
proper functioning of the trade-through rule and for the 
facilitation of various beneficial trading strategies, including 
smart routing and block trading. Therefore, we applaud the SEC's 
decision to include such an exception in its Reproposal.'').
---------------------------------------------------------------------------

6. Benefits and Costs of Order Protection Rule
    The dissent states that the Commission's estimate of $321 million 
in annual benefits to investors from the Order Protection Rule 
constitutes a ``mere rounding error'' compared to the $18.7 trillion in 
total dollar value of trading in 2003.\986\ However, the dissent also 
states that $143.8 million in one-time start-up costs and $22 million 
in annual costs to comply with the Rule, which ultimately will be paid 
by investors, are ``very high.'' \987\ These statements appear to be 
inconsistent. If more than $300 million in net annual benefits is an 
inconsequential amount to investors, why is less than one-half of that 
amount in one-time start-up costs a significant burden for investors?
---------------------------------------------------------------------------

    \986\ Dissent, text accompanying note 41.
    \987\ Dissent, section V.C.
---------------------------------------------------------------------------

    In fact, of course, both of the amounts are substantial, and the 
dissent has used an ``apples-to-oranges'' comparison. The $321 million 
amount measures the estimated reduction in investor transaction costs. 
Even the total amount of transaction costs will always be a fraction of 
the total dollar volume of trading in the U.S. equity markets. Indeed, 
if transaction costs were ever to represent a large proportion of the 
total dollar volume of trading, investors would cease to trade, 
liquidity would dry up, and the cost of capital for listed companies 
would be prohibitive. All transaction costs, however, eat away at the 
long-term returns of investors. One of the keys to successful long-term 
investing is to minimize, wherever possible, transaction costs of all 
kinds. Even under the conservative estimate used in the Commission's 
cost-benefit analysis, which is based on the dissent's preferred trade-
through measure--the share volume of quotations that are traded through 
\988\--investors would benefit over a five-year period by a total of 
more than $1.3 billion.\989\ Moreover, this estimate is conservative 
because it does not include any benefits for investors that would 
result from improved market depth and liquidity,\990\ nor does it 
reflect the non-monetary benefits associated with enhanced investor 
confidence in the fairness and orderliness of the equity markets. The

[[Page 37609]]

Commission believes that all of these benefits amply justify the costs 
of the Order Protection Rule.
---------------------------------------------------------------------------

    \988\ See Dissent, text accompanying note 33; Trade-Through 
Study at 3 ($321 million ``includes only share volume that traded 
through depth displayed on market center's top of book'').
    \989\ The estimated net benefits of more than $1.3 billion over 
a five-year period are calculated by deducting the estimated annual 
costs of compliance of $22 million from the estimated annual 
benefits of $321 million, multiplying by five, and then deducting 
the estimated one-time start-up costs of $143.8 million.
    \990\ As discussed in section II.A.6 above, even small 
percentage improvements in depth and liquidity can generate enormous 
dollar benefits for investors in the form of reduced transaction 
costs because the total amount of transaction costs incurred each 
year by investors is so large. Such costs were conservatively 
estimated earlier in this release at more than $30 billion annually. 
Supra, text accompanying notes 300-305. Others have estimated such 
costs as being much higher. See, e.g., Instinet Group Incorporated, 
Eliminating Unnecessary Cost: Reducing Transaction Costs and 
Recapturing Value for Your Portfolio 2 (2004) (available at 
www.instinetgroup.com) (``Transaction costs can have a significant 
effect on returns. Implementation shortfall in U.S. equity markets 
has been estimated to range from 20 basis points to as much as 2% of 
the principal value of transactions and orders. Taking the mid-point 
of this range, however, even an average of 1% per year in lost 
performance, before inflation and taxes, compounded over the average 
life of a pension liability, represents substantial foregone value. 
If we apply it to the $12 trillion U.S. equity market, we get 
approximately $120 billion lost to transaction costs every year.'').
---------------------------------------------------------------------------

7. Alternatives to Order Protection Rule
    The dissent states that the Commission did not seriously consider 
alternatives to the Order Protection Rule.\991\ It suggests that the 
Commission first could have adopted only access standards, and then 
adopted a price protection rule later if deemed necessary, or, 
alternatively, that the Commission could have adopted a price 
protection rule in stages for some markets, while waiting to evaluate 
its effect before applying the rule to other markets. Both of these 
alternatives were considered, and the Commission believed that they 
would have led to continued uncertainty concerning the future 
regulatory structure of the U.S. equity markets, and that the second 
alternative would have perpetuated inconsistent regulatory requirements 
for different NMS markets and stocks. At bottom, these alternatives 
simply reflect the dissenters' policy view that a price protection rule 
is not needed and will not be effective. Indeed, it is not clear why 
the dissent believes that the alternatives should have been seriously 
considered when they also believe that intermarket price protection in 
general will not be effective. It is even more difficult to understand 
how these alternatives could be suggested by the dissenters if they 
believe that the very basis of intermarket price protection is 
``arbitrary, unreasonable and anticompetitive.'' The Commission 
disagrees and believes that further delay in reaching final decisions 
on vital NMS issues could have caused significant harm to the U.S. 
markets.
---------------------------------------------------------------------------

    \991\ Dissent, note 6.
---------------------------------------------------------------------------

    The dissent also states that the Commission failed to consider the 
alternative of prohibiting only those trade-throughs that are more than 
three cents inferior to the best prices. A three-cent trade-through 
threshold is analogous to the temporary exemption from the ITS trade-
through provisions that was originally granted in 2002 for trading in 
three exchange-traded funds.\992\ These derivative securities, one of 
which tracks the Nasdaq-100 Index (then referred to as the ``QQQ''), 
are highly liquid and their value is readily derived from the values of 
their underlying stocks. The deficiencies of the ITS trade-through 
provisions, which protect both automated and manual quotations, were 
most evident in these securities. The Commission granted the exemption 
to address the pressing need for regulatory action in these securities, 
while it continued to evaluate a more comprehensive resolution of NMS 
issues.
---------------------------------------------------------------------------

    \992\ Securities Exchange Act Release No. 46428 (Aug. 28, 2002), 
67 FR 56607 (Sep. 14, 2002).
---------------------------------------------------------------------------

    The dissent argues that the exemption led to increased competition, 
narrowing of spreads, and a significant reduction in trade-through 
rates, citing an October 2002 study of trading in the QQQs by the 
Commission's Office of Economic Analysis that was referenced in the 
Proposing Release.\993\ This study, however, found that trade-through 
rates were extremely high both before and after the exemption was 
granted--48% before and 47% after. The exemption therefore essentially 
ratified trading activity that already was occurring.\994\ 
Consequently, data on trading before and after the exemption provides 
little basis for drawing conclusions on the effect of the exemption.
---------------------------------------------------------------------------

    \993\ Dissent, note 6 (citing Proposing Release, 69 FR at 11134 
n. 50).
    \994\ Unlike the more recent Trade-Through Study, the October 
2002 study did not incorporate a three-second quotation window to 
address timing latency issues. The earlier study also included 
manual quotations disseminated by Amex and the NYSE in the QQQs. The 
respective findings of the two studies therefore are not comparable. 
The October 2002 study did not examine the effect of the exemption 
on the spreads paid by investors. The dissent also cites a comment 
letter stating that spreads narrowed in the QQQ's when they became a 
Nasdaq-listed security in December 2004. Dissent, note 6. Given that 
the three-cent trade-through threshold already allowed an extremely 
high percentage of trade-throughs even prior to the switch from Amex 
to Nasdaq listing, there is no basis to believe that the effect of 
the switch on spreads, if accurately stated, is related to any 
change in trade-through protection.
---------------------------------------------------------------------------

    Most importantly, the Commission considered and rejected a rule 
with a three-cent trade-through threshold because it so clearly would 
fail to achieve any of the primary objectives of the Order Protection 
Rule, including investor protection, fair and orderly markets, and 
increased depth and liquidity. Such a rule would allow intermediaries 
and markets to execute investor orders at prices significantly inferior 
to the best prices that are immediately and automatically accessible. 
In many NMS stocks, quoted spreads are as low as one penny. A three-
cent trade-through on a single trade would represent a 300% increase in 
investor transaction costs in these stocks. In addition, allowing 
three-cent trade-throughs would seriously undercut the objectives of 
encouraging the display of limit orders. The average trade-through 
amount is 2.3 cents per share in Nasdaq stocks and 2.2 cents per share 
in NYSE stocks.\995\ Consequently, a rule with a three-cent threshold 
would not affect the majority of trade-throughs and thereby have little 
beneficial effect on the incentives to display limit orders.
---------------------------------------------------------------------------

    \995\ Trade-Through Study, Tables 3, 10.
---------------------------------------------------------------------------

C. Market Data

    The dissent addresses issues relating to the level of market data 
fees and the single consolidator model for disseminating market data. 
As discussed above,\996\ the Commission has determined that the most 
appropriate forum in which to address the level of market data fees is 
its review of SRO structure, and it has retained the single 
consolidator model primarily because of its significant role in 
protecting investors.
---------------------------------------------------------------------------

    \996\ Supra, section V.A.
---------------------------------------------------------------------------

D. Conclusion

    The dissent concludes by stating that Regulation NMS is ``far from 
final'' and that it fears that ``inevitable delays in obtaining 
guidance, the attendant regulatory uncertainty, and concomitant costs 
will harm a competitive marketplace.'' \997\ In fact, the Commission 
has taken great care to craft clear and workable rules for market 
participants to follow. Indeed, as discussed throughout this release, a 
variety of changes to the rules as originally proposed have been made 
specifically to respond to the comments of market participants.\998\ 
Given the wide range of participants in the securities markets, the 
particular means chosen by different entities to comply with the NMS 
rules may vary. The staff, under the purview of the Commission, will be 
available to work with the securities industry and the public to 
provide any desired guidance on implementation questions. In this 
regard, the NMS rules are no different from other rules that the 
Commission adopts, including previously-adopted NMS rules, such as 
those relating to limit order display and execution quality disclosure, 
which were widely cited by commenters as effective regulation. The 
Commission's experience with these other rules has demonstrated the 
wisdom of this approach.
---------------------------------------------------------------------------

    \997\ Dissent, Conclusion.
    \998\ See, e.g., supra, text accompanying notes 191-196 
(discussing rule provisions that respond to commenters' suggestions 
on ways to make rules workable and implementable in a fair and 
orderly fashion).
---------------------------------------------------------------------------

XIII. Statutory Authority

    Pursuant to the Exchange Act and particularly, Sections 2, 3(b), 5, 
6, 11, 11A, 15, 15A, 17(a) and (b), 19, 23(a), and 36 thereof, 15 
U.S.C. 78b, 78c(b), 78e, 78f, 78k-1, 78o, 78o-3, 78q(a) and (b), 78s; 
78w(a), and 78mm, and Rules 11Aa3-2(b)(2) and 11Aa3-2(c)(1)

[[Page 37610]]

thereunder, 17 CFR 240.11Aa3-2(b)(2) and 17 CFR 240.11Aa3-2(c)(1), the 
Commission: (1) Redesignates the NMS rules under Section 11A of the 
Exchange Act as Regulation NMS rules; (2) adopts Rules 600, 610, 611, 
and 612 of Regulation NMS; (3) amends current Rules 11Aa3-1 and 11Ac1-2 
under the Exchange Act and redesignates them as Rules 601 and 603 of 
Regulation NMS; (4) amends the CTA Plan, the CQ Plan, and the Nasdaq 
UTP Plan; and (5) amends various other rules to reflect the adoption of 
Regulation NMS, as set forth below.

XIV. Text of Adopted Amendments to the CTA Plan, the CQ Plan, and the 
Nasdaq UTP Plan

    The Commission hereby amends the CTA Plan, the CQ Plan, and the 
Nasdaq UTP Plan to incorporate the new net income allocation formula 
into each Plan, which supersedes the existing allocation formulas in 
those Plans, and to incorporate the new Plan governance language into 
each Plan.
    Set forth below is the text of (1) the new allocation formula to be 
incorporated into each of the Plans, and (2) the new Plan governance 
language to be incorporated into each of the Plans.
Allocation Amendment
    () Allocation of Net Income.
    (a) Annual Payment. Notwithstanding any other provision of this 
Plan, each Participant eligible to receive distributable net income 
under the Plan shall receive an annual payment for each calendar year 
that is equal to the sum of the Participant's Trading Shares and 
Quoting Shares, as defined below, in each Eligible Security for the 
calendar year.
    (b) Security Income Allocation. The Security Income Allocation for 
an Eligible Security shall be determined by multiplying (i) the 
distributable net income of the Plan for the calendar year by (ii) the 
Volume Percentage for such Eligible Security (the ``initial 
allocation''), and then adding or subtracting any amounts specified in 
the reallocation set forth below. The Volume Percentage for an Eligible 
Security shall be determined by dividing (i) the square root of the 
dollar volume of transaction reports disseminated by the Processor in 
such Eligible Security during the calendar year by (ii) the sum of the 
square roots of the dollar volume of transaction reports disseminated 
by the Processor in each Eligible Security during the calendar year. If 
the initial allocation of distributable net income in accordance with 
the Volume Percentage of an Eligible Security equals an amount greater 
than $4.00 multiplied by the total number of qualified transaction 
reports in such Eligible Security during the calendar year, the excess 
amount shall be subtracted from the initial allocation for such 
Eligible Security and reallocated among all Eligible Securities in 
direct proportion to the dollar volume of transaction reports 
disseminated by the Processor in Eligible Securities during the 
calendar year. A transaction report with a dollar volume of $5000 or 
more shall constitute one qualified transaction report. A transaction 
report with a dollar volume of less than $5000 shall constitute a 
fraction of a qualified transaction report that equals the dollar 
volume of the transaction report divided by $5000.
    (c) Trading Share. The Trading Share of a Participant in an 
Eligible Security shall be determined by multiplying (i) an amount 
equal to fifty percent of the Security Income Allocation for the 
Eligible Security by (ii) the Participant's Trade Rating in the 
Eligible Security. A Participant's Trade Rating in an Eligible Security 
shall be determined by taking the average of (i) the Participant's 
percentage of the total dollar volume of transaction reports 
disseminated by the Processor in the Eligible Security during the 
calendar year, and (ii) the Participant's percentage of the total 
number of qualified transaction reports disseminated by the Processor 
in the Eligible Security during the calendar year.
    (d) Quoting Share. The Quoting Share of a Participant in an 
Eligible Security shall be determined by multiplying (i) an amount 
equal to fifty percent of the Security Income Allocation for the 
Eligible Security by (ii) the Participant's Quote Rating in the 
Eligible Security. A Participant's Quote Rating in an Eligible Security 
shall be determined by dividing (i) the sum of the Quote Credits earned 
by the Participant in such Eligible Security during the calendar year 
by (ii) the sum of the Quote Credits earned by all Participants in such 
Eligible Security during the calendar year. A Participant shall earn 
one Quote Credit for each second of time (with a minimum of one full 
second) multiplied by dollar value of size that an automated best bid 
(offer) transmitted by the Participant to the Processor during regular 
trading hours is equal to the price of the national best bid (offer) in 
the Eligible Security and does not lock or cross a previously displayed 
automated quotation. An automated bid (offer) shall have the meaning 
specified in Rule 600 of Regulation NMS of the Exchange Act for an 
``automated quotation.'' The dollar value of size of a quote shall be 
determined by multiplying the price of a quote by its size.
Governance Amendment
    () Advisory Committee.
    (a) Formation. Notwithstanding any other provision of this Plan, an 
Advisory Committee to the Plan shall be formed and shall function in 
accordance with the provisions set forth in this section.
    (b) Composition. Members of the Advisory Committee shall be 
selected for two-year terms as follows:
    (1) Operating Committee Selections. By affirmative vote of a 
majority of the Participants entitled to vote, the Operating Committee 
shall select at least one representative from each of the following 
categories to be members of the Advisory Committee: (i) a broker-dealer 
with a substantial retail investor customer base, (ii) a broker-dealer 
with a substantial institutional investor customer base, (iii) an 
alternative trading system, (iv) a data vendor, and (v) an investor.
    (2) Participant Selections. Each Participant shall have the right 
to select one member of the Advisory Committee. A Participant shall not 
select any person employed by or affiliated with any Participant or its 
affiliates or facilities.
    (c) Function. Members of the Advisory Committee shall have the 
right to submit their views to the Operating Committee on Plan matters, 
prior to a decision by the Operating Committee on such matters. Such 
matters shall include, but not be limited to, any new or modified 
product, fee, contract, or pilot program that is offered or used 
pursuant to the Plan.
    (d) Meetings and Information. Members of the Advisory Committee 
shall have the right to attend all meetings of the Operating Committee 
and to receive any information concerning Plan matters that is 
distributed to the Operating Committee; provided, however, that the 
Operating Committee may meet in executive session if, by affirmative 
vote of a majority of the Participants entitled to vote, the Operating 
Committee determines that an item of Plan business requires 
confidential treatment.

XV. Text of Adopted Rules

List of Subjects

17 CFR Part 200

    Administrative practice and procedure, Authority delegations 
(Government agencies), Organization and functions (Government 
agencies).

[[Page 37611]]

17 CFR Part 201

    Administrative practice and procedure, Securities.

17 CFR Parts 230 and 270

    Reporting and recordkeeping requirements, Securities.

17 CFR Parts 240, 242, and 249

    Brokers, Reporting and recordkeeping requirements, Securities.

0
For the reasons set out in the preamble, Title 17, Chapter II of the 
Code of the Federal Regulations is amended as follows:

PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND 
REQUESTS

0
1. The authority citation for part 200 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77s, 77o, 77sss, 78d, 78d-1, 78d-2, 78w, 
78ll(d), 78mm, 79t, 80a-37, 80b-11, and 7202, unless otherwise 
noted.
* * * * *

0
2. Section 200.30-3 is amended by:
0
a. Removing paragraphs (a)(62) and (a)(71);
0
b. Redesignating paragraphs (a)(63) through (a)(70) as paragraphs 
(a)(62) through (a)(69);
0
c. Redesignating paragraphs (a)(72) through (a)(82) as paragraphs 
(a)(70) through (a)(80);
0
d. Revising paragraphs (a)(27), (a)(28), (a)(36), (a)(37), (a)(42), 
(a)(49), (a)(61), and newly redesignated paragraphs (a)(68), and 
(a)(69); and
0
e. Adding new paragraphs (a)(81), (a)(82), and (a)(83).
0
The revisions and additions read as follows:


Sec.  200.30-3  Delegation of authority to Director of Division of 
Market Regulation.

* * * * *
    (a) * * *
    (27) To approve amendments to the joint industry plan governing 
consolidated transaction reporting declared effective by the Commission 
pursuant to Rule 601 (17 CFR 242.601) or its predecessors, Rule 11Aa3-1 
and Rule 17a-15, and to grant exemptions from Rule 601 pursuant to Rule 
601(f) (17 CFR 242.601(f)) to exchanges trading listed securities that 
are designated as national market system securities until such times as 
a Joint Reporting Plan for such securities is filed and approved by the 
Commission.
    (28) To grant exemptions from Rule 602 (17 CFR 242.602), pursuant 
to Rule 602(d) (17 CFR 242.602(d)).
* * * * *
    (36) To grant exemptions from Rule 603 (17 CFR 242.603), pursuant 
to Rule 603(d) (17 CFR 242.603(d)).
    (37) Pursuant to Rule 600 (17 CFR 242.600), to publish notice of 
the filing of a designation plan with respect to national market system 
securities, or any proposed amendment thereto, and to approve such plan 
or amendment.
* * * * *
    (42) Under 17 CFR 242.608(e), to grant or deny exemptions from 17 
CFR 242.608.
* * * * *
    (49) Pursuant to section 11A(b) of the Act (15 U.S.C. 78k-1(b)) and 
Rule 609 thereunder (17 CFR 242.609), to publish notice of and, by 
order, grant under section 11A(b) of the Act and Rule 609 thereunder: 
Applications for registration as a securities information processor; 
and exemptions from that section and any rules or regulations 
promulgated thereunder, either conditionally or unconditionally.
* * * * *
    (61) To grant exemptions from Rule 604 (17 CFR 242.604), pursuant 
to Rule 604(c) (17 CFR 242.604(c)).
* * * * *
    (68) Pursuant to Rule 605(b) (17 CFR 242.605(b)), to grant or deny 
exemptions, conditionally or unconditionally, from any provision or 
provisions of Rule 605 (17 CFR 242.605).
    (69) Pursuant to Rule 606(c) (17 CFR 242.606(c)), to grant or deny 
exemptions, conditionally or unconditionally, from any provision or 
provisions of Rule 606 (17 CFR 242.606).
* * * * *
    (81) To grant or deny exemptions from Rule 610 (17 CFR 242.610), 
pursuant to Rule 610(e) (17 CFR 242.610(e)).
    (82) To grant or deny exemptions from Rule 611 (17 CFR 242.611), 
pursuant to Rule 611(d) (17 CFR 242.611(d)).
    (83) To grant or deny exemptions from Rule 612 (17 CFR 242.612), 
pursuant to Rule 612(c) (17 CFR 242.612(c)).
* * * * *

Subpart N--Commission Information Collection Requirements Under the 
Paperwork Reduction Act: OMB Control Numbers

0
3. The authority citation for Subpart N continues to read as follows:

    Authority: 44 U.S.C. 3506; 44 U.S.C. 3507.

0
4. Section 200.800 is amended by revising paragraph (b) to read as 
follows:


Sec.  200.800  OMB control numbers assigned pursuant to the Paperwork 
Reduction Act.

* * * * *
    (b) Display.

----------------------------------------------------------------------------------------------------------------
                                                   17 CFR part or section where identified and      Current OMB
       Information collection requirement                           described                       control No.
----------------------------------------------------------------------------------------------------------------
Regulation S-X.................................  PART 210.......................................       3235-0009
Regulation S-B.................................  PART 228.......................................       3235-0417
Regulation S-K.................................  PART 229.......................................       3235-0071
Rule 154.......................................  230.154........................................       3235-0495
Rule 155.......................................  230.155........................................       3235-0549
Rule 236.......................................  230.236........................................       3235-0095
Rule 237.......................................  230.237........................................       3235-0528
Regulation A...................................  230.251 thru 230.263...........................       3235-0286
Regulation C...................................  230.400 thru 230.494...........................       3235-0074
Rule 425.......................................  230.425........................................       3235-0521
Rule 477.......................................  230.477........................................       3235-0550
Rule 489.......................................  230.489........................................       3235-0411
Rule 498.......................................  230.498........................................       3235-0488
Regulation D...................................  230.501 thru 230.506...........................       3235-0076
Regulation E...................................  230.601 thru 230.610a..........................       3235-0232
Rule 604.......................................  230.604........................................       3235-0232
Rule 605.......................................  230.605........................................       3235-0232
Rule 609.......................................  230.609........................................       3235-0233
Rule 701.......................................  230.701........................................       3235-0522
Regulation S...................................  230.901 thru 230.905...........................       3235-0357

[[Page 37612]]

 
Regulation S-T.................................  Part 232.......................................       3235-0424
Form SB-1......................................  239.9..........................................       3235-0423
Form SB-2......................................  239.10.........................................       3235-0418
Form S-1.......................................  239.11.........................................       3235-0065
Form S-2.......................................  239.12.........................................       3235-0072
Form S-3.......................................  239.13.........................................       3235-0073
Form N-2.......................................  239.14.........................................       3235-0026
Form N-1A......................................  239.15A........................................       3235-0307
Form S-6.......................................  239.16.........................................       3235-0184
Form S-8.......................................  239.16b........................................       3235-0066
Form N-3.......................................  239.17a........................................       3235-0316
Form N-4.......................................  239.17b........................................       3235-0318
Form S-11......................................  239.18.........................................       3235-0067
Form N-14......................................  239.23.........................................       3235-0336
Form N-5.......................................  239.24.........................................       3235-0169
Form S-4.......................................  239.25.........................................       3235-0324
Form F-1.......................................  239.31.........................................       3235-0258
Form F-2.......................................  239.32.........................................       3235-0257
Form F-3.......................................  239.33.........................................       3235-0256
Form F-4.......................................  239.34.........................................       3235-0325
Form F-6.......................................  239.36.........................................       3235-0292
Form F-7.......................................  239.37.........................................       3235-0383
Form F-8.......................................  239.38.........................................       3235-0378
Form F-9.......................................  239.39.........................................       3235-0377
Form F-10......................................  239.40.........................................       3235-0380
Form F-80......................................  239.41.........................................       3235-0404
Form F-X.......................................  239.42.........................................       3235-0379
Form F-N.......................................  239.43.........................................       3235-0411
Form ET........................................  239.62.........................................       3235-0329
Form ID........................................  239.63.........................................       3235-0328
Form SE........................................  239.64.........................................       3235-0327
Form TH........................................  239.65.........................................       3235-0425
Form 1-A.......................................  239.90.........................................       3235-0286
Form 2-A.......................................  239.91.........................................       3235-0286
Form 144.......................................  239.144........................................       3235-0101
Form 1-E.......................................  239.200........................................       3235-0232
Form CB........................................  239.800........................................       3235-0518
Rule 6a-1......................................  240.6a-1.......................................       3235-0017
Rule 6a-3......................................  240.6a-3.......................................       3235-0021
Rule 6a-4......................................  240.6a-4.......................................       3235-0554
Rule 6h-1......................................  240.6h-1.......................................       3235-0555
Rule 8c-1......................................  240.8c-1.......................................       3235-0514
Rule 9b-1......................................  240.9b-1.......................................       3235-0480
Rule 10a-1.....................................  240.10a-1......................................       3235-0475
Rule 10b-10....................................  240.10b-10.....................................       3235-0444
Rule 10b-17....................................  240.10b-17.....................................       3235-0476
Rule 10b-18....................................  240.10b-18.....................................       3235-0474
Rule 10A-1.....................................  240.10A-1......................................       3235-0468
Rule 11a1-1(T).................................  240.11a1-1(T)..................................       3235-0478
Rule 12a-5.....................................  240.12a-5......................................       3235-0079
Regulation 12B.................................  240.12b-1 thru 240.12b-36......................       3235-0062
Rule 12d1-3....................................  240.12d1-3.....................................       3235-0109
Rule 12d2-1....................................  240.12d2-1.....................................       3235-0081
Rule 12d2-2....................................  240.12d2-2.....................................       3235-0080
Rule 12f-1.....................................  240.12f-1......................................       3235-0128
Rule 13a-16....................................  240.13a-16.....................................       3235-0116
Regulation 13D/G...............................  240.13d-1 thru 240.13d-7.......................       3235-0145
Schedule 13D...................................  240.13d-101....................................       3235-0145
Schedule 13G...................................  240.13d-102....................................       3235-0145
Rule 13e-1.....................................  240.13e-1......................................       3235-0305
Rule 13e-3.....................................  240.13e-3......................................       3235-0007
Schedule 13E-3.................................  240.13e-100....................................       3235-0007
Schedule 13e-4F................................  240.13e-101....................................       3235-0375
Regulation 14A.................................  240.14a-1 thru 240.14a-12......................       3235-0059
Schedule 14A...................................  240.14a-101....................................       3235-0059
Regulation 14C.................................  240.14c-1......................................       3235-0057
Schedule 14C...................................  240.14c-101....................................       3235-0057
Regulation 14D.................................  240.14d-1 thru 240.14d-9.......................       3235-0102
Schedule TO....................................  240.14d-100....................................       3235-0515
Schedule 14D-1.................................  240.14d-101....................................       3235-0102
Schedule 14D-9.................................  240.14d-101....................................       3235-0102
Schedule 14D-1F................................  240.14d-102....................................       3235-0376
Schedule 14D-9F................................  240.14d-103....................................       3235-0382

[[Page 37613]]

 
Regulation 14E.................................  240.14e-1 thru 240.14e-2.......................       3235-0102
Rule 14f-1.....................................  240.14f-1......................................       3235-0108
Rule 15a-4.....................................  240.15a-4......................................       3235-0010
Rule 15a-6.....................................  240.15a-6......................................       3235-0371
Rule 15b1-1....................................  240.15b1-1.....................................       3235-0012
Rule 15b6-1(a).................................  240.15b6-1(a)..................................       3235-0018
Rule 15c1-5....................................  240.15c1-5.....................................       3235-0471
Rule 15c1-6....................................  240.15c1-6.....................................       3235-0472
Rule 15c1-7....................................  240.15c1-7.....................................       3235-0134
Rule 15c2-1....................................  240.15c2-1.....................................       3235-0485
Rule 15c2-5....................................  240.15c2-5.....................................       3235-0198
Rule 15c2-7....................................  240.15c2-7.....................................       3235-0479
Rule 15c2-8....................................  240.15c2-8.....................................       3235-0481
Rule 15c2-11...................................  240.15c2-11....................................       3235-0202
Rule 15c2-12...................................  240.15c2-12....................................       3235-0372
Rule 15c3-1....................................  240.15c3-1.....................................       3235-0200
Rule 15c3-1(c)(13).............................  240.15c3-1(c)(13)..............................       3235-0499
Appendix F to Rule 15c3-1......................  240.15c3-1f....................................       3235-0496
Rule 15c3-3....................................  240.15c3-3.....................................       3235-0078
Rule 15c3-4....................................  240.15c3-4.....................................       3235-0497
Rule 15d-16....................................  240.15d-16.....................................       3235-0116
Rule 15g-2.....................................  240.15g-2......................................       3235-0434
Rule 15g-3.....................................  240.15g-3......................................       3235-0392
Rule 15g-4.....................................  240.15g-4......................................       3235-0393
Rule 15g-5.....................................  240.15g-5......................................       3235-0394
Rule 15g-6.....................................  240.15g-6......................................       3235-0395
Rule 15g-9.....................................  240.15g-9......................................       3235-0385
Rule 15Aj-1....................................  240.15Aj-1.....................................       3235-0044
Rule 15Ba2-1...................................  240.15Ba2-1....................................       3235-0083
Rule 15Ba2-5...................................  240.15Ba2-5....................................       3235-0088
Rule 15Bc3-1...................................  240.15Bc3-1....................................       3235-0087
Rule 17a-1.....................................  240.17a-1......................................       3235-0208
Rule 17a-2.....................................  240.17a-2......................................       3235-0201
Rule 17a-3.....................................  240.17a-3......................................       3235-0033
Rule 17a-3(a)(16)..............................  240.17a-3(a)(16)...............................       3235-0508
Rule 17a-4.....................................  240.17a-4......................................       3235-0279
Rule 17a-4(b)(10)..............................  240.17a-4(b)(10)...............................       3235-0506
Rule 17a-5.....................................  240.17a-5......................................       3235-0123
Rule 17a-5(c)..................................  240.17a-5(c)...................................       3235-0199
Rule 17a-6.....................................  240.17a-6......................................       3235-0489
Rule 17a-7.....................................  240.17a-7......................................       3235-0131
Rule 17a-8.....................................  240.17a-8......................................       3235-0092
Rule 17a-9T....................................  240.17a-9T.....................................       3235-0524
Rule 17a-10....................................  240.17a-10.....................................       3235-0122
Rule 17a-11....................................  240.17a-11.....................................       3235-0085
Rule 17a-12....................................  240.17a-12.....................................       3235-0498
Rule 17a-13....................................  240.17a-13.....................................       3235-0035
Rule 17a-19....................................  240.17a-19.....................................       3235-0133
Rule 17a-22....................................  240.17a-22.....................................       3235-0196
Rule 17a-25....................................  240.17a-25.....................................       3235-0540
Rule 17f-1(b)..................................  240.17f-1(b)...................................       3235-0032
Rule 17f-1(c)..................................  240.17f-1(c)...................................       3235-0037
Rule 17f-1(g)..................................  240.17f-1(g)...................................       3235-0290
Rule 17f-2(a)..................................  240.17f-2(a)...................................       3235-0034
Rule 17f-2(c)..................................  240.17f-2(c)...................................       3235-0029
Rule 17f-2(d)..................................  240.17f-2(d)...................................       3235-0028
Rule 17f-2(e)..................................  240.17f-2(e)...................................       3235-0031
Rule 17f-5.....................................  240.17f-5......................................       3235-0269
Rule 17h-1T....................................  240.17h-1T.....................................       3235-0410
Rule 17h-2T....................................  240.17h-2T.....................................       3235-0410
Rule 17Ab2-1...................................  240.17Ab2-1(a).................................       3235-0195
Rule 17Ac2-1...................................  240.17Ac2-1....................................       3235-0084
Rule 17Ad-2(c), (d), and (h)...................  240.17Ad-2(c), (d) and (h).....................       3235-0130
Rule 17Ad-3(b).................................  240.17Ad-3(b)..................................       3235-0473
Rule 17Ad-4(b) and (c).........................  240.17Ad-4(b) and (c)..........................       3235-0341
Rule 17Ad-6....................................  240.17Ad-6.....................................       3235-0291
Rule 17Ad-7....................................  240.17Ad-7.....................................       3235-0291
Rule 17Ad-10...................................  240.17Ad-10....................................       3235-0273
Rule 17Ad-11...................................  240.17Ad-11....................................       3235-0274
Rule 17Ad-13...................................  240.17Ad-13....................................       3235-0275
Rule 17Ad-15...................................  240.17Ad-15....................................       3235-0409
Rule 17Ad-16...................................  240.17Ad-16....................................       3235-0413
Rule 17Ad-17...................................  240.17Ad-17....................................       3235-0469

[[Page 37614]]

 
Rule 19b-1.....................................  240.19b-1......................................       3235-0354
Rule 19b-4.....................................  240.19b-4......................................       3235-0045
Rule 19b-4(e)..................................  240.19b-4(e)...................................       3235-0504
Rule 19b-5.....................................  240.19b-5......................................       3235-0507
Rule 19b-7.....................................  240.19b-7......................................       3235-0553
Rule 19d-1.....................................  240.19d-1(b) thru 240.19d-1(i).................       3235-0206
Rule 19d-2.....................................  240.19d-2......................................       3235-0205
Rule 19d-3.....................................  240.19d-3......................................       3235-0204
Rule 19h-1.....................................  240.19h-1(a), (c) thru (e), and (g)............       3235-0259
Rule 24b-1.....................................  240.24b-1......................................       3235-0194
Rule 101.......................................  242.101........................................       3235-0464
Rule 102.......................................  242.102........................................       3235-0467
Rule 103.......................................  242.103........................................       3235-0466
Rule 104.......................................  242.104........................................       3235-0465
Rule 301.......................................  242.301........................................       3235-0509
Rule 302.......................................  242.302........................................       3235-0510
Rule 303.......................................  242.303........................................       3235-0505
Rule 604.......................................  242.604........................................       3235-0462
Rule 605.......................................  242.605........................................       3235-0542
Rule 606.......................................  242.606........................................       3235-0541
Rule 607.......................................  242.607........................................       3235-0435
Rule 608.......................................  242.608........................................       3235-0500
Rule 609.......................................  242.609........................................       3235-0043
Rule 611.......................................  242.611........................................       3235-0600
Regulation S-P.................................  Part 248.......................................       3235-0537
Form 1.........................................  249.1..........................................       3235-0017
Form 1-N.......................................  249.10.........................................       3235-0554
Form 25........................................  249.25.........................................       3235-0080
Form 26........................................  249.26.........................................       3235-0079
Form 3.........................................  249.103........................................       3235-0104
Form 4.........................................  249.104........................................       3235-0287
Form 5.........................................  249.105........................................       3235-0362
Form 8-A.......................................  249.208a.......................................       3235-0056
Form 10........................................  249.210........................................       3235-0064
Form 10-SB.....................................  249.210b.......................................       3235-0419
Form 18........................................  249.218........................................       3235-0121
Form 20-F......................................  249.220f.......................................       3235-0288
Form 40-F......................................  249.240f.......................................       3235-0381
Form 6-K.......................................  249.306........................................       3235-0116
Form 8-K.......................................  249.308........................................       3235-0060
Form 10-Q......................................  249.308a.......................................       3235-0070
Form 10-QSB....................................  249.308b.......................................       3235-0416
Form 10-K......................................  249.310........................................       3235-0063
Form 10-KSB....................................  249.310b.......................................       3235-0420
Form 11-K......................................  249.311........................................       3235-0082
Form 18-K......................................  249.318........................................       3235-0120
Form 12B-25....................................  249.322........................................       3235-0058
Form 15........................................  249.323........................................       3235-0167
Form 13F.......................................  249.325........................................       3235-0006
Form SE........................................  249.444........................................       3235-0327
Form ET........................................  249.445........................................       3235-0329
Form ID........................................  249.446........................................       3235-0328
Form DF........................................  249.448........................................       3235-0482
Form BD........................................  249.501........................................       3235-0012
Form BDW.......................................  249.501a.......................................       3235-0018
Form BD-N......................................  249.501b.......................................       3235-0556
Form X-17A-5...................................  249.617........................................       3235-0123
Form X-17A-19..................................  249.635........................................       3235-0133
Form ATS.......................................  249.637........................................       3235-0509
Form ATS-R.....................................  249.638........................................       3235-0509
Form X-15AJ-1..................................  249.802........................................       3235-0044
Form X-15AJ-2..................................  249.803........................................       3235-0044
Form 19b-4.....................................  249.819........................................       3235-0045
Form 19b-4(e)..................................  249.820........................................       3235-0504
Form Pilot.....................................  249.821........................................       3235-0507
Form SIP.......................................  249.1001.......................................       3235-0043
Form MSD.......................................  249.1100.......................................       3235-0083
Form MSDW......................................  249.1110.......................................       3235-0087
Form X-17F-1A..................................  249.1200.......................................       3235-0037
Form TA-1......................................  249b.100.......................................       3235-0084
Form TA-W......................................  249b.101.......................................       3235-0151
Form TA-2......................................  249b.102.......................................       3235-0337
Form CA-1......................................  249b.200.......................................       3235-0195

[[Page 37615]]

 
Rule 1(a)......................................  250.1(a).......................................       3235-0170
Rule 1(b)......................................  250.1(b).......................................       3235-0170
Rule 1(c)......................................  250.1(c).......................................       3235-0164
Rule 2.........................................  250.2..........................................       3235-0161
Rule 3.........................................  250.3..........................................       3235-0160
Rule 7.........................................  250.7..........................................       3235-0165
Rule 7(d)......................................  250.7(d).......................................       3235-0165
Rule 20(b).....................................  250.20(b)......................................       3235-0125
Rule 20(c).....................................  250.20(c)......................................       3235-0125
Rule 20(d).....................................  250.20(d)......................................       3235-0163
Rule 23........................................  250.23.........................................       3235-0125
Rule 24........................................  250.24.........................................       3235-0126
Rule 26........................................  250.26.........................................       3235-0183
Rule 29........................................  250.29.........................................       3235-0149
Rule 44........................................  250.44.........................................       3235-0147
Rule 45........................................  250.45.........................................       3235-0154
Rule 47(b).....................................  250.47(b)......................................       3235-0163
Rule 52........................................  250.52.........................................       3235-0369
Form 53........................................  250.53.........................................       3235-0426
Rule 54........................................  250.54.........................................       3235-0427
Rule 57(a).....................................  250.57(a)......................................       3235-0428
Rule 57(b).....................................  250.57(b)......................................       3235-0429
Rule 58........................................  250.58.........................................       3235-0457
Rule 62........................................  250.62.........................................       3235-0152
Rule 71(a).....................................  250.71(a)......................................       3235-0173
Rule 72........................................  250.72.........................................       3235-0149
Rule 83........................................  250.83.........................................       3235-0181
Rule 87........................................  250.87.........................................       3235-0552
Rule 88........................................  250.88.........................................       3235-0182
Rule 93........................................  250.93.........................................       3235-0153
Rule 94........................................  250.94.........................................       3235-0153
Rule 95........................................  250.95.........................................       3235-0162
Rule 100(a)....................................  250.100(a).....................................       3235-0125
Uniform System of Accounts for Mutual Service    Part 256.......................................       3235-0153
 Companies and Subsidiary Service Companies,
 Public Utility Holding Company Act of 1935.
Preservation and Destruction of Records of       Part 257.......................................       3235-0306
 Registered Public Utility Holding Companies
 and of Mutual and Subsidiary Service Companies.
Form U5A.......................................  259.5a.........................................       3235-0170
Form U5B.......................................  259.5b.........................................       3235-0170
Form U5S.......................................  259.5s.........................................       3235-0164
Form U-1.......................................  259.101........................................       3235-0125
Form U-13-1....................................  259.113........................................       3235-0182
Form U-6B-2....................................  259.206........................................       3235-0163
Form U-57......................................  259.207........................................       3235-0428
Form U-9C-3....................................  259.208........................................       3235-0457
Form U-12(I)-A.................................  259.212a.......................................       3235-0173
Form U-12(I)-B.................................  259.212b.......................................       3235-0173
Form U-13E-1...................................  259.213........................................       3235-0162
Form U-R-1.....................................  259.221........................................       3235-0152
Form U-13-60...................................  259.313........................................       3235-0153
Form U-3A-2....................................  259.402........................................       3235-0161
Form U-3A3-1...................................  259.403........................................       3235-0160
Form U-7D......................................  259.404........................................       3235-0165
Form U-33-S....................................  259.405........................................       3235-0429
Form ET........................................  259.601........................................       3235-0329
Form ID........................................  259.602........................................       3235-0328
Form SE........................................  259.603........................................       3235-0327
Rule 7a-15 thru 7a-37..........................  260.7a-15 thru 260.7a-37.......................       3235-0132
Form T-1.......................................  269.1..........................................       3235-0110
Form T-2.......................................  269.2..........................................       3235-0111
Form T-3.......................................  269.3..........................................       3235-0105
Form T-4.......................................  269.4..........................................       3235-0107
Form ET........................................  269.6..........................................       3235-0329
Form ID........................................  269.7..........................................       3235-0328
Form SE........................................  269.8..........................................       3235-0327
Form T-6.......................................  269.9..........................................       3235-0391
Rule 0-1.......................................  270.0-1........................................       3235-0531
Rule 2a-7......................................  270.2a-7.......................................       3235-0268
Rule 2a19-1....................................  270.2a19-1.....................................       3235-0332
Rule 3a-4......................................  270.3a-4.......................................       3235-0459
Rule 6c-7......................................  270.6c-7.......................................       3235-0276

[[Page 37616]]

 
Rule 6e-2......................................  270.6e-2.......................................       3235-0177
Rule 7d-1......................................  270.7d-1.......................................       3235-0311
Rule 7d-2......................................  270.7d-2.......................................       3235-0527
Section 8(b) of the Investment Company Act of    270.8b-1 thru 270.8b-32........................       3235-0176
 1940.
Rule 10f-3.....................................  270.10f-3......................................       3235-0226
Rule 11a-2.....................................  270.11a-2......................................       3235-0272
Rule 11a-3.....................................  270.11a-3......................................       3235-0358
Rule 12b-1.....................................  270.12b-1......................................       3235-0212
Rule 17a-7.....................................  270.17a-7......................................       3235-0214
Rule 17a-8.....................................  270.17a-8......................................       3235-0235
Rule 17e-1.....................................  270.17e-1......................................       3235-0217
Rule 17f-1.....................................  270.17f-1......................................       3235-0222
Rule 17f-2.....................................  270.17f-2......................................       3235-0223
Rule 17f-4.....................................  270.17f-4......................................       3235-0225
Rule 17f-6.....................................  270.17f-6......................................       3235-0447
Rule 17f-7.....................................  270.17f-7......................................       3235-0529
Rule 17g-1(g)..................................  270.17g-1(g)...................................       3235-0213
Rule 17j-1.....................................  270.17j-1......................................       3235-0224
Rule 18f-1.....................................  270.18f-1......................................       3235-0211
Rule 18f-3.....................................  270.18f-3......................................       3235-0441
Rule 19a-1.....................................  270.19a-1......................................       3235-0216
Rule 20a-1.....................................  270.20a-1......................................       3235-0158
Rule 22d-1.....................................  270.22d-1......................................       3235-0310
Rule 23c-1.....................................  270.23c-1......................................       3235-0260
Rule 23c-3.....................................  270.23c-3......................................       3235-0422
Rule 27e-1.....................................  270.27e-1......................................       3235-0545
Rule 30b2-1....................................  270.30b2-1.....................................       3235-0220
Rule 30d-2.....................................  270.30d-2......................................       3235-0494
Rule 30e-1.....................................  270.30e-1......................................       3235-0025
Rule 31a-1.....................................  270.31a-1......................................       3235-0178
Rule 31a-2.....................................  270.31a-2......................................       3235-0179
Rule 32a-4.....................................  270.32a-4......................................       3235-0530
Rule 34b-1.....................................  270.34b-1......................................       3235-0346
Rule 35d-1.....................................  270.35d-1......................................       3235-0548
Form N-5.......................................  274.5..........................................       3235-0169
Form N-8A......................................  274.10.........................................       3235-0175
Form N-2.......................................  274.11a-1......................................       3235-0026
Form N-3.......................................  274.11b........................................       3235-0316
Form N-4.......................................  274.11c........................................       3235-0318
Form N-8B-2....................................  274.12.........................................       3235-0186
Form N-6F......................................  274.15.........................................       3235-0238
Form 24F-2.....................................  274.24.........................................       3235-0456
Form N-18F-1...................................  274.51.........................................       3235-0211
Form N-54A.....................................  274.53.........................................       3235-0237
Form N-54C.....................................  274.54.........................................       3235-0236
Form N-SAR.....................................  274.101........................................       3235-0330
Form N-27E-1...................................  274.127e-1.....................................       3235-0545
Form N-27F-1...................................  274.127f-1.....................................       3235-0546
Form N-17D-1...................................  274.200........................................       3235-0229
Form N-23C-1...................................  274.201........................................       3235-0230
Form N-8F......................................  274.218........................................       3235-0157
Form N-17F-1...................................  274.219........................................       3235-0359
Form N-17F-2...................................  274.220........................................       3235-0360
Form N-23c-3...................................  274.221........................................       3235-0422
Form ET........................................  274.401........................................       3235-0329
Form ID........................................  274.402........................................       3235-0328
Form SE........................................  274.403........................................       3235-0327
Rule 0-2.......................................  275.0-2........................................       3235-0240
Rule 203-3.....................................  275.203-3......................................       3235-0538
Rule 204-2.....................................  275.204-2......................................       3235-0278
Rule 204-3.....................................  275.204-3......................................       3235-0047
Rule 206(3)-2..................................  275.206(3)-2...................................       3235-0243
Rule 206(4)-2..................................  275.206(4)-2...................................       3235-0241
Rule 206(4)-3..................................  275.206(4)-3...................................       3235-0242
Rule 206(4)-4..................................  275.206(4)-4...................................       3235-0345
Form ADV.......................................  279.1..........................................       3235-0049
Schedule I to Form ADV.........................  279.1..........................................       3235-0490
Form ADV-W.....................................  279.2..........................................       3235-0313
Form ADV-H.....................................  379.3..........................................       3235-0538
Form 4-R.......................................  279.4..........................................       3235-0240
Form 5-R.......................................  279.5..........................................       3235-0240
Form 6-R.......................................  279.6..........................................       3235-0240
Form 7-R.......................................  279.7..........................................       3235-0240

[[Page 37617]]

 
Form ADV-E.....................................  279.8..........................................       3235-0361
----------------------------------------------------------------------------------------------------------------

PART 201--RULES OF PRACTICE

Subpart D--Rules of Practice

0
5. The authority citation for part 201, subpart D, continues to read as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77h-1, 77j, 77s, 77u, 
78c(b), 78d-1, 78d-2, 78l, 78m, 78n, 78o(d), 78o-3, 78s, 78u-2, 78u-
3, 78v, 78w, 79c, 79s, 79t, 79z-5a, 77sss, 77ttt, 80a-8, 80a-9, 80a-
37, 80a-38, 80a-39, 80a-40, 80a-41, 80a-44, 80b-3, 80b-9, 80b-11, 
80b-12, 7202, 7215, and 7217.

0
6. Section 201.101 is amended by revising paragraphs (a)(9)(vi) and 
(a)(9)(vii) to read as follows:


Sec.  201.101  Definitions.

    (a) * * *
    (9) * * *
    (vi) By the filing, pursuant to Sec.  242.601 of this chapter, of 
an application for review of an action or failure to act in connection 
with the implementation or operation of any effective transaction 
reporting plan; or
    (vii) By the filing, pursuant to Sec.  242.608 of this chapter, of 
an application for review of an action taken or failure to act in 
connection with the implementation or operation of any effective 
national market system plan; or
* * * * *

PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933

0
7. The authority citation for part 230 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77b, 77c, 77d, 77f, 77g, 77h, 77j, 77r, 
77s, 77z-3, 77sss, 78c, 78d, 78j, 78l, 78m, 78n, 78o, 78t, 78w, 
78ll(d), 78mm, 79t, 80a-8, 80a-24, 80a-28, 80a-29, 80a-30, and 80a-
37, unless otherwise noted.
* * * * *

0
8. Section 230.144 is amended by:
0
a. Removing the authority citation following Sec.  230.144; and
0
b. Revising paragraph (e)(1)(iii).
    The revision reads as follows:


Sec.  230.144  Persons deemed not to be engaged in a distribution and 
therefore not underwriters.

* * * * *
    (e) * * *
    (1) * * *
    (iii) The average weekly volume of trading in such securities 
reported pursuant to an effective transaction reporting plan or an 
effective national market system plan as those terms are defined in 
Sec.  242.600 of this chapter during the four-week period specified in 
paragraph (e)(1)(ii) of this section.
* * * * *

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

0
9. The authority citation for part 240 continues to read as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-
3, 80b-4, 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless 
otherwise noted.
* * * * *

0
10. Section 240.0-10 is amended by revising paragraph (e)(1) to read as 
follows:


Sec.  240.0-10  Small entities under the Securities Exchange Act for 
purposes of the Regulatory Flexibility Act.

* * * * *
    (e) * * *
    (1) Has been exempted from the reporting requirements of Sec.  
242.601 of this chapter; and
* * * * *

0
11. Section 240.3a51-1 is amended by revising the introductory text of 
paragraphs (a) and (e) to read as follows:


Sec.  240.3a51-1  Definition of ``penny stock.''

* * * * *
    (a) That is an NMS stock, as defined in Sec.  242.600 of this 
chapter:
* * * * *
    (e) That is registered, or approved for registration upon notice of 
issuance, on a national securities exchange that makes transaction 
reports available pursuant to Sec.  242.601 of this chapter, provided 
that:
* * * * *

0
12. Section 240.3b-16 is amended by revising paragraph (d) to read as 
follows:


Sec.  240.3b-16  Definitions of terms used in Section 3(a)(1) of the 
Act.

* * * * *
    (d) For the purposes of this section, the terms bid and offer shall 
have the same meaning as under Sec.  242.600 of this chapter.
* * * * *

0
13. Section 240.10a-1 is amended by revising paragraphs (a)(1), 
(e)(5)(ii) and (e)(11) to read as follows:


Sec.  240.10a-1  Short sales.

    (a)(1)(i) No person shall, for his own account or for the account 
of any other person, effect a short sale of any security registered on, 
or admitted to unlisted trading privileges on, a national securities 
exchange, if trades in such securities are reported pursuant to an 
``effective transaction reporting plan'' as defined in Sec.  242.600 of 
this chapter and information as to such trades is made available in 
accordance with such plan on a real-time basis to vendors of market 
transaction information:
    (A) Below the price at which the last sale thereof, regular way, 
was reported pursuant to an effective transaction reporting plan; or
    (B) At such price unless such price is above the next proceeding 
different price at which a sale of such security, regular way, was 
reported pursuant to an effective transaction reporting plan.
    (ii) The provisions of paragraph (a)(1)(i) of this section hereof 
shall not apply to transactions by any person in Nasdaq securities as 
defined in Sec.  242.600 of this chapter, except for those Nasdaq 
securities for which transaction reports are collected, processed, and 
made available pursuant to the plan originally submitted to the 
Commission pursuant to Sec.  240.17a-15 (subsequently amended and 
redesignated as Sec.  240.11Aa3-1 and subsequently redesignated as 
Sec.  242.601 of this chapter), which plan was declared effective as of 
May 17, 1974.
* * * * *
    (e) * * *
    (5) * * *
    (ii) Effected at a price equal to the most recent offer 
communicated for the security by such registered specialist, registered 
exchange market maker or third market maker to an exchange or a 
national securities association (``association'') pursuant to Sec.  
242.602 of this chapter, if such offer, when communicated, was equal to 
or above the last sale, regular way, reported for such security 
pursuant to an effective transaction reporting plan:
    Provided, however, That any exchange, by rule, may prohibit its 
registered specialist and registered exchange market makers from 
availing themselves of the exemption afforded by this paragraph (e)(5) 
if that exchange determines that such action is necessary or 
appropriate in its market in the

[[Page 37618]]

public interest or for the protection of investors;
* * * * *
    (11) Any sale of a security covered by paragraph (a) of this 
section (except a sale to a stabilizing bid complying with Sec.  
242.104 of this chapter) by any broker or dealer, for his own account 
or for the account of any other person, effected at a price equal to 
the most recent offer communicated by such broker or dealer to an 
exchange or association pursuant to Sec.  242.602 of this chapter in an 
amount less than or equal to the quotation size associated with such 
offer, if such offer, when communicated, was:
    (i) Above the price at which the last sale, regular way, for such 
security was reported pursuant to an effective transaction reporting 
plan; or
    (ii) At such last sale price, if such last sale price is above the 
next preceding different price at which a sale of such security, 
regular way, was reported pursuant to an effective transaction 
reporting plan.
* * * * *

0
14. Section 240.10b-10 is amended by:
0
a. Revising paragraphs (a)(2)(i)(C), (a)(2)(ii)(B) and (d)(7);
0
b. Removing paragraph (d)(8); and
0
c. Redesignating paragraphs (d)(9) and (d)(10) as paragraphs (d)(8) and 
(d)(9).
    The revisions read as follows:


Sec.  240.10b-10  Confirmation of transactions.

* * * * *
    (a) * * *
    (2) * * *
    (i) * * *
    (C) For a transaction in any NMS stock as defined in Sec.  242.600 
of this chapter or a security authorized for quotation on an automated 
interdealer quotation system that has the characteristics set forth in 
section 17B of the Act (15 U.S.C. 78q-2), a statement whether payment 
for order flow is received by the broker or dealer for transactions in 
such securities and the fact that the source and nature of the 
compensation received in connection with the particular transaction 
will be furnished upon written request of the customer; provided, 
however, that brokers or dealers that do not receive payment for order 
flow in connection with any transaction have no disclosure obligations 
under this paragraph; and
* * * * *
    (ii) * * *
    (B) In the case of any other transaction in an NMS stock as defined 
by Sec.  242.600 of this chapter, or an equity security that is traded 
on a national securities exchange and that is subject to last sale 
reporting, the reported trade price, the price to the customer in the 
transaction, and the difference, if any, between the reported trade 
price and the price to the customer.
* * * * *
    (d) * * *
    (7) NMS stock shall have the meaning provided in Sec.  242.600 of 
this chapter.
* * * * *

0
15. Section 240.10b-18 is amended by revising paragraph (a)(6) to read 
as follows:


Sec.  240.10b-18  Purchases of certain equity securities by the issuer 
and others.

* * * * *
    (a) * * *
    (6) Consolidated system means a consolidated transaction or 
quotation reporting system that collects and publicly disseminates on a 
current and continuous basis transaction or quotation information in 
common equity securities pursuant to an effective transaction reporting 
plan or an effective national market system plan (as those terms are 
defined in Sec.  242.600 of this chapter).
* * * * *


Sec.  240.11Aa2-1 through 240.11Ac1-6  [Removed]

0
16. The undesignated center heading preceding Sec.  240.11Aa2-1 is 
removed; and Sec. Sec.  240.11Aa2-1 through 240.11Ac1-6 are removed.

0
17. Section 240.12a-7 is amended by revising the introductory text of 
paragraph (a)(2) to read as follows:


Sec.  240.12a-7  Exemption of stock contained in standardized market 
baskets from section 12(a) of the Act.

    (a) * * *
    (2) The stock is an NMS stock as defined in Sec.  242.600 of this 
chapter and is either:
* * * * *
0
18. Section 240.12f-1 is amended by:
0
a. Removing the authority citation following the section;
0
b. Removing ``and'' at the end of paragraph (a)(3); and
0
c. Revising paragraph (a)(4).

0
The revision reads as follows:


Sec.  240.12f-1  Applications for permission to reinstate unlisted 
trading privileges.

    (a) * * *
    (4) Whether transaction information concerning such security is 
reported pursuant to an effective transaction reporting plan 
contemplated by Sec.  242.601 of this chapter;
* * * * *

0
19. Section 240.12f-2 is amended by revising paragraph (a) to read as 
follows:


Sec.  240.12f-2  Extending unlisted trading privileges to a security 
that is the subject of an initial public offering.

    (a) General provision. A national securities exchange may extend 
unlisted trading privileges to a subject security when at least one 
transaction in the subject security has been effected on the national 
securities exchange upon which the security is listed and the 
transaction has been reported pursuant to an effective transaction 
reporting plan, as defined in Sec.  242.600 of this chapter.
* * * * *

0
20. Section 240.15b9-1 is amended by:
0
a. Removing the authority citation following the section; and
0
b. Revising paragraph (c).

0
The revision reads as follows:


Sec.  240.15b9-1  Exemption for certain exchange members.

* * * * *
    (c) For purposes of this section, the term Intermarket Trading 
System shall mean the intermarket communications linkage operated 
jointly by certain self-regulatory organizations pursuant to a plan 
filed with, and approved by, the Commission pursuant to Sec.  242.608 
of this chapter.

0
21. Section 240.15c2-11 is amended by revising paragraph (f)(5) to read 
as follows:


Sec.  240.15c2-11  Initiation or resumption of quotations without 
specified information.

* * * * *
    (f) * * *
    (5) The publication or submission of a quotation respecting a 
Nasdaq security (as defined in Sec.  242.600 of this chapter), and such 
security's listing is not suspended, terminated, or prohibited.
* * * * *

0
22. Section 240.19c-3 is amended by revising paragraph (b)(6) to read 
as follows:


Sec.  240.19c-3  Governing off-board trading by members of national 
securities exchanges.

* * * * *
    (b) * * *
    (6) The term effective transaction reporting plan shall mean any 
plan approved by the Commission pursuant to Sec.  242.601 of this 
chapter for collecting, processing, and making available transaction 
reports with respect to transactions in an equity security or class of 
equity securities.
0
23. Section 240.19c-4 is amended by revising paragraph (e)(6) to read 
as follows:

[[Page 37619]]

Sec.  240.19c-4  Governing certain listing or authorization 
determinations by national securities exchanges and associations.

* * * * *
    (e) * * *
    (6) The term exchange shall mean a national securities exchange, 
registered as such with the Securities and Exchange Commission pursuant 
to section 6 of the Act (15 U.S.C. 78f), which makes transaction 
reports available pursuant to Sec.  242.601 of this chapter; and
* * * * *

0
24. Section 240.31 is amended by revising paragraph (a)(11)(v) to read 
as follows:


Sec.  240.31  Section 31 transaction fees.

    (a) * * *
    (11) * * *
    (v) Any sale of a security that is executed outside the United 
States and is not reported, or required to be reported, to a 
transaction reporting association as defined in Sec.  242.600 of this 
chapter and any approved plan filed thereunder;
* * * * *

PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS AND CUSTOMER MARGIN 
REQUIREMENTS FOR SECURITY FUTURES

0
25. The authority citation for part 242 continues to read as follow:

    Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2), 
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g), 
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and 
80a-37.

0
26. The part heading for part 242 is revised as set forth above.
0
27. Section 242.100 is amended by revising the definition for 
``electronic communications network'' and ``Nasdaq'' found in paragraph 
(b) to read as follows:


Sec.  242.100  Preliminary note; definitions.

* * * * *
* * * * *
    (b) * * *
    Electronic communications network has the meaning provided in Sec.  
242.600.
* * * * *
    Nasdaq means the electronic dealer quotation system owned and 
operated by The Nasdaq Stock Market, Inc.
* * * * *

0
28. Section 242.300 is amended by:
0
a. Revising paragraphs (g) and (h);
0
b. Removing paragraphs (i) and (j); and
0
c. Redesignating paragraphs (k), (l), and (m) as paragraphs (i), (j), 
and (k).

0
The revisions read as follows:


Sec.  242.300  Definitions.

* * * * *
    (g) NMS stock shall have the meaning provided in Sec.  242.600; 
provided, however, that a debt or convertible debt security shall not 
be deemed an NMS stock for purposes of this Regulation ATS.
    (h) Effective transaction reporting plan shall have the meaning 
provided in Sec.  242.600.
* * * * *

0
29. Section 242.301 is amended by revising paragraphs (b)(3), (b)(5), 
and (b)(6) to read as follows:


Sec.  242.301  Requirements for alternative trading systems.

* * * * *
    (b) * * *
    (3) Order display and execution access. (i) An alternative trading 
system shall comply with the requirements set forth in paragraph 
(b)(3)(ii) of this section, with respect to any NMS stock in which the 
alternative trading system:
    (A) Displays subscriber orders to any person (other than 
alternative trading system employees); and
    (B) During at least 4 of the preceding 6 calendar months, had an 
average daily trading volume of 5 percent or more of the aggregate 
average daily share volume for such NMS stock as reported by an 
effective transaction reporting plan.
    (ii) Such alternative trading system shall provide to a national 
securities exchange or national securities association the prices and 
sizes of the orders at the highest buy price and the lowest sell price 
for such NMS stock, displayed to more than one person in the 
alternative trading system, for inclusion in the quotation data made 
available by the national securities exchange or national securities 
association to vendors pursuant to Sec.  242.602.
    (iii) With respect to any order displayed pursuant to paragraph 
(b)(3)(ii) of this section, an alternative trading system shall provide 
to any broker-dealer that has access to the national securities 
exchange or national securities association to which the alternative 
trading system provides the prices and sizes of displayed orders 
pursuant to paragraph (b)(3)(ii) of this section, the ability to effect 
a transaction with such orders that is:
    (A) Equivalent to the ability of such broker-dealer to effect a 
transaction with other orders displayed on the exchange or by the 
association; and
    (B) At the price of the highest priced buy order or lowest priced 
sell order displayed for the lesser of the cumulative size of such 
priced orders entered therein at such price, or the size of the 
execution sought by such broker-dealer.
* * * * *
    (5) Fair access. (i) An alternative trading system shall comply 
with the requirements in paragraph (b)(5)(ii) of this section, if 
during at least 4 of the preceding 6 calendar months, such alternative 
trading system had:
    (A) With respect to any NMS stock, 5 percent or more of the average 
daily volume in that security reported by an effective transaction 
reporting plan;
    (B) With respect to an equity security that is not an NMS stock and 
for which transactions are reported to a self-regulatory organization, 
5 percent or more of the average daily trading volume in that security 
as calculated by the self-regulatory organization to which such 
transactions are reported;
    (C) With respect to municipal securities, 5 percent or more of the 
average daily volume traded in the United States;
    (D) With respect to investment grade corporate debt, 5 percent or 
more of the average daily volume traded in the United States; or
    (E) With respect to non-investment grade corporate debt, 5 percent 
or more of the average daily volume traded in the United States.
    (ii) An alternative trading system shall:
    (A) Establish written standards for granting access to trading on 
its system;
    (B) Not unreasonably prohibit or limit any person in respect to 
access to services offered by such alternative trading system by 
applying the standards established under paragraph (b)(5)(ii)(A) of 
this section in an unfair or discriminatory manner;
    (C) Make and keep records of:
    (1) All grants of access including, for all subscribers, the 
reasons for granting such access; and
    (2) All denials or limitations of access and reasons, for each 
applicant, for denying or limiting access; and
    (D) Report the information required on Form ATS-R (Sec.  249.638 of 
this chapter) regarding grants, denials, and limitations of access.
    (iii) Notwithstanding paragraph (b)(5)(i) of this section, an 
alternative trading system shall not be required to comply with the 
requirements in paragraph (b)(5)(ii) of this section, if such 
alternative trading system:
    (A) Matches customer orders for a security with other customer 
orders;
    (B) Such customers' orders are not displayed to any person, other 
than employees of the alternative trading system; and

[[Page 37620]]

    (C) Such orders are executed at a price for such security 
disseminated by an effective transaction reporting plan, or derived 
from such prices.
    (6) Capacity, integrity, and security of automated systems. (i) The 
alternative trading system shall comply with the requirements in 
paragraph (b)(6)(ii) of this section, if during at least 4 of the 
preceding 6 calendar months, such alternative trading system had:
    (A) With respect to any NMS stock, 20 percent or more of the 
average daily volume reported by an effective transaction reporting 
plan;
    (B) With respect to equity securities that are not NMS stocks and 
for which transactions are reported to a self-regulatory organization, 
20 percent or more of the average daily volume as calculated by the 
self-regulatory organization to which such transactions are reported;
    (C) With respect to municipal securities, 20 percent or more of the 
average daily volume traded in the United States;
    (D) With respect to investment grade corporate debt, 20 percent or 
more of the average daily volume traded in the United States; or
    (E) With respect to non-investment grade corporate debt, 20 percent 
or more of the average daily volume traded in the United States.
    (ii) With respect to those systems that support order entry, order 
routing, order execution, transaction reporting, and trade comparison, 
the alternative trading system shall:
    (A) Establish reasonable current and future capacity estimates;
    (B) Conduct periodic capacity stress tests of critical systems to 
determine such system's ability to process transactions in an accurate, 
timely, and efficient manner;
    (C) Develop and implement reasonable procedures to review and keep 
current its system development and testing methodology;
    (D) Review the vulnerability of its systems and data center 
computer operations to internal and external threats, physical hazards, 
and natural disasters;
    (E) Establish adequate contingency and disaster recovery plans;
    (F) On an annual basis, perform an independent review, in 
accordance with established audit procedures and standards, of such 
alternative trading system's controls for ensuring that paragraphs 
(b)(6)(ii)(A) through (E) of this section are met, and conduct a review 
by senior management of a report containing the recommendations and 
conclusions of the independent review; and
    (G) Promptly notify the Commission staff of material systems 
outages and significant systems changes.
    (iii) Notwithstanding paragraph (b)(6)(i) of this section, an 
alternative trading system shall not be required to comply with the 
requirements in paragraph (b)(6)(ii) of this section, if such 
alternative trading system:
    (A) Matches customer orders for a security with other customer 
orders;
    (B) Such customers' orders are not displayed to any person, other 
than employees of the alternative trading system; and
    (C) Such orders are executed at a price for such security 
disseminated by an effective transaction reporting plan, or derived 
from such prices.
* * * * *

0
30. Part 242 is amended by adding Regulation NMS, Sec. Sec.  242.600 
through 242.612, to read as follows:

Regulation NMS--Regulation of the National Market System

Sec.
242.600 NMS security designation and definitions.
242.601 Dissemination of transaction reports and last sale data with 
respect to transactions in NMS stocks.
242.602 Dissemination of quotations in NMS securities.
242.603 Distribution, consolidation, and display of information with 
respect to quotations for and transactions in NMS stocks.
242.604 Display of customer limit orders.
242.605 Disclosure of order execution information.
242.606 Disclosure of order routing information.
242.607 Customer account statements.
242.608 Filing and amendment of national market system plans.
242.609 Registration of securities information processors: form of 
application and amendments.
242.610 Access to quotations.
242.611 Order protection rule.
242.612 Minimum pricing increment.

Regulation NMS--Regulation of the National Market System


Sec.  242.600  NMS security designation and definitions.

    (a) The term national market system security as used in section 
11A(a)(2) of the Act (15 U.S.C. 78k-1(a)(2)) shall mean any NMS 
security as defined in paragraph (b) of this section.
    (b) For purposes of Regulation NMS (Sec. Sec.  242.600 through 
242.612), the following definitions shall apply:
    (1)  Aggregate quotation size means the sum of the quotation sizes 
of all responsible brokers or dealers who have communicated on any 
national securities exchange bids or offers for an NMS security at the 
same price.
    (2) Alternative trading system has the meaning provided in Sec.  
242.300(a).
    (3) Automated quotation means a quotation displayed by a trading 
center that:
    (i) Permits an incoming order to be marked as immediate-or-cancel;
    (ii) Immediately and automatically executes an order marked as 
immediate-or-cancel against the displayed quotation up to its full 
size;
    (iii) Immediately and automatically cancels any unexecuted portion 
of an order marked as immediate-or-cancel without routing the order 
elsewhere;
    (iv) Immediately and automatically transmits a response to the 
sender of an order marked as immediate-or-cancel indicating the action 
taken with respect to such order; and
    (v) Immediately and automatically displays information that updates 
the displayed quotation to reflect any change to its material terms.
    (4) Automated trading center means a trading center that:
    (i) Has implemented such systems, procedures, and rules as are 
necessary to render it capable of displaying quotations that meet the 
requirements for an automated quotation set forth in paragraph (b)(3) 
of this section;
    (ii) Identifies all quotations other than automated quotations as 
manual quotations;
    (iii) Immediately identifies its quotations as manual quotations 
whenever it has reason to believe that it is not capable of displaying 
automated quotations; and
    (iv) Has adopted reasonable standards limiting when its quotations 
change from automated quotations to manual quotations, and vice versa, 
to specifically defined circumstances that promote fair and efficient 
access to its automated quotations and are consistent with the 
maintenance of fair and orderly markets.
    (5) Average effective spread means the share-weighted average of 
effective spreads for order executions calculated, for buy orders, as 
double the amount of difference between the execution price and the 
midpoint of the national best bid and national best offer at the time 
of order receipt and, for sell orders, as double the amount of 
difference between the midpoint of the national best bid and national 
best offer at the time of order receipt and the execution price.
    (6) Average realized spread means the share-weighted average of 
realized spreads for order executions calculated, for buy orders, as 
double the amount of difference between the execution price and the 
midpoint of the national best bid and national best offer five minutes

[[Page 37621]]

after the time of order execution and, for sell orders, as double the 
amount of difference between the midpoint of the national best bid and 
national best offer five minutes after the time of order execution and 
the execution price; provided, however, that the midpoint of the final 
national best bid and national best offer disseminated for regular 
trading hours shall be used to calculate a realized spread if it is 
disseminated less than five minutes after the time of order execution.
    (7) Best bid and best offer mean the highest priced bid and the 
lowest priced offer.
    (8) Bid or offer means the bid price or the offer price 
communicated by a member of a national securities exchange or member of 
a national securities association to any broker or dealer, or to any 
customer, at which it is willing to buy or sell one or more round lots 
of an NMS security, as either principal or agent, but shall not include 
indications of interest.
    (9) Block size with respect to an order means it is:
    (i) Of at least 10,000 shares; or
    (ii) For a quantity of stock having a market value of at least 
$200,000.
    (10) Categorized by order size means dividing orders into separate 
categories for sizes from 100 to 499 shares, from 500 to 1999 shares, 
from 2000 to 4999 shares, and 5000 or greater shares.
    (11) Categorized by order type means dividing orders into separate 
categories for market orders, marketable limit orders, inside-the-quote 
limit orders, at-the-quote limit orders, and near-the-quote limit 
orders.
    (12) Categorized by security means dividing orders into separate 
categories for each NMS stock that is included in a report.
    (13) Consolidated display means:
    (i) The prices, sizes, and market identifications of the national 
best bid and national best offer for a security; and
    (ii) Consolidated last sale information for a security.
    (14) Consolidated last sale information means the price, volume, 
and market identification of the most recent transaction report for a 
security that is disseminated pursuant to an effective national market 
system plan.
    (15) Covered order means any market order or any limit order 
(including immediate-or-cancel orders) received by a market center 
during regular trading hours at a time when a national best bid and 
national best offer is being disseminated, and, if executed, is 
executed during regular trading hours, but shall exclude any order for 
which the customer requests special handling for execution, including, 
but not limited to, orders to be executed at a market opening price or 
a market closing price, orders submitted with stop prices, orders to be 
executed only at their full size, orders to be executed on a particular 
type of tick or bid, orders submitted on a ``not held'' basis, orders 
for other than regular settlement, and orders to be executed at prices 
unrelated to the market price of the security at the time of execution.
    (16) Customer means any person that is not a broker or dealer.
    (17) Customer limit order means an order to buy or sell an NMS 
stock at a specified price that is not for the account of either a 
broker or dealer; provided, however, that the term customer limit order 
shall include an order transmitted by a broker or dealer on behalf of a 
customer.
    (18) Customer order means an order to buy or sell an NMS security 
that is not for the account of a broker or dealer, but shall not 
include any order for a quantity of a security having a market value of 
at least $50,000 for an NMS security that is an option contract and a 
market value of at least $200,000 for any other NMS security.
    (19) Directed order means a customer order that the customer 
specifically instructed the broker or dealer to route to a particular 
venue for execution.
    (20) Dynamic market monitoring device means any service provided by 
a vendor on an interrogation device or other display that:
    (i) Permits real-time monitoring, on a dynamic basis, of 
transaction reports, last sale data, or quotations with respect to a 
particular security; and
    (ii) Displays the most recent transaction report, last sale data, 
or quotation with respect to that security until such report, data, or 
quotation has been superseded or supplemented by the display of a new 
transaction report, last sale data, or quotation reflecting the next 
reported transaction or quotation in that security.
    (21) Effective national market system plan means any national 
market system plan approved by the Commission (either temporarily or on 
a permanent basis) pursuant to Sec.  242.608.
    (22) Effective transaction reporting plan means any transaction 
reporting plan approved by the Commission pursuant to Sec.  242.601.
    (23) Electronic communications network means, for the purposes of 
Sec.  242.602(b)(5), 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; except that the term electronic communications network 
shall not include:
    (i) Any system that crosses multiple orders at one or more 
specified times at a single price set by the system (by algorithm or by 
any derivative pricing mechanism) and does not allow orders to be 
crossed or executed against directly by participants outside of such 
times; or
    (ii) Any system operated by, or on behalf of, an OTC market maker 
or exchange market maker that executes customer orders primarily 
against the account of such market maker as principal, other than 
riskless principal.
    (24) Exchange market maker means any member of a national 
securities exchange that is registered as a specialist or market maker 
pursuant to the rules of such exchange.
    (25) Exchange-traded security means any NMS security or class of 
NMS securities listed and registered, or admitted to unlisted trading 
privileges, on a national securities exchange; provided, however, that 
securities not listed on any national securities exchange that are 
traded pursuant to unlisted trading privileges are excluded.
    (26) Executed at the quote means, for buy orders, execution at a 
price equal to the national best offer at the time of order receipt 
and, for sell orders, execution at a price equal to the national best 
bid at the time of order receipt.
    (27) Executed outside the quote means, for buy orders, execution at 
a price higher than the national best offer at the time of order 
receipt and, for sell orders, execution at a price lower than the 
national best bid at the time of order receipt.
    (28) Executed with price improvement means, for buy orders, 
execution at a price lower than the national best offer at the time of 
order receipt and, for sell orders, execution at a price higher than 
the national best bid at the time of order receipt.
    (29) Inside-the-quote limit order, at-the-quote limit order, and 
near-the-quote limit order mean non-marketable buy orders with limit 
prices that are, respectively, higher than, equal to, and lower by 
$0.10 or less than the national best bid at the time of order receipt, 
and non-marketable sell orders with limit prices that are, 
respectively, lower than, equal to, and higher by $0.10 or less than 
the national best offer at the time of order receipt.
    (30) Intermarket sweep order means a limit order for an NMS stock 
that meets the following requirements:
    (i) When routed to a trading center, the limit order is identified 
as an intermarket sweep order; and

[[Page 37622]]

    (ii) Simultaneously with the routing of the limit order identified 
as an intermarket sweep order, one or more additional limit orders, as 
necessary, are routed to execute against the full displayed size of any 
protected bid, in the case of a limit order to sell, or the full 
displayed size of any protected offer, in the case of a limit order to 
buy, for the NMS stock with a price that is superior to the limit price 
of the limit order identified as an intermarket sweep order. These 
additional routed orders also must be marked as intermarket sweep 
orders.
    (31) Interrogation device means any securities information 
retrieval system capable of displaying transaction reports, last sale 
data, or quotations upon inquiry, on a current basis on a terminal or 
other device.
    (32) Joint self-regulatory organization plan means a plan as to 
which two or more self-regulatory organizations, acting jointly, are 
sponsors.
    (33) Last sale data means any price or volume data associated with 
a transaction.
    (34) Listed equity security means any equity security listed and 
registered, or admitted to unlisted trading privileges, on a national 
securities exchange.
    (35) Listed option means any option traded on a registered national 
securities exchange or automated facility of a national securities 
association.
    (36) Make publicly available means posting on an Internet Web site 
that is free and readily accessible to the public, furnishing a written 
copy to customers on request without charge, and notifying customers at 
least annually in writing that a written copy will be furnished on 
request.
    (37) Manual quotation means any quotation other than an automated 
quotation.
    (38) Market center means any exchange market maker, OTC market 
maker, alternative trading system, national securities exchange, or 
national securities association.
    (39) Marketable limit order means any buy order with a limit price 
equal to or greater than the national best offer at the time of order 
receipt, or any sell order with a limit price equal to or less than the 
national best bid at the time of order receipt.
    (40) Moving ticker means any continuous real-time moving display of 
transaction reports or last sale data (other than a dynamic market 
monitoring device) provided on an interrogation or other display 
device.
    (41) Nasdaq security means any registered security listed on The 
Nasdaq Stock Market, Inc.
    (42) National best bid and national best offer means, with respect 
to quotations for an NMS security, the best bid and best offer for such 
security that are calculated and disseminated on a current and 
continuing basis by a plan processor pursuant to an effective national 
market system plan; provided, that in the event two or more market 
centers transmit to the plan processor pursuant to such plan identical 
bids or offers for an NMS security, the best bid or best offer (as the 
case may be) shall be determined by ranking all such identical bids or 
offers (as the case may be) first by size (giving the highest ranking 
to the bid or offer associated with the largest size), and then by time 
(giving the highest ranking to the bid or offer received first in 
time).
    (43) National market system plan means any joint self-regulatory 
organization plan in connection with:
    (i) The planning, development, operation or regulation of a 
national market system (or a subsystem thereof) or one or more 
facilities thereof; or
    (ii) The development and implementation of procedures and/or 
facilities designed to achieve compliance by self-regulatory 
organizations and their members with any section of this Regulation NMS 
and part 240, subpart A of this chapter promulgated pursuant to section 
11A of the Act (15 U.S.C. 78k-1).
    (44) National securities association means any association of 
brokers and dealers registered pursuant to section 15A of the Act (15 
U.S.C. 78o-3).
    (45) National securities exchange means any exchange registered 
pursuant to section 6 of the Act (15 U.S.C. 78f).
    (46) NMS security means any security or class of securities for 
which transaction reports are collected, processed, and made available 
pursuant to an effective transaction reporting plan, or an effective 
national market system plan for reporting transactions in listed 
options.
    (47) NMS stock means any NMS security other than an option.
    (48) Non-directed order means any customer order other than a 
directed order.
    (49) Odd-lot means an order for the purchase or sale of an NMS 
stock in an amount less than a round lot.
    (50) Options class means all of the put option or call option 
series overlying a security, as defined in section 3(a)(10) of the Act 
(15 U.S.C. 78c(a)(10)).
    (51) Options series means the contracts in an options class that 
have the same unit of trade, expiration date, and exercise price, and 
other terms or conditions.
    (52) OTC market maker means any dealer that holds itself out as 
being willing to buy from and sell to its customers, or others, in the 
United States, an NMS stock for its own account on a regular or 
continuous basis otherwise than on a national securities exchange in 
amounts of less than block size.
    (53) Participants, when used in connection with a national market 
system plan, means any self-regulatory organization which has agreed to 
act in accordance with the terms of the plan but which is not a 
signatory of such plan.
    (54) Payment for order flow has the meaning provided in Sec.  
240.10b-10 of this chapter.
    (55) Plan processor means any self-regulatory organization or 
securities information processor acting as an exclusive processor in 
connection with the development, implementation and/or operation of any 
facility contemplated by an effective national market system plan.
    (56) Profit-sharing relationship means any ownership or other type 
of affiliation under which the broker or dealer, directly or 
indirectly, may share in any profits that may be derived from the 
execution of non-directed orders.
    (57) Protected bid or protected offer means a quotation in an NMS 
stock that:
    (i) Is displayed by an automated trading center;
    (ii) Is disseminated pursuant to an effective national market 
system plan; and
    (iii) Is an automated quotation that is the best bid or best offer 
of a national securities exchange, the best bid or best offer of The 
Nasdaq Stock Market, Inc., or the best bid or best offer of a national 
securities association other than the best bid or best offer of The 
Nasdaq Stock Market, Inc.
    (58) Protected quotation means a protected bid or a protected 
offer.
    (59) Published aggregate quotation size means the aggregate 
quotation size calculated by a national securities exchange and 
displayed by a vendor on a terminal or other display device at the time 
an order is presented for execution to a responsible broker or dealer.
    (60) Published bid and published offer means the bid or offer of a 
responsible broker or dealer for an NMS security communicated by it to 
its national securities exchange or association pursuant to Sec.  
242.602 and displayed by a vendor on a terminal or other display device 
at the time an order is presented for execution to such responsible 
broker or dealer.
    (61) Published quotation size means the quotation size of a 
responsible

[[Page 37623]]

broker or dealer communicated by it to its national securities exchange 
or association pursuant to Sec.  242.602 and displayed by a vendor on a 
terminal or other display device at the time an order is presented for 
execution to such responsible broker or dealer.
    (62) Quotation means a bid or an offer.
    (63) Quotation size, when used with respect to a responsible 
broker's or dealer's bid or offer for an NMS security, means:
    (i) The number of shares (or units of trading) of that security 
which such responsible broker or dealer has specified, for purposes of 
dissemination to vendors, that it is willing to buy at the bid price or 
sell at the offer price comprising its bid or offer, as either 
principal or agent; or
    (ii) In the event such responsible broker or dealer has not so 
specified, a normal unit of trading for that NMS security.
    (64) Regular trading hours means the time between 9:30 a.m. and 
4:00 p.m. Eastern Time, or such other time as is set forth in the 
procedures established pursuant to Sec.  242.605(a)(2).
    (65) Responsible broker or dealer means:
    (i) When used with respect to bids or offers communicated on a 
national securities exchange, any member of such national securities 
exchange who communicates to another member on such national securities 
exchange, at the location (or locations) or through the facility or 
facilities designated by such national securities exchange for trading 
in an NMS security a bid or offer for such NMS security, as either 
principal or agent; provided, however, that, in the event two or more 
members of a national securities exchange have communicated on or 
through such national securities exchange bids or offers for an NMS 
security at the same price, each such member shall be considered a 
responsible broker or dealer for that bid or offer, subject to the 
rules of priority and precedence then in effect on that national 
securities exchange; and further provided, that for a bid or offer 
which is transmitted from one member of a national securities exchange 
to another member who undertakes to represent such bid or offer on such 
national securities exchange as agent, only the last member who 
undertakes to represent such bid or offer as agent shall be considered 
the responsible broker or dealer for that bid or offer; and
    (ii) When used with respect to bids and offers communicated by a 
member of an association to a broker or dealer or a customer, the 
member communicating the bid or offer (regardless of whether such bid 
or offer is for its own account or on behalf of another person).
    (66) Revised bid or offer means a market maker's bid or offer which 
supersedes its published bid or published offer.
    (67) Revised quotation size means a market maker's quotation size 
which supersedes its published quotation size.
    (68) Self-regulatory organization means any national securities 
exchange or national securities association.
    (69) Specified persons, when used in connection with any 
notification required to be provided pursuant to Sec.  242.602(a)(3) 
and any election (or withdrawal thereof) permitted under Sec.  
242.602(a)(5), means:
    (i) Each vendor;
    (ii) Each plan processor; and
    (iii) The processor for the Options Price Reporting Authority (in 
the case of a notification for a subject security which is a class of 
securities underlying options admitted to trading on any national 
securities exchange).
    (70) Sponsor, when used in connection with a national market system 
plan, means any self-regulatory organization which is a signatory to 
such plan and has agreed to act in accordance with the terms of the 
plan.
    (71) SRO display-only facility means a facility operated by or on 
behalf of a national securities exchange or national securities 
association that displays quotations in a security, but does not 
execute orders against such quotations or present orders to members for 
execution.
    (72) SRO trading facility means a facility operated by or on behalf 
of a national securities exchange or a national securities association 
that executes orders in a security or presents orders to members for 
execution.
    (73) Subject security means:
    (i) With respect to a national securities exchange:
    (A) Any exchange-traded security other than a security for which 
the executed volume of such exchange, during the most recent calendar 
quarter, comprised one percent or less of the aggregate trading volume 
for such security as reported pursuant to an effective transaction 
reporting plan or effective national market system plan; and
    (B) Any other NMS security for which such exchange has in effect an 
election, pursuant to Sec.  242.602(a)(5)(i), to collect, process, and 
make available to a vendor bids, offers, quotation sizes, and aggregate 
quotation sizes communicated on such exchange; and
    (ii) With respect to a member of a national securities association:
    (A) Any exchange-traded security for which such member acts in the 
capacity of an OTC market maker unless the executed volume of such 
member, during the most recent calendar quarter, comprised one percent 
or less of the aggregate trading volume for such security as reported 
pursuant to an effective transaction reporting plan or effective 
national market system plan; and
    (B) Any other NMS security for which such member acts in the 
capacity of an OTC market maker and has in effect an election, pursuant 
to Sec.  242.602(a)(5)(ii), to communicate to its association bids, 
offers, and quotation sizes for the purpose of making such bids, 
offers, and quotation sizes available to a vendor.
    (74) Time of order execution means the time (to the second) that an 
order was executed at any venue.
    (75) Time of order receipt means the time (to the second) that an 
order was received by a market center for execution.
    (76) Time of the transaction has the meaning provided in Sec.  
240.10b-10 of this chapter.
    (77) Trade-through means the purchase or sale of an NMS stock 
during regular trading hours, either as principal or agent, at a price 
that is lower than a protected bid or higher than a protected offer.
    (78) Trading center means a national securities exchange or 
national securities association that operates an SRO trading facility, 
an alternative trading system, an exchange market maker, an OTC market 
maker, or any other broker or dealer that executes orders internally by 
trading as principal or crossing orders as agent.
    (79) Trading rotation means, with respect to an options class, the 
time period on a national securities exchange during which:
    (i) Opening, re-opening, or closing transactions in options series 
in such options class are not yet completed; and
    (ii) Continuous trading has not yet commenced or has not yet ended 
for the day in options series in such options class.
    (80) Transaction report means a report containing the price and 
volume associated with a transaction involving the purchase or sale of 
one or more round lots of a security.
    (81) Transaction reporting association means any person authorized 
to implement or administer any transaction reporting plan on behalf of 
persons acting jointly under Sec.  242.601(a).

[[Page 37624]]

    (82) Transaction reporting plan means any plan for collecting, 
processing, making available or disseminating transaction reports with 
respect to transactions in securities filed with the Commission 
pursuant to, and meeting the requirements of, Sec.  242.601.
    (83) Vendor means any securities information processor engaged in 
the business of disseminating transaction reports, last sale data, or 
quotations with respect to NMS securities to brokers, dealers, or 
investors on a real-time or other current and continuing basis, whether 
through an electronic communications network, moving ticker, or 
interrogation device.


Sec.  242.601  Dissemination of transaction reports and last sale data 
with respect to transactions in NMS stocks.

    (a) Filing and effectiveness of transaction reporting plans. (1) 
Every national securities exchange shall file a transaction reporting 
plan regarding transactions in listed equity and Nasdaq securities 
executed through its facilities, and every national securities 
association shall file a transaction reporting plan regarding 
transactions in listed equity and Nasdaq securities executed by its 
members otherwise than on a national securities exchange.
    (2) Any transaction reporting plan, or any amendment thereto, filed 
pursuant to this section shall be filed with the Commission, and 
considered for approval, in accordance with the procedures set forth in 
Sec.  242.608(a) and (b). Any such plan, or amendment thereto, shall 
specify, at a minimum:
    (i) The listed equity and Nasdaq securities or classes of such 
securities for which transaction reports shall be required by the plan;
    (ii) Reporting requirements with respect to transactions in listed 
equity securities and Nasdaq securities, for any broker or dealer 
subject to the plan;
    (iii) The manner of collecting, processing, sequencing, making 
available and disseminating transaction reports and last sale data 
reported pursuant to such plan;
    (iv) The manner in which such transaction reports reported pursuant 
to such plan are to be consolidated with transaction reports from 
national securities exchanges and national securities associations 
reported pursuant to any other effective transaction reporting plan;
    (v) The applicable standards and methods which will be utilized to 
ensure promptness of reporting, and accuracy and completeness of 
transaction reports;
    (vi) Any rules or procedures which may be adopted to ensure that 
transaction reports or last sale data will not be disseminated in a 
fraudulent or manipulative manner;
    (vii) Specific terms of access to transaction reports made 
available or disseminated pursuant to the plan; and (viii) That 
transaction reports or last sale data made available to any vendor for 
display on an interrogation device identify the marketplace where each 
transaction was executed.
    (3) No transaction reporting plan filed pursuant to this section, 
or any amendment to an effective transaction reporting plan, shall 
become effective unless approved by the Commission or otherwise 
permitted in accordance with the procedures set forth in Sec.  242.608.
    (b) Prohibitions and reporting requirements. (1) No broker or 
dealer may execute any transaction in, or induce or attempt to induce 
the purchase or sale of, any NMS stock:
    (i) On or through the facilities of a national securities exchange 
unless there is an effective transaction reporting plan with respect to 
transactions in such security executed on or through such exchange 
facilities; or
    (ii) Otherwise than on a national securities exchange unless there 
is an effective transaction reporting plan with respect to transactions 
in such security executed otherwise than on a national securities 
exchange by such broker or dealer.
    (2) Every broker or dealer who is a member of a national securities 
exchange or national securities association shall promptly transmit to 
the exchange or association of which it is a member all information 
required by any effective transaction reporting plan filed by such 
exchange or association (either individually or jointly with other 
exchanges and/or associations).
    (c) Retransmission of transaction reports or last sale data. 
Notwithstanding any provision of any effective transaction reporting 
plan, no national securities exchange or national securities 
association may, either individually or jointly, by rule, stated policy 
or practice, transaction reporting plan or otherwise, prohibit, 
condition or otherwise limit, directly or indirectly, the ability of 
any vendor to retransmit, for display in moving tickers, transaction 
reports or last sale data made available pursuant to any effective 
transaction reporting plan; provided, however, that a national 
securities exchange or national securities association may, by means of 
an effective transaction reporting plan, condition such retransmission 
upon appropriate undertakings to ensure that any charges for the 
distribution of transaction reports or last sale data in moving tickers 
permitted by paragraph (d) of this section are collected.
    (d) Charges. Nothing in this section shall preclude any national 
securities exchange or national securities association, separately or 
jointly, pursuant to the terms of an effective transaction reporting 
plan, from imposing reasonable, uniform charges (irrespective of 
geographic location) for distribution of transaction reports or last 
sale data.
    (e) Appeals. The Commission may, in its discretion, entertain 
appeals in connection with the implementation or operation of any 
effective transaction reporting plan in accordance with the provisions 
of Sec.  242.608(d).
    (f) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any national securities exchange, national securities 
association, broker, dealer, or specified security if the Commission 
determines that such exemption is consistent with the public interest, 
the protection of investors and the removal of impediments to, and 
perfection of the mechanisms of, a national market system.


Sec.  242.602  Dissemination of quotations in NMS securities.

    (a) Dissemination requirements for national securities exchanges 
and national securities associations. (1) Every national securities 
exchange and national securities association shall establish and 
maintain procedures and mechanisms for collecting bids, offers, 
quotation sizes, and aggregate quotation sizes from responsible brokers 
or dealers who are members of such exchange or association, processing 
such bids, offers, and sizes, and making such bids, offers, and sizes 
available to vendors, as follows:
    (i) Each national securities exchange shall at all times such 
exchange is open for trading, collect, process, and make available to 
vendors the best bid, the best offer, and aggregate quotation sizes for 
each subject security listed or admitted to unlisted trading privileges 
which is communicated on any national securities exchange by any 
responsible broker or dealer, but shall not include:
    (A) Any bid or offer executed immediately after communication and 
any bid or offer communicated by a responsible broker or dealer other 
than an exchange market maker which is cancelled or withdrawn if not 
executed immediately after communication; and
    (B) Any bid or offer communicated during a period when trading in 
that security has been suspended or halted,

[[Page 37625]]

or prior to the commencement of trading in that security on any trading 
day, on that exchange.
    (ii) Each national securities association shall, at all times that 
last sale information with respect to NMS securities is reported 
pursuant to an effective transaction reporting plan, collect, process, 
and make available to vendors the best bid, best offer, and quotation 
sizes communicated otherwise than on an exchange by each member of such 
association acting in the capacity of an OTC market maker for each 
subject security and the identity of that member (excluding any bid or 
offer executed immediately after communication), except during any 
period when over-the-counter trading in that security has been 
suspended.
    (2) Each national securities exchange shall, with respect to each 
published bid and published offer representing a bid or offer of a 
member for a subject security, establish and maintain procedures for 
ascertaining and disclosing to other members of that exchange, upon 
presentation of orders sought to be executed by them in reliance upon 
paragraph (b)(2) of this section, the identity of the responsible 
broker or dealer who made such bid or offer and the quotation size 
associated with it.
    (3)(i) If, at any time a national securities exchange is open for 
trading, such exchange determines, pursuant to rules approved by the 
Commission pursuant to section 19(b)(2) of the Act (15 U.S.C. 
78s(b)(2)), that the level of trading activities or the existence of 
unusual market conditions is such that the exchange is incapable of 
collecting, processing, and making available to vendors the data for a 
subject security required to be made available pursuant to paragraph 
(a)(1) of this section in a manner that accurately reflects the current 
state of the market on such exchange, such exchange shall immediately 
notify all specified persons of that determination. Upon such 
notification, responsible brokers or dealers that are members of that 
exchange shall be relieved of their obligation under paragraphs (b)(2) 
and (c)(3) of this section and such exchange shall be relieved of its 
obligations under paragraphs (a)(1) and (2) of this section for that 
security; provided, however, that such exchange will continue, to the 
maximum extent practicable under the circumstances, to collect, 
process, and make available to vendors data for that security in 
accordance with paragraph (a)(1) of this section.
    (ii) During any period a national securities exchange, or any 
responsible broker or dealer that is a member of that exchange, is 
relieved of any obligation imposed by this section for any subject 
security by virtue of a notification made pursuant to paragraph 
(a)(3)(i) of this section, such exchange shall monitor the activity or 
conditions which formed the basis for such notification and shall 
immediately renotify all specified persons when that exchange is once 
again capable of collecting, processing, and making available to 
vendors the data for that security required to be made available 
pursuant to paragraph (a)(1) of this section in a manner that 
accurately reflects the current state of the market on such exchange. 
Upon such renotification, any exchange or responsible broker or dealer 
which had been relieved of any obligation imposed by this section as a 
consequence of the prior notification shall again be subject to such 
obligation.
    (4) Nothing in this section shall preclude any national securities 
exchange or national securities association from making available to 
vendors indications of interest or bids and offers for a subject 
security at any time such exchange or association is not required to do 
so pursuant to paragraph (a)(1) of this section.
    (5)(i) Any national securities exchange may make an election for 
purposes of the definition of subject security in Sec.  242.600(b)(73) 
for any NMS security, by collecting, processing, and making available 
bids, offers, quotation sizes, and aggregate quotation sizes in that 
security; except that for any NMS security previously listed or 
admitted to unlisted trading privileges on only one exchange and not 
traded by any OTC market maker, such election shall be made by 
notifying all specified persons, and shall be effective at the opening 
of trading on the business day following notification.
    (ii) Any member of a national securities association acting in the 
capacity of an OTC market maker may make an election for purposes of 
the definition of subject security in Sec.  242.600(b)(73) for any NMS 
security, by communicating to its association bids, offers, and 
quotation sizes in that security; except that for any other NMS 
security listed or admitted to unlisted trading privileges on only one 
exchange and not traded by any other OTC market maker, such election 
shall be made by notifying its association and all specified persons, 
and shall be effective at the opening of trading on the business day 
following notification.
    (iii) The election of a national securities exchange or member of a 
national securities association for any NMS security pursuant to this 
paragraph (a)(5) shall cease to be in effect if such exchange or member 
ceases to make available or communicate bids, offers, and quotation 
sizes in such security.
    (b) Obligations of responsible brokers and dealers. (1) Each 
responsible broker or dealer shall promptly communicate to its national 
securities exchange or national securities association, pursuant to the 
procedures established by that exchange or association, its best bids, 
best offers, and quotation sizes for any subject security.
    (2) Subject to the provisions of paragraph (b)(3) of this section, 
each responsible broker or dealer shall be obligated to execute any 
order to buy or sell a subject security, other than an odd-lot order, 
presented to it by another broker or dealer, or any other person 
belonging to a category of persons with whom such responsible broker or 
dealer customarily deals, at a price at least as favorable to such 
buyer or seller as the responsible broker's or dealer's published bid 
or published offer (exclusive of any commission, commission equivalent 
or differential customarily charged by such responsible broker or 
dealer in connection with execution of any such order) in any amount up 
to its published quotation size.
    (3)(i) No responsible broker or dealer shall be obligated to 
execute a transaction for any subject security as provided in paragraph 
(b)(2) of this section to purchase or sell that subject security in an 
amount greater than such revised quotation size if:
    (A) Prior to the presentation of an order for the purchase or sale 
of a subject security, a responsible broker or dealer has communicated 
to its exchange or association, pursuant to paragraph (b)(1) of this 
section, a revised quotation size; or
    (B) At the time an order for the purchase or sale of a subject 
security is presented, a responsible broker or dealer is in the process 
of effecting a transaction in such subject security, and immediately 
after the completion of such transaction, it communicates to its 
exchange or association a revised quotation size, such responsible 
broker or dealer shall not be obligated by paragraph (b)(2) of this 
section to purchase or sell that subject security in an amount greater 
than such revised quotation size.
    (ii) No responsible broker or dealer shall be obligated to execute 
a transaction for any subject security as provided in paragraph (b)(2) 
of this section if:
    (A) Before the order sought to be executed is presented, such 
responsible broker or dealer has communicated to

[[Page 37626]]

its exchange or association pursuant to paragraph (b)(1) of this 
section, a revised bid or offer; or
    (B) At the time the order sought to be executed is presented, such 
responsible broker or dealer is in the process of effecting a 
transaction in such subject security, and, immediately after the 
completion of such transaction, such responsible broker or dealer 
communicates to its exchange or association pursuant to paragraph 
(b)(1) of this section, a revised bid or offer; provided, however, that 
such responsible broker or dealer shall nonetheless be obligated to 
execute any such order in such subject security as provided in 
paragraph (b)(2) of this section at its revised bid or offer in any 
amount up to its published quotation size or revised quotation size.
    (4) Subject to the provisions of paragraph (a)(4) of this section:
    (i) No national securities exchange or OTC market maker may make 
available, disseminate or otherwise communicate to any vendor, directly 
or indirectly, for display on a terminal or other display device any 
bid, offer, quotation size, or aggregate quotation size for any NMS 
security which is not a subject security with respect to such exchange 
or OTC market maker; and
    (ii) No vendor may disseminate or display on a terminal or other 
display device any bid, offer, quotation size, or aggregate quotation 
size from any national securities exchange or OTC market maker for any 
NMS security which is not a subject security with respect to such 
exchange or OTC market maker.
    (5)(i) Entry of any priced order for an NMS security by an exchange 
market maker or OTC market maker in that security into an electronic 
communications network that widely disseminates such order shall be 
deemed to be:
    (A) A bid or offer under this section, to be communicated to the 
market maker's exchange or association pursuant to this paragraph (b) 
for at least the minimum quotation size that is required by the rules 
of the market maker's exchange or association if the priced order is 
for the account of a market maker, or the actual size of the order up 
to the minimum quotation size required if the priced order is for the 
account of a customer; and
    (B) A communication of a bid or offer to a vendor for display on a 
display device for purposes of paragraph (b)(4) of this section.
    (ii) An exchange market maker or OTC market maker that has entered 
a priced order for an NMS security into an electronic communications 
network that widely disseminates such order shall be deemed to be in 
compliance with paragraph (b)(5)(i)(A) of this section if the 
electronic communications network:
    (A)(1) Provides to a national securities exchange or national 
securities association (or an exclusive processor acting on behalf of 
one or more exchanges or associations) the prices and sizes of the 
orders at the highest buy price and the lowest sell price for such 
security entered in, and widely disseminated by, the electronic 
communications network by exchange market makers and OTC market makers 
for the NMS security, and such prices and sizes are included in the 
quotation data made available by such exchange, association, or 
exclusive processor to vendors pursuant to this section; and
    (2) Provides, to any broker or dealer, the ability to effect a 
transaction with a priced order widely disseminated by the electronic 
communications network entered therein by an exchange market maker or 
OTC market maker that is:
    (i) Equivalent to the ability of any broker or dealer to effect a 
transaction with an exchange market maker or OTC market maker pursuant 
to the rules of the national securities exchange or national securities 
association to which the electronic communications network supplies 
such bids and offers; and
    (ii) At the price of the highest priced buy order or lowest priced 
sell order, or better, for the lesser of the cumulative size of such 
priced orders entered therein by exchange market makers or OTC market 
makers at such price, or the size of the execution sought by the broker 
or dealer, for such security; or
    (B) Is an alternative trading system that:
    (1) Displays orders and provides the ability to effect transactions 
with such orders under Sec.  242.301(b)(3); and
    (2) Otherwise is in compliance with Regulation ATS (Sec.  242.300 
through Sec.  242.303).
    (c) Transactions in listed options. (1) A national securities 
exchange or national securities association:
    (i) Shall not be required, under paragraph (a) of this section, to 
collect from responsible brokers or dealers who are members of such 
exchange or association, or to make available to vendors, the quotation 
sizes and aggregate quotation sizes for listed options, if such 
exchange or association establishes by rule and periodically publishes 
the quotation size for which such responsible brokers or dealers are 
obligated to execute an order to buy or sell an options series that is 
a subject security at its published bid or offer under paragraph (b)(2) 
of this section;
    (ii) May establish by rule and periodically publish a quotation 
size, which shall not be for less than one contract, for which 
responsible brokers or dealers who are members of such exchange or 
association are obligated under paragraph (b)(2) of this section to 
execute an order to buy or sell a listed option for the account of a 
broker or dealer that is in an amount different from the quotation size 
for which it is obligated to execute an order for the account of a 
customer; and
    (iii) May establish and maintain procedures and mechanisms for 
collecting from responsible brokers and dealers who are members of such 
exchange or association, and making available to vendors, the quotation 
sizes and aggregate quotation sizes in listed options for which such 
responsible broker or dealer will be obligated under paragraph (b)(2) 
of this section to execute an order from a customer to buy or sell a 
listed option and establish by rule and periodically publish the size, 
which shall not be less than one contract, for which such responsible 
brokers or dealers are obligated to execute an order for the account of 
a broker or dealer.
    (2) If, pursuant to paragraph (c)(1) of this section, the rules of 
a national securities exchange or national securities association do 
not require its members to communicate to it their quotation sizes for 
listed options, a responsible broker or dealer that is a member of such 
exchange or association shall:
    (i) Be relieved of its obligations under paragraph (b)(1) of this 
section to communicate to such exchange or association its quotation 
sizes for any listed option; and
    (ii) Comply with its obligations under paragraph (b)(2) of this 
section by executing any order to buy or sell a listed option, in an 
amount up to the size established by such exchange's or association's 
rules under paragraph (c)(1) of this section.
    (3) Thirty second response. Each responsible broker or dealer, 
within thirty seconds of receiving an order to buy or sell a listed 
option in an amount greater than the quotation size established by a 
national securities exchange's or national securities association's 
rules pursuant to paragraph (c)(1) of this section, or its published 
quotation size must:
    (i) Execute the entire order; or
    (ii)(A) Execute that portion of the order equal to at least:
    (1) The quotation size established by a national securities 
exchange's or national securities association's rules, pursuant to 
paragraph (c)(1) of this

[[Page 37627]]

section, to the extent that such exchange or association does not 
collect and make available to vendors quotation size and aggregate 
quotation size under paragraph (a) of this section; or
    (2) Its published quotation size; and
    (B) Revise its bid or offer.
    (4) Notwithstanding paragraph (c)(3) of this section, no 
responsible broker or dealer shall be obligated to execute a 
transaction for any listed option as provided in paragraph (b)(2) of 
this section if:
    (i) Any of the circumstances in paragraph (b)(3) of this section 
exist; or
    (ii) The order for the purchase or sale of a listed option is 
presented during a trading rotation in that listed option.
    (d) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any responsible broker or dealer, electronic communications 
network, national securities exchange, or national securities 
association if the Commission determines that such exemption is 
consistent with the public interest, the protection of investors and 
the removal of impediments to and perfection of the mechanism of a 
national market system.


Sec.  242.603  Distribution, consolidation, and display of information 
with respect to quotations for and transactions in NMS stocks.

    (a) Distribution of information. (1) Any exclusive processor, or 
any broker or dealer with respect to information for which it is the 
exclusive source, that distributes information with respect to 
quotations for or transactions in an NMS stock to a securities 
information processor shall do so on terms that are fair and 
reasonable.
    (2) Any national securities exchange, national securities 
association, broker, or dealer that distributes information with 
respect to quotations for or transactions in an NMS stock to a 
securities information processor, broker, dealer, or other persons 
shall do so on terms that are not unreasonably discriminatory.
    (b) Consolidation of information. Every national securities 
exchange on which an NMS stock is traded and national securities 
association shall act jointly pursuant to one or more effective 
national market system plans to disseminate consolidated information, 
including a national best bid and national best offer, on quotations 
for and transactions in NMS stocks. Such plan or plans shall provide 
for the dissemination of all consolidated information for an individual 
NMS stock through a single plan processor.
    (c) Display of information. (1) No securities information 
processor, broker, or dealer shall provide, in a context in which a 
trading or order-routing decision can be implemented, a display of any 
information with respect to quotations for or transactions in an NMS 
stock without also providing, in an equivalent manner, a consolidated 
display for such stock.
    (2) The provisions of paragraph (c)(1) of this section shall not 
apply to a display of information on the trading floor or through the 
facilities of a national securities exchange or to a display in 
connection with the operation of a market linkage system implemented in 
accordance with an effective national market system plan.
    (d) Exemptions. The Commission, by order, may exempt from the 
provisions of this section, either unconditionally or on specified 
terms and conditions, any person, security, or item of information, or 
any class or classes of persons, securities, or items of information, 
if the Commission determines that such exemption is necessary or 
appropriate in the public interest, and is consistent with the 
protection of investors.


Sec.  242.604  Display of customer limit orders.

    (a) Specialists and OTC market makers. For all NMS stocks:
    (1) Each member of a national securities exchange that is 
registered by that exchange as a specialist, or is authorized by that 
exchange to perform functions substantially similar to that of a 
specialist, shall publish immediately a bid or offer that reflects:
    (i) The price and the full size of each customer limit order held 
by the specialist that is at a price that would improve the bid or 
offer of such specialist in such security; and
    (ii) The full size of each customer limit order held by the 
specialist that:
    (A) Is priced equal to the bid or offer of such specialist for such 
security;
    (B) Is priced equal to the national best bid or national best 
offer; and
    (C) Represents more than a de minimis change in relation to the 
size associated with the specialist's bid or offer.
    (2) Each registered broker or dealer that acts as an OTC market 
maker shall publish immediately a bid or offer that reflects:
    (i) The price and the full size of each customer limit order held 
by the OTC market maker that is at a price that would improve the bid 
or offer of such OTC market maker in such security; and
    (ii) The full size of each customer limit order held by the OTC 
market maker that:
    (A) Is priced equal to the bid or offer of such OTC market maker 
for such security;
    (B) Is priced equal to the national best bid or national best 
offer; and
    (C) Represents more than a de minimis change in relation to the 
size associated with the OTC market maker's bid or offer.
    (b) Exceptions. The requirements in paragraph (a) of this section 
shall not apply to any customer limit order:
    (1) That is executed upon receipt of the order.
    (2) That is placed by a customer who expressly requests, either at 
the time that the order is placed or prior thereto pursuant to an 
individually negotiated agreement with respect to such customer's 
orders, that the order not be displayed.
    (3) That is an odd-lot order.
    (4) That is a block size order, unless a customer placing such 
order requests that the order be displayed.
    (5) That is delivered immediately upon receipt to a national 
securities exchange or national securities association-sponsored 
system, or an electronic communications network that complies with the 
requirements of Sec.  242.602(b)(5)(ii) with respect to that order.
    (6) That is delivered immediately upon receipt to another exchange 
member or OTC market maker that complies with the requirements of this 
section with respect to that order.
    (7) That is an ``all or none'' order.
    (c) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any responsible broker or dealer, electronic communications 
network, national securities exchange, or national securities 
association if the Commission determines that such exemption is 
consistent with the public interest, the protection of investors and 
the removal of impediments to and perfection of the mechanism of a 
national market system.


Sec.  242.605  Disclosure of order execution information.

    Preliminary Note: Section 242.605 requires market centers to 
make available standardized, monthly reports of statistical 
information concerning their order executions. This information is 
presented in accordance with uniform standards that are based on 
broad assumptions about order execution and routing practices. The 
information will provide a starting point to promote visibility and 
competition on the part of market centers and broker-dealers, 
particularly on the factors of execution price and speed. The 
disclosures required by this section do not encompass all of the 
factors that may be important to investors in evaluating the order 
routing services of a broker-dealer. In addition, any particular 
market center's statistics will encompass

[[Page 37628]]

varying types of orders routed by different broker-dealers on behalf 
of customers with a wide range of objectives. Accordingly, the 
statistical information required by this section alone does not 
create a reliable basis to address whether any particular broker-
dealer failed to obtain the most favorable terms reasonably 
available under the circumstances for customer orders.

    (a) Monthly electronic reports by market centers. (1) Every market 
center shall make available for each calendar month, in accordance with 
the procedures established pursuant to paragraph (a)(2) of this 
section, a report on the covered orders in NMS stocks that it received 
for execution from any person. Such report shall be in electronic form; 
shall be categorized by security, order type, and order size; and shall 
include the following columns of information:
    (i) For market orders, marketable limit orders, inside-the-quote 
limit orders, at-the-quote limit orders, and near-the-quote limit 
orders:
    (A) The number of covered orders;
    (B) The cumulative number of shares of covered orders;
    (C) The cumulative number of shares of covered orders cancelled 
prior to execution;
    (D) The cumulative number of shares of covered orders executed at 
the receiving market center;
    (E) The cumulative number of shares of covered orders executed at 
any other venue;
    (F) The cumulative number of shares of covered orders executed from 
0 to 9 seconds after the time of order receipt;
    (G) The cumulative number of shares of covered orders executed from 
10 to 29 seconds after the time of order receipt;
    (H) The cumulative number of shares of covered orders executed from 
30 seconds to 59 seconds after the time of order receipt;
    (I) The cumulative number of shares of covered orders executed from 
60 seconds to 299 seconds after the time of order receipt;
    (J) The cumulative number of shares of covered orders executed from 
5 minutes to 30 minutes after the time of order receipt; and
    (K) The average realized spread for executions of covered orders; 
and
    (ii) For market orders and marketable limit orders:
    (A) The average effective spread for executions of covered orders;
    (B) The cumulative number of shares of covered orders executed with 
price improvement;
    (C) For shares executed with price improvement, the share-weighted 
average amount per share that prices were improved;
    (D) For shares executed with price improvement, the share-weighted 
average period from the time of order receipt to the time of order 
execution;
    (E) The cumulative number of shares of covered orders executed at 
the quote;
    (F) For shares executed at the quote, the share-weighted average 
period from the time of order receipt to the time of order execution;
    (G) The cumulative number of shares of covered orders executed 
outside the quote;
    (H) For shares executed outside the quote, the share-weighted 
average amount per share that prices were outside the quote; and
    (I) For shares executed outside the quote, the share-weighted 
average period from the time of order receipt to the time of order 
execution.
    (2) Every national securities exchange on which NMS stocks are 
traded and each national securities association shall act jointly in 
establishing procedures for market centers to follow in making 
available to the public the reports required by paragraph (a)(1) of 
this section in a uniform, readily accessible, and usable electronic 
form. In the event there is no effective national market system plan 
establishing such procedures, market centers shall prepare their 
reports in a consistent, usable, and machine-readable electronic 
format, and make such reports available for downloading from an 
Internet Web site that is free and readily accessible to the public.
    (3) A market center shall make available the report required by 
paragraph (a)(1) of this section within one month after the end of the 
month addressed in the report.
    (b) Exemptions. The Commission may, by order upon application, 
conditionally or unconditionally exempt any person, security, or 
transaction, or any class or classes of persons, securities, or 
transactions, from any provision or provisions of this section, if the 
Commission determines that such exemption is necessary or appropriate 
in the public interest, and is consistent with the protection of 
investors.


Sec.  242.606  Disclosure of order routing information.

    (a) Quarterly report on order routing. (1) Every broker or dealer 
shall make publicly available for each calendar quarter a report on its 
routing of non-directed orders in NMS securities during that quarter. 
For NMS stocks, such report shall be divided into three separate 
sections for securities that are listed on the New York Stock Exchange, 
Inc., securities that are qualified for inclusion in The Nasdaq Stock 
Market, Inc., and securities that are listed on the American Stock 
Exchange LLC or any other national securities exchange. Such report 
also shall include a separate section for NMS securities that are 
option contracts. Each of the four sections in a report shall include 
the following information:
    (i) The percentage of total customer orders for the section that 
were non-directed orders, and the percentages of total non-directed 
orders for the section that were market orders, limit orders, and other 
orders;
    (ii) The identity of the ten venues to which the largest number of 
total non-directed orders for the section were routed for execution and 
of any venue to which five percent or more of non-directed orders were 
routed for execution, the percentage of total non-directed orders for 
the section routed to the venue, and the percentages of total non-
directed market orders, total non-directed limit orders, and total non-
directed other orders for the section that were routed to the venue; 
and
    (iii) A discussion of the material aspects of the broker's or 
dealer's relationship with each venue identified pursuant to paragraph 
(a)(1)(ii) of this section, including a description of any arrangement 
for payment for order flow and any profit-sharing relationship.
    (2) A broker or dealer shall make the report required by paragraph 
(a)(1) of this section publicly available within one month after the 
end of the quarter addressed in the report.
    (b) Customer requests for information on order routing. (1) Every 
broker or dealer shall, on request of a customer, disclose to its 
customer the identity of the venue to which the customer's orders were 
routed for execution in the six months prior to the request, whether 
the orders were directed orders or non-directed orders, and the time of 
the transactions, if any, that resulted from such orders.
    (2) A broker or dealer shall notify customers in writing at least 
annually of the availability on request of the information specified in 
paragraph (b)(1) of this section.
    (c) Exemptions. The Commission may, by order upon application, 
conditionally or unconditionally exempt any person, security, or 
transaction, or any class or classes of persons, securities, or 
transactions, from any provision or provisions of this section, if the 
Commission determines that such exemption is necessary or appropriate 
in the public interest, and is consistent with the protection of 
investors.

[[Page 37629]]

Sec.  242.607  Customer account statements.

    (a) No broker or dealer acting as agent for a customer may effect 
any transaction in, induce or attempt to induce the purchase or sale 
of, or direct orders for purchase or sale of, any NMS stock or a 
security authorized for quotation on an automated inter-dealer 
quotation system that has the characteristics set forth in section 17B 
of the Act (15 U.S.C. 78q-2), unless such broker or dealer informs such 
customer, in writing, upon opening a new account and on an annual basis 
thereafter, of the following:
    (1) The broker's or dealer's policies regarding receipt of payment 
for order flow from any broker or dealer, national securities exchange, 
national securities association, or exchange member to which it routes 
customers' orders for execution, including a statement as to whether 
any payment for order flow is received for routing customer orders and 
a detailed description of the nature of the compensation received; and
    (2) The broker's or dealer's policies for determining where to 
route customer orders that are the subject of payment for order flow 
absent specific instructions from customers, including a description of 
the extent to which orders can be executed at prices superior to the 
national best bid and national best offer.
    (b) Exemptions. The Commission, upon request or upon its own 
motion, may exempt by rule or by order, any broker or dealer or any 
class of brokers or dealers, security or class of securities from the 
requirements of paragraph (a) of this section with respect to any 
transaction or class of transactions, either unconditionally or on 
specified terms and conditions, if the Commission determines that such 
exemption is consistent with the pubic interest and the protection of 
investors.


Sec.  242.608  Filing and amendment of national market system plans.

    (a) Filing of national market system plans and amendments thereto. 
(1) Any two or more self-regulatory organizations, acting jointly, may 
file a national market system plan or may propose an amendment to an 
effective national market system plan (``proposed amendment'') by 
submitting the text of the plan or amendment to the Secretary of the 
Commission, together with a statement of the purpose of such plan or 
amendment and, to the extent applicable, the documents and information 
required by paragraphs (a)(4) and (5) of this section.
    (2) The Commission may propose amendments to any effective national 
market system plan by publishing the text thereof, together with a 
statement of the purpose of such amendment, in accordance with the 
provisions of paragraph (b) of this section.
    (3) Self-regulatory organizations are authorized to act jointly in:
    (i) Planning, developing, and operating any national market 
subsystem or facility contemplated by a national market system plan;
    (ii) Preparing and filing a national market system plan or any 
amendment thereto; or
    (iii) Implementing or administering an effective national market 
system plan.
    (4) Every national market system plan filed pursuant to this 
section, or any amendment thereto, shall be accompanied by:
    (i) Copies of all governing or constituent documents relating to 
any person (other than a self-regulatory organization) authorized to 
implement or administer such plan on behalf of its sponsors; and
    (ii) To the extent applicable:
    (A) A detailed description of the manner in which the plan or 
amendment, and any facility or procedure contemplated by the plan or 
amendment, will be implemented;
    (B) A listing of all significant phases of development and 
implementation (including any pilot phase) contemplated by the plan or 
amendment, together with the projected date of completion of each 
phase;
    (C) An analysis of the impact on competition of implementation of 
the plan or amendment or of any facility contemplated by the plan or 
amendment;
    (D) A description of any written understandings or agreements 
between or among plan sponsors or participants relating to 
interpretations of the plan or conditions for becoming a sponsor or 
participant in the plan; and
    (E) In the case of a proposed amendment, a statement that such 
amendment has been approved by the sponsors in accordance with the 
terms of the plan.
    (5) Every national market system plan, or any amendment thereto, 
filed pursuant to this section shall include a description of the 
manner in which any facility contemplated by the plan or amendment will 
be operated. Such description shall include, to the extent applicable:
    (i) The terms and conditions under which brokers, dealers, and/or 
self-regulatory organizations will be granted or denied access 
(including specific procedures and standards governing the granting or 
denial of access);
    (ii) The method by which any fees or charges collected on behalf of 
all of the sponsors and/or participants in connection with access to, 
or use of, any facility contemplated by the plan or amendment will be 
determined and imposed (including any provision for distribution of any 
net proceeds from such fees or charges to the sponsors and/or 
participants) and the amount of such fees or charges;
    (iii) The method by which, and the frequency with which, the 
performance of any person acting as plan processor with respect to the 
implementation and/or operation of the plan will be evaluated; and
    (iv) The method by which disputes arising in connection with the 
operation of the plan will be resolved.
    (6) In connection with the selection of any person to act as plan 
processor with respect to any facility contemplated by a national 
market system plan (including renewal of any contract for any person to 
so act), the sponsors shall file with the Commission a statement 
identifying the person selected, describing the material terms under 
which such person is to serve as plan processor, and indicating the 
solicitation efforts, if any, for alternative plan processors, the 
alternatives considered and the reasons for selection of such person.
    (7) Any national market system plan (or any amendment thereto) 
which is intended by the sponsors to satisfy a plan filing requirement 
contained in any other section of this Regulation NMS and part 240, 
subpart A of this chapter shall, in addition to compliance with this 
section, also comply with the requirements of such other section.
    (b) Effectiveness of national market system plans. (1) The 
Commission shall publish notice of the filing of any national market 
system plan, or any proposed amendment to any effective national market 
system plan (including any amendment initiated by the Commission), 
together with the terms of substance of the filing or a description of 
the subjects and issues involved, and shall provide interested persons 
an opportunity to submit written comments. No national market system 
plan, or any amendment thereto, shall become effective unless approved 
by the Commission or otherwise permitted in accordance with paragraph 
(b)(3) of this section.
    (2) Within 120 days of the date of publication of notice of filing 
of a national market system plan or an amendment to an effective 
national market system plan, or within such longer period as the 
Commission may designate up to 180 days of such date if it finds such 
longer period to be appropriate and publishes its reasons

[[Page 37630]]

for so finding or as to which the sponsors consent, the Commission 
shall approve such plan or amendment, with such changes or subject to 
such conditions as the Commission may deem necessary or appropriate, if 
it finds that such plan or amendment is necessary or appropriate in the 
public interest, for the protection of investors and the maintenance of 
fair and orderly markets, to remove impediments to, and perfect the 
mechanisms of, a national market system, or otherwise in furtherance of 
the purposes of the Act. Approval of a national market system plan, or 
an amendment to an effective national market system plan (other than an 
amendment initiated by the Commission), shall be by order. Promulgation 
of an amendment to an effective national market system plan initiated 
by the Commission shall be by rule.
    (3) A proposed amendment may be put into effect upon filing with 
the Commission if designated by the sponsors as:
    (i) Establishing or changing a fee or other charge collected on 
behalf of all of the sponsors and/or participants in connection with 
access to, or use of, any facility contemplated by the plan or 
amendment (including changes in any provision with respect to 
distribution of any net proceeds from such fees or other charges to the 
sponsors and/or participants);
    (ii) Concerned solely with the administration of the plan, or 
involving the governing or constituent documents relating to any person 
(other than a self-regulatory organization) authorized to implement or 
administer such plan on behalf of its sponsors; or
    (iii) Involving solely technical or ministerial matters. At any 
time within 60 days of the filing of any such amendment, the Commission 
may summarily abrogate the amendment and require that such amendment be 
refiled in accordance with paragraph (a)(1) of this section and 
reviewed in accordance with paragraph (b)(2) of this section, if it 
appears to the Commission that such action is necessary or appropriate 
in the public interest, for the protection of investors, or the 
maintenance of fair and orderly markets, to remove impediments to, and 
perfect the mechanisms of, a national market system or otherwise in 
furtherance of the purposes of the Act.
    (4) Notwithstanding the provisions of paragraph (b)(1) of this 
section, a proposed amendment may be put into effect summarily upon 
publication of notice of such amendment, on a temporary basis not to 
exceed 120 days, if the Commission finds that such action is necessary 
or appropriate in the public interest, for the protection of investors 
or the maintenance of fair and orderly markets, to remove impediments 
to, and perfect the mechanisms of, a national market system or 
otherwise in furtherance of the purposes of the Act.
    (5) Any plan (or amendment thereto) in connection with:
    (i) The planning, development, operation, or regulation of a 
national market system (or a subsystem thereof) or one or more 
facilities thereof; or
    (ii) The development and implementation of procedures and/or 
facilities designed to achieve compliance by self-regulatory 
organizations and/or their members of any section of this Regulation 
NMS (Sec. Sec. 242.600 through 242.612) and part 240, subpart A of this 
chapter promulgated pursuant to section 11A of the Act (15 U.S.C. 78k-
1), approved by the Commission pursuant to section 11A of the Act (or 
pursuant to any rule or regulation thereunder) prior to the effective 
date of this section (either temporarily or permanently) shall be 
deemed to have been filed and approved pursuant to this section and no 
additional filing need be made by the sponsors with respect to such 
plan or amendment; provided, however, that all terms and conditions 
associated with any such approval (including time limitations) shall 
continue to be applicable; provided, further, that any amendment to 
such plan filed with or approved by the Commission on or after the 
effective date of this section shall be subject to the provisions of, 
and considered in accordance with the procedures specified in, this 
section.
    (c) Compliance with terms of national market system plans. Each 
self-regulatory organization shall comply with the terms of any 
effective national market system plan of which it is a sponsor or a 
participant. Each self-regulatory organization also shall, absent 
reasonable justification or excuse, enforce compliance with any such 
plan by its members and persons associated with its members.
    (d) Appeals. The Commission may, in its discretion, entertain 
appeals in connection with the implementation or operation of any 
effective national market system plan as follows:
    (1) Any action taken or failure to act by any person in connection 
with an effective national market system plan (other than a prohibition 
or limitation of access reviewable by the Commission pursuant to 
section 11A(b)(5) or section 19(d) of the Act (15 U.S.C. 78k-1(b)(5) or 
78s(d))) shall be subject to review by the Commission, on its own 
motion or upon application by any person aggrieved thereby (including, 
but not limited to, self-regulatory organizations, brokers, dealers, 
issuers, and vendors), filed not later than 30 days after notice of 
such action or failure to act or within such longer period as the 
Commission may determine.
    (2) Application to the Commission for review, or the institution of 
review by the Commission on its own motion, shall not operate as a stay 
of any such action unless the Commission determines otherwise, after 
notice and opportunity for hearing on the question of a stay (which 
hearing may consist only of affidavits or oral arguments).
    (3) In any proceedings for review, if the Commission, after 
appropriate notice and opportunity for hearing (which hearing may 
consist solely of consideration of the record of any proceedings 
conducted in connection with such action or failure to act and an 
opportunity for the presentation of reasons supporting or opposing such 
action or failure to act) and upon consideration of such other data, 
views, and arguments as it deems relevant, finds that the action or 
failure to act is in accordance with the applicable provisions of such 
plan and that the applicable provisions are, and were, applied in a 
manner consistent with the public interest, the protection of 
investors, the maintenance of fair and orderly markets, and the removal 
of impediments to, and the perfection of the mechanisms of a national 
market system, the Commission, by order, shall dismiss the proceeding. 
If the Commission does not make any such finding, or if it finds that 
such action or failure to act imposes any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Act, the 
Commission, by order, shall set aside such action and/or require such 
action with respect to the matter reviewed as the Commission deems 
necessary or appropriate in the public interest, for the protection of 
investors, and the maintenance of fair and orderly markets, or to 
remove impediments to, and perfect the mechanisms of, a national market 
system.
    (e) Exemptions. The Commission may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any self-regulatory organization, member thereof, or 
specified security, 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.

[[Page 37631]]

Sec.  242.609  Registration of securities information processors: form 
of application and amendments.

    (a) An application for the registration of a securities information 
processor shall be filed on Form SIP (Sec.  249.1001 of this chapter) 
in accordance with the instructions contained therein.
    (b) If any information reported in items 1-13 or item 21 of Form 
SIP or in any amendment thereto is or becomes inaccurate for any 
reason, whether before or after the registration has been granted, the 
securities information processor shall promptly file an amendment on 
Form SIP correcting such information.
    (c) The Commission, upon its own motion or upon application by any 
securities information processor, may conditionally or unconditionally 
exempt any securities information processor from any provision of the 
rules or regulations adopted under section 11A(b) of the Act (15 U.S.C. 
78k-1(b)).
    (d) Every amendment filed pursuant to this section shall constitute 
a ``report'' within the meaning of sections 17(a), 18(a) and 32(a) of 
the Act (15 U.S.C. 78q(a), 78r(a), and 78ff(a)).


Sec.  242.610  Access to quotations.

    (a) Quotations of SRO trading facility. A national securities 
exchange or national securities association shall not impose unfairly 
discriminatory terms that prevent or inhibit any person from obtaining 
efficient access through a member of the national securities exchange 
or national securities association to the quotations in an NMS stock 
displayed through its SRO trading facility.
    (b) Quotations of SRO display-only facility. (1) Any trading center 
that displays quotations in an NMS stock through an SRO display-only 
facility shall provide a level and cost of access to such quotations 
that is substantially equivalent to the level and cost of access to 
quotations displayed by SRO trading facilities in that stock.
    (2) Any trading center that displays quotations in an NMS stock 
through an SRO display-only facility shall not impose unfairly 
discriminatory terms that prevent or inhibit any person from obtaining 
efficient access to such quotations through a member, subscriber, or 
customer of the trading center.
    (c) Fees for access to quotations. A trading center shall not 
impose, nor permit to be imposed, any fee or fees for the execution of 
an order against a protected quotation of the trading center or against 
any other quotation of the trading center that is the best bid or best 
offer of a national securities exchange, the best bid or best offer of 
The Nasdaq Stock Market, Inc., or the best bid or best offer of a 
national securities association other than the best bid or best offer 
of The Nasdaq Stock Market, Inc. in an NMS stock that exceed or 
accumulate to more than the following limits:
    (1) If the price of a protected quotation or other quotation is 
$1.00 or more, the fee or fees cannot exceed or accumulate to more than 
$0.003 per share; or
    (2) If the price of a protected quotation or other quotation is 
less than $1.00, the fee or fees cannot exceed or accumulate to more 
than 0.3% of the quotation price per share.
    (d) Locking or crossing quotations. Each national securities 
exchange and national securities association shall establish, maintain, 
and enforce written rules that:
    (1) Require its members reasonably to avoid:
    (i) Displaying quotations that lock or cross any protected 
quotation in an NMS stock; and
    (ii) Displaying manual quotations that lock or cross any quotation 
in an NMS stock disseminated pursuant to an effective national market 
system plan;
    (2) Are reasonably designed to assure the reconciliation of locked 
or crossed quotations in an NMS stock; and
    (3) Prohibit its members from engaging in a pattern or practice of 
displaying quotations that lock or cross any protected quotation in an 
NMS stock, or of displaying manual quotations that lock or cross any 
quotation in an NMS stock disseminated pursuant to an effective 
national market system plan, other than displaying quotations that lock 
or cross any protected or other quotation as permitted by an exception 
contained in its rules established pursuant to paragraph (d)(1) of this 
section.
    (e) Exemptions. The Commission, by order, may exempt from the 
provisions of this section, either unconditionally or on specified 
terms and conditions, any person, security, quotations, orders, or 
fees, or any class or classes of persons, securities, quotations, 
orders, or fees, if the Commission determines that such exemption is 
necessary or appropriate in the public interest, and is consistent with 
the protection of investors.


Sec.  242.611  Order protection rule.

    (a) Reasonable policies and procedures. (1) A trading center shall 
establish, maintain, and enforce written policies and procedures that 
are reasonably designed to prevent trade-throughs on that trading 
center of protected quotations in NMS stocks that do not fall within an 
exception set forth in paragraph (b) of this section and, if relying on 
such an exception, that are reasonably designed to assure compliance 
with the terms of the exception.
    (2) A trading center shall regularly surveil to ascertain the 
effectiveness of the policies and procedures required by paragraph 
(a)(1) of this section and shall take prompt action to remedy 
deficiencies in such policies and procedures.
    (b) Exceptions. (1) The transaction that constituted the trade-
through was effected when the trading center displaying the protected 
quotation that was traded through was experiencing a failure, material 
delay, or malfunction of its systems or equipment.
    (2) The transaction that constituted the trade-through was not a 
``regular way'' contract.
    (3) The transaction that constituted the trade-through was a 
single-priced opening, reopening, or closing transaction by the trading 
center.
    (4) The transaction that constituted the trade-through was executed 
at a time when a protected bid was priced higher than a protected offer 
in the NMS stock.
    (5) The transaction that constituted the trade-through was the 
execution of an order identified as an intermarket sweep order.
    (6) The transaction that constituted the trade-through was effected 
by a trading center that simultaneously routed an intermarket sweep 
order to execute against the full displayed size of any protected 
quotation in the NMS stock that was traded through.
    (7) The transaction that constituted the trade-through was the 
execution of an order at a price that was not based, directly or 
indirectly, on the quoted price of the NMS stock at the time of 
execution and for which the material terms were not reasonably 
determinable at the time the commitment to execute the order was made.
    (8) The trading center displaying the protected quotation that was 
traded through had displayed, within one second prior to execution of 
the transaction that constituted the trade-through, a best bid or best 
offer, as applicable, for the NMS stock with a price that was equal or 
inferior to the price of the trade-through transaction.
    (9) The transaction that constituted the trade-through was the 
execution by a trading center of an order for which, at the time of 
receipt of the order, the trading center had guaranteed an execution at 
no worse than a specified price (a ``stopped order''), where:

[[Page 37632]]

    (i) The stopped order was for the account of a customer;
    (ii) The customer agreed to the specified price on an order-by-
order basis; and
    (iii) The price of the trade-through transaction was, for a stopped 
buy order, lower than the national best bid in the NMS stock at the 
time of execution or, for a stopped sell order, higher than the 
national best offer in the NMS stock at the time of execution.
    (c) Intermarket sweep orders. The trading center, broker, or dealer 
responsible for the routing of an intermarket sweep order shall take 
reasonable steps to establish that such order meets the requirements 
set forth in Sec.  242.600(b)(30).
    (d) Exemptions. The Commission, by order, may exempt from the 
provisions of this section, either unconditionally or on specified 
terms and conditions, any person, security, transaction, quotation, or 
order, or any class or classes of persons, securities, quotations, or 
orders, if the Commission determines that such exemption is necessary 
or appropriate in the public interest, and is consistent with the 
protection of investors.


Sec.  242.612  Minimum pricing increment.

    (a) No national securities exchange, national securities 
association, alternative trading system, vendor, or broker or dealer 
shall display, rank, or accept from any person a bid or offer, an 
order, or an indication of interest in any NMS stock priced in an 
increment smaller than $0.01 if that bid or offer, order, or indication 
of interest is priced equal to or greater than $1.00 per share.
    (b) No national securities exchange, national securities 
association, alternative trading system, vendor, or broker or dealer 
shall display, rank, or accept from any person a bid or offer, an 
order, or an indication of interest in any NMS stock priced in an 
increment smaller than $0.0001 if that bid or offer, order, or 
indication of interest is priced less than $1.00 per share.
    (c) The Commission, by order, may exempt from the provisions of 
this section, either unconditionally or on specified terms and 
conditions, any person, security, quotation, or order, or any class or 
classes of persons, securities, quotations, or orders, if the 
Commission determines that such exemption is necessary or appropriate 
in the public interest, and is consistent with the protection of 
investors.

PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934

0
31. The authority citation for part 249 continues to read in part as 
follows:

    Authority: 15 U.S.C. 78a et seq. and 7201 et seq.; and 18 U.S.C. 
1350, unless otherwise noted.
* * * * *

0
32. Section 249.1001 is revised to read as follows:


Sec.  249.1001  Form SIP, for application for registration as a 
securities information processor or to amend such an application or 
registration.

    This form shall be used for application for registration as a 
securities information processor, pursuant to section 11A(b) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78k-1(b)) and Sec.  242.609 
of this chapter, or to amend such an application or registration.

0
33. Form SIP (referenced in Sec.  249.1001) is amended by revising 
Instruction 6 of General Instructions for Preparing and Filing Form SIP 
to read as follows:

    Note: The text of Form SIP does not and this amendment will not 
appear in the Code of Federal Regulations.

FORM SIP

* * * * *

General Instructions for Preparing and Filing Form SIP

* * * * *
    6. Rule 609(b) of Regulation NMS requires that if any information 
contained in items 1 through 13 or item 21 of this application, or any 
supplement or amendment thereto, is or becomes inaccurate for any 
reason, an amendment must be filed promptly on Form SIP correcting such 
information.
* * * * *

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

0
34. The authority citation for part 270 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *

0
35. Section 270.17a-7 is amended by revising paragraph (b)(1) to read 
as follows:


Sec.  270.17a-7  Exemption of certain purchase or sale transactions 
between an investment company and certain affiliated persons thereof.

* * * * *
    (b) * * *
    (1) If the security is an ``NMS stock'' as that term is defined in 
17 CFR 242.600, the last sale price with respect to such security 
reported in the consolidated transaction reporting system 
(``consolidated system'') or the average of the highest current 
independent bid and lowest current independent offer for such security 
(reported pursuant to 17 CFR 242.602) if there are no reported 
transactions in the consolidated system that day; or
* * * * *

    Dated: June 9, 2005.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.

Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins to the 
Adoption of Regulation NMS

Introduction

    As a result of our strong disagreement with the majority's adoption 
of Regulation NMS,\1\ we write jointly to make clear the reasons for 
our dissent. We support Regulation NMS'' overarching goal of enhancing 
the efficiency of our markets. We do not believe, however, that 
Regulation NMS will achieve this goal, and we are concerned about its 
detrimental impact on competition and innovation. In our view, 
Regulation NMS is at odds with Congress' goal, expressed in the 
Securities Acts Amendments of 1975 (``1975 Act Amendments''),\2\ of 
protecting competition within the national market system.\3\ In 
analyzing

[[Page 37633]]

Regulation NMS and voting to dissent from its adoption, we have been 
guided by Congress' clear preference that competitive forces, rather 
than unnecessary regulation, guide the development of the national 
market system.\4\ With the adoption of Regulation NMS, the majority's 
arbitrary notions and unfounded assumptions about how markets and 
investors should interact have taken unwarranted precedence over the 
interplay of competitive forces within the marketplace.\5\ We believe 
that Regulation NMS turns back Commission policy regarding competition 
and innovation and sets up roadblocks for our markets.
---------------------------------------------------------------------------

    \1\ Securities Exchange Act Release No. 51808 (June 9, 2005) 
(``Adopting Release''). Regulation NMS is composed of four 
substantive rules: A requirement that markets provide fair and non-
discriminatory access to quotations, a prohibition on the display of 
quotations in pricing increments of less than a penny, amendments to 
the formulas currently used to allocate market data revenues to 
self-regulatory organizations (``SROs'') under joint industry plans, 
and a trade-through rule applicable to both the listed and the 
Nasdaq markets. In the Adopting Release, the trade-through rule is 
renamed the ``order protection rule.'' Adopting Release at note 2. 
This is a misnomer. An order displayed at the best price is not 
necessarily protected because it can be matched or an execution can 
occur at an inferior price by using an exception to the rule.
    \2\ Pub. L. 94-29, 89 Stat. 97 (1975).
    \3\ As the Senate Banking Committee stated in its report on the 
bill that ultimately became the 1975 Act Amendments:
    [T]he Commission's responsibility [is] to balance the perceived 
anti-competitive effects of the regulatory policy or decision at 
issue against the purposes of the Exchange Act that would be 
advanced thereby and the costs of doing so. Competition would not 
thereby become paramount to the great purposes of the Exchange Act, 
but the need for and effectiveness of regulatory actions in 
achieving those purposes would have to be weighed against any 
detrimental impact on competition.
    Senate Committee on Banking, Housing and Urban Affairs, S. Rep. 
No. 94-75, 94th Cong., 1st Sess. (1975) (``Senate Report''), at 13-
14. See also House Committee on Interstate and Foreign Commerce, 
H.R. Rep. 94-123, 94th Cong., 1st Sess. (1975), at 47 (``in the 
economic areas affecting the securities industry, competition, 
rather than regulation, should be the guiding force'') (quoting 
Securities Industry Study, Report of the Subcomm. on Commerce and 
Finance of the Committee on Interstate and Foreign Commerce, H.R. 
Rep. No. 92-1519, 92d Cong., 2d Sess. (1972), at 1).
    \4\ See, e.g., H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 
(1975) (``Conference Report''), at 92 (``It is the intent of the 
[House and Senate] conferees that the national market system evolve 
through the interplay of competitive forces as unnecessary 
regulatory restrictions are removed.'').
    \5\ See, e.g., Senate Report, supra note , at 12 (``This is not 
to suggest that under S. 249 the SEC would have either the 
responsibility or the power to operate as an ``economic czar'' for 
the development of a national market system.'') (citations omitted).
---------------------------------------------------------------------------

    The majority's statutory interpretations and policy changes are 
arbitrary, unreasonable and anticompetitive. They are not supported by 
substantial evidence that, notwithstanding their anti-competitive 
effect, they are necessary or appropriate to further the purposes of 
the Exchange Act. The impetus for the Commission's efforts to modernize 
the securities markets was the outdated Intermarket Trading System 
(``ITS'') trade-through rule that impeded the ability of electronic 
trading centers to compete against floor-based exchanges in the listed 
market. It is ironic that the end result of this lengthy process is the 
imposition of even more complex trade-through restrictions, not only on 
the New York Stock Exchange, Inc. (``NYSE''), but on Nasdaq, a market 
in which competition is already robust.
    We believe the wiser and more practical approach to improving the 
efficiency of U.S. markets for all investors would have been to improve 
access to quotations, enhance connectivity among markets and market 
participants, clarify the broker's duty of best execution, and reduce 
barriers to competition. In our view, these steps would improve market 
efficiency without exposing our markets to unforeseen consequences, 
redundant regulatory oversight and the concomitant compliance costs 
that will ultimately be borne by investors.\6\
---------------------------------------------------------------------------

    \6\ Given the uncertainty about the impact of the trade-through 
rule and the clear determination of the majority to pursue its 
chosen policy direction, we believe that it would have been prudent 
for the majority to have considered alternatives that would have 
permitted the Commission to gain more experience with the rule 
before requiring its implementation on all markets. One alternative 
would have been to implement access standards first, and adopt a 
trade-through rule only if deemed necessary after access and 
connectivity had been improved. Another alternative would have been 
to phase in the implementation of the trade-through rule in 
successive stages, allowing for sufficient time between stages to 
permit the Commission to evaluate the impact of the rule before full 
implementation across all markets. Yet another alternative would 
have been to extend the de minimis pilot approved in August 2002 for 
certain exchange-traded funds. See Securities Exchange Act Release 
No. 46428 (Aug. 28, 2002), 67 FR 56607 (Sept. 4, 2002). The 
exemption, which the Commission extended twice, led to increased 
competition, narrowing of spreads, and a reduction in trade-through 
rates. See Securities Exchange Act Release No. 49325 (Feb. 26, 
2004), 69 FR 11126 (Mar. 9, 2004) (``Proposing Release''), at 11134 
note 50 (citing October 2002 Analysis of QQQ Trading Before and 
After De Minimis, Memorandum from the Commission's Office of 
Economic Analysis to the File (Feb. 24, 2004) (available at: http://www.sec.gov/rules/proposed/s71004/oeamemo022404.pdf)). See also 
Comment Letter of C. Thomas Richardson, Managing Director, Citigroup 
Global Markets, Inc. (Jan. 26, 2005) (``Citigroup Reproposal Comment 
Letter''), at 2-3 (noting, with respect to trading in QQQQs: ``In 
its first six weeks of trading as a Nasdaq-listed product, the 
average consolidated effective spread on trades executed dropped by 
34%, despite the lack of any trade-through protection. In addition, 
quoted spreads did not widen, but, in fact, decreased approximately 
15% as measured by the average consolidated spread. What is so 
significant about this comparison is that before the QQQQs began 
trading in Nasdaq's electronic market, a $0.03 de minimis exception 
to the Trade-Through Rule existed already and had narrowed spreads 
significantly.'') (citing economic research provided by NASDAQ). 
However, no such alternatives were given serious consideration.
---------------------------------------------------------------------------

    For purposes of our dissent, we will focus principally on the 
trade-through rule. The issues raised in our dissent reflect the same 
concerns we made public at the open Commission meeting on April 6, 
2005, at which we dissented from the adoption of Regulation NMS. Our 
specific concerns are set forth below.

I. The Majority Mischaracterizes the Trade-Through Rule as Needed To 
Increase Market Depth

    One of the original catalysts for Regulation NMS was the need to 
address market inefficiencies caused by the antiquated ITS trade-
through rule. The Commission's policy objectives for the trade-through 
rule have expanded, however, far beyond a cure for integrating 
automated and manual markets. During the rulemaking, rationales offered 
for the trade-through rule have been a moving target, morphing from the 
protection of limit orders, to the need to increase market depth and 
liquidity, to the reduction of transaction costs for long-term 
investors and issuers.
    In February 2004, the Commission proposed a uniform trade-through 
rule as part of Regulation NMS, with the stated goals of encouraging 
limit orders and aggressive quoting.\7\ The proposed rule contained two 
major exceptions. The first exception provided an ``opt-out'' from the 
trade-through rule for informed customers,\8\ and the second permitted 
an automated order execution facility to trade through the quotations 
of non-automated markets.\9\ The opt-out proposal was intended to 
provide investors with flexibility in choosing where to route their 
orders and in determining whether their orders should trade-through 
better-priced quotes.\10\ The automated market exception was intended 
to resolve problems of integrating automated and manual markets under 
the ITS trade-through rule by protecting only the quotations of 
automated markets.\11\
---------------------------------------------------------------------------

    \7\ See Proposing Release, supra note 6, at Section III.B.2 
(``Intermarket Price Protection'').
    \8\ See Proposing Release, supra note 6, at Section III.D.1 
(``Opt-Out Orders'').
    \9\ See Proposing Release, supra note 6, at Section III.D.2 
(``Automated Order Execution Facility Exception'').
    \10\ The opt-out exception ``strives to preserve the usual 
customers' expectation of having their orders executed at the best 
displayed price, but allows a choice for those investors whose 
trading strategies may benefit from an immediate execution priced 
outside the national best bid and offer (`NBBO').'' Proposing 
Release, supra note 6, at 11138. ``Large traders may also want the 
ability to execute a block immediately at a price outside the 
quotes, to avoid parceling the block out over time in a series of 
transactions that could cause the market to move to an inferior 
price.'' Id.
    \11\ See generally Proposing Release, supra note 6, at Sections 
III.B.2. (``Intermarket Price Protection'') and III.D.2 (``Automated 
Order Execution Facility Exception''). In May 2004, the Commission 
solicited comment on whether individual automated quotations, rather 
than automated markets, should receive protection under the trade-
through rule. Securities Exchange Act Release No. 49749 (May 20, 
2004), 69 FR 30142 (May 26, 2004) (``Supplemental Release'').
---------------------------------------------------------------------------

    Commenters on the Proposing and Supplemental Releases were split on 
the need for a trade-through rule to promote fair and efficient 
markets.\12\ The floor-based exchanges and many institutional investors 
supported a trade-through rule and opposed an opt-out.\13\ Electronic

[[Page 37634]]

markets, online retail broker-dealers, and Nasdaq market makers were 
generally opposed to a trade-through rule,\14\ although there was some 
support for a rule, provided that it included an opt-out.\15\ Numerous 
commenters particularly opposed extending the trade-through rule to 
Nasdaq.\16\
---------------------------------------------------------------------------

    \12\ See Adopting Release, supra note 1, at Section II.A.1 
(``Need for Intermarket Trade-Through Rule'').
    \13\ See, e.g., Comment Letter of Darla C. Stuckey, Corporate 
Secretary of the New York Stock Exchange, Inc. (July 2, 2004); 
Comment Letter of David Humphreville, President, Specialist 
Association (June 30, 2004); Comment Letter of Kenneth J. Polcari, 
President, Organization of Independent Floor Brokers (May 12, 2004); 
Comment Letter of Ari Burstein, Associate Counsel, Investment 
Company Institute (June 30, 2004); George U. Sauter, Managing 
Director, The Vanguard Group, Inc. (July 14, 2004).
    \14\ See, e.g., Comment Letter of John H. Bluher, Executive Vice 
President and General Counsel, Knight Trading Group (July 2, 2004) 
(``Knight Proposal Comment Letter''); Comment Letter of Edward S. 
Knight, Executive Vice President and General Counsel, Nasdaq Stock 
Market, Inc. (July 2, 2004) (``Nasdaq Proposal Comment Letter''); 
Comment Letter of Eric D. Roiter, Senior Vice President and General 
Counsel, Fidelity Management & Research Co. (June 22, 2004), at 3-6; 
Comment Letter of Huw Jenkins, Managing Director, UBS Securities LLC 
(July 2, 2004) (``UBS Proposal Comment Letter''), at 3; Comment 
Letter of Kenneth Griffin, President and Chief Executive Officer, 
Citadel Investment Group, LLC (July 9, 2004) (``Citadel Proposal 
Comment Letter''); Comment Letter of Ellen L. S. Koplow, Executive 
Vice President and General Counsel, Ameritrade, Inc. (June 30, 
2004), at 2-4; Comment Letter of Carrie E. Dwyer, General Counsel 
and Executive Vice President, Charles Schwab & Co., Inc. (June 30, 
2004) (``Schwab Proposal Comment Letter''), at 13-16; Comment Letter 
of Kim Bang, President and Chief Executive Officer, Bloomberg 
Tradebook LLC (June 30, 2004), at 2 and 9-14.
    \15\ See, e.g., Comment Letter of Thomas N. McManus, Managing 
Director and Counsel, Morgan Stanley & Co., Inc. (Aug. 19, 2004); 
Comment Letter of Edward J. Nicoll, Instinet Group Inc. (June 30, 
2004).
    \16\ See, e.g., Comment Letter of Kevin O'Hara, General Counsel, 
Archipelago Holdings, Inc. (Sept. 24, 2004); Nasdaq Proposal Comment 
Letter, supra note 14; UBS Proposal Comment Letter, supra note 14, 
at 4; Citadel Proposal Comment Letter, supra note 14, at 6; Schwab 
Proposal Comment Letter, supra note 14, at 13 and 16; Knight 
Proposal Comment Letter, supra note 14.
---------------------------------------------------------------------------

    In December 2004, the Commission voted to repropose Regulation NMS, 
over Commissioner Atkins' dissent.\17\ In the Reproposing Release, the 
Commission's prior emphasis on encouraging aggressive quoting was 
dropped, and concern about market depth became more prominent.\18\ The 
Commission noted that many commenters opposing a trade-through rule, 
particularly on Nasdaq, had pointed to Nasdaq's efficient functioning 
without a trade-through rule.\19\ In response to these comments 
regarding Nasdaq's market quality, the Commission's Office of Economic 
Analysis (``OEA'') was asked to conduct a study of trade-through rates 
on several markets.\20\ The Division of Market Regulation also prepared 
an analysis of comparative execution quality statistics between Nasdaq 
and NYSE stocks.\21\
---------------------------------------------------------------------------

    \17\ Securities Exchange Act Release No. 50870 (Dec. 16, 2004), 
69 FR 77424 (Dec. 27, 2004) (``Reproposing Release''). The staff had 
recommended a final rule, including a trade-through rule covering 
full depth of book, which was scheduled for a Commission vote on 
December 15, 2004, without seeking further comment from the public. 
When details of the staff's final recommendation for a trade-through 
rule became public, however, the ensuing outcry led the Commission 
instead to repropose the rule. Leaving no doubt that there would be 
a trade-through rule in the final rule, the Commission solicited 
comment on whether the trade-through rule should apply to the ``top 
of book'' or to a voluntary ``depth of book.'' At the December 15, 
2004 open meeting at which Regulation NMS was reproposed, 
Commissioner Glassman urged commenters not to accept the 
inevitability of a trade-through rule. She asked for comment on the 
need for any trade-through rule, not just whether the rule should 
offer ``top of book'' or ``depth of book'' protection. SEC Open 
Meeting on Regulation NMS (Dec. 15, 2004) (webcast available at: 
http://www.sec.gov/news/openmeetings.shtml.).
    \18\ Compare Proposing Release, supra note 6, 69 FR at 11134 
with Reproposing Release, supra note 6, 69 FR at 77426.
    \19\ Reproposing Release, supra note 17, 69 FR at 77427-28.
    \20\ Analysis of Trade-throughs in Nasdaq and NYSE Issues, 
Memorandum from the Commission's Office of Economic Analysis to the 
File (Dec. 15, 2004) (``OEA Study'') (available at: http://www.sec.gov/spotlight/regnms/analysis121504.pdf). As one commenter 
noted, the Proposing Release's ``complete lack of economic analysis 
supporting the trade-through provisions'' was surprising. Comment 
Letter of W. Hardy Callcott (May 6, 2004), at 6.
    \21\ Comparative Analysis of Rule 11Ac1-5 Statistics by S&P 
Index, Memorandum to File from the Commission's Division of Market 
Regulation (Dec. 15, 2004) (``Market Regulation Study'') (available 
at: http://www.sec.gov/rules/proposed/s71004/mrmemo121504.pdf).
---------------------------------------------------------------------------

    The divide among commenters on the need for a trade-through rule 
continued in response to the Reproposing Release. However, commenters 
who had originally opposed the rule as well as those whose support for 
a trade-through rule had been conditioned on a general opt-out 
provision, which was dropped from the reproposal, were united in their 
opposition to the reproposed rule.\22\ They noted fallacies in the 
Commission's rationale for protecting limit orders and pointed to flaws 
in the OEA Study.\23\ They also stated that the Commission had 
significantly underestimated the costs of implementation.\24\
---------------------------------------------------------------------------

    \22\ See, e.g., Comment Letter of Thomas N. McManus, Managing 
Director and Counsel, Morgan Stanley (Feb. 7, 2005) (``Morgan 
Stanley Reproposal Comment Letter''), at 5; Comment Letter of Bruce 
C. Turner, Managing Director, CIBC World Markets Corp. (Feb. 4, 
2005) (``CIBC Reproposal Comment Letter''); Comment Letter of 
Michael J. Lynch, Managing Director, Merrill Lynch, Pierce, Fenner & 
Smith Inc. (Feb. 4, 2005) (``Merrill Lynch Reproposal Comment 
Letter''); Comment Letter of Richard M. Whiting, Executive Director 
and General Counsel, Financial Services Roundtable (Feb. 4, 2005); 
Comment Letter of David Baker, Global Head of Cash Trading and 
Global Head of Portfolio Trading, Deutsche Bank Securities Inc. 
(Feb. 3, 2005) (``Deutsche Bank Reproposal Comment Letter''); 
Comment Letter of Jeffrey T. Brown, Senior Vice President, Charles 
Schwab (Feb. 1, 2005) (``Schwab Reproposal Comment Letter''); 
Comment Letter of James T. Brett, Managing Director, J.P. Morgan 
Securities, Inc. (Jan. 28, 2005) (``J.P. Morgan Reproposal Comment 
Letter''); Comment Letter of Stewart P. Greene, Chief Counsel, 
Securities Law, Teachers Insurance and Annuity Assoc. of America, 
College Retirement Equities Fund (Jan. 27, 2005) (``TIAA CREF 
Reproposal Comment Letter''); Citigroup Reproposal Comment Letter, 
supra note 6; Comment Letter of Minder Cheng, Managing Director, 
Barclays Global Investors (Jan. 26, 2005) (``Barclays Reproposal 
Comment Letter''); Edward S. Knight, Executive Vice President and 
General Counsel, Nasdaq Stock Market, Inc. (Jan. 26, 2005) (``Nasdaq 
Reproposal Comment Letter''); Comment Letter of Adam Cooper, Senior 
Managing Director and General Counsel, Citadel Investment Group, 
L.L.C. (Jan. 26. 2005); Comment Letter of Phylis M. Esposito, 
Executive Vice President and Chief Strategy Officer, Ameritrade, 
Inc. (Jan. 26, 2005) (``Ameritrade Reproposal Comment Letter''); 
Comment Letter of Steve Swanson, CEO & President, Automated Trading 
Desk, LLC (Jan. 26, 2005) (``Automated Trading Desk Reproposal 
Comment Letter''); Comment Letter of the Competitive Enterprise 
Institute (Jan. 26, 2005); Comment Letter of Edward J. Nicoll, Chief 
Executive Officer, Instinet Group Inc. (Jan. 26, 2005) (``Instinet 
Reproposal Comment Letter''); Comment Letter of Kevin J.P. O'Hara, 
Chief Administrative Officer & General Counsel, Archipelago 
Holdings, Inc. (Jan. 26, 2005) (``Archipelago Reproposal Comment 
Letter''); Comment Letter of Eric D. Roiter, Senior Vice President 
and General Counsel, Fidelity Management & Research Co. (Jan. 26, 
2005) (``Fidelity Reproposal Comment Letter''); Comment Letter of 
Daniel Coleman, Managing Director, Head of Equities for the 
Americas, UBS Securities LLC (Jan. 25, 2005) (``UBS Reproposal 
Comment Letter''); Comment Letter of Thomas M. Joyce, CEO and 
President, Knight Trading Group, Inc. (Jan. 25, 2005) (``Knight 
Trading Reproposal Comment Letter''); Comment Letter of Kim Bang, 
Bloomberg L.P. (Jan. 25, 2005).
    \23\ See, e.g., Fidelity Reproposal Comment Letter, supra note 
22, at 7-8 (``We caution that the Commission's analysis, 
particularly as set forth in the OEA's study * * * is open to 
serious question and likely rests on serious methodological flaws. * 
* * Our own preliminary review of the OEA's study suggests that 
trade-throughs of displayed superior orders equal to or greater in 
size than the incoming ``trading-through'' order may amount to only 
0.4% of Nasdaq volume, and perhaps only 0.22% pf NYSE share volume * 
* *.''); Nasdaq Reproposal Comment Letter, supra note 22, Exhibit 1, 
at 5; Instinet Reproposal Comment Letter, supra note 22, at 6; 
Comment Letter of Kevin J.P. O'Hara, Chief Administrative Officer & 
General Counsel, Archipelago Reproposal Comment Letter, supra note 
22, at 6; UBS Reproposal Comment Letter, supra note 22, at 4 
(``[T]he OEA Study is based upon several improper assumptions, and 
thus results in a fundamentally flawed analysis.''). See generally 
Robert Battalio and Robert Jennings, Analysis of the Re-proposing 
Release of Reg NMS and the OEA's Trade-through Study (Mar. 28, 2005) 
(``Battalio-Jennings Study'') (attachment to Comment Letter of Eric 
D. Roiter, Senior Vice President and General Counsel, Fidelity 
Management & Research Co. (Mar. 28, 2005)).
    \24\ See, e.g., Deutsche Bank Reproposal Comment Letter, supra 
note 22, at 4-5.
---------------------------------------------------------------------------

    Over our dissent, the majority voted to adopt Regulation NMS on 
April 6, 2005, approving a trade-through rule protecting quotations at 
the ``top of book.'' The rule contains several exceptions, but does not 
include a general opt-out provision.\25\ In the Adopting Release, the 
goal of trade-through regulation is recast once again.

[[Page 37635]]

Now, the goal is increasing market depth and liquidity in order to 
minimize the impact of large orders, while decreasing transitory 
volatility and transaction costs for the benefit of long-term investors 
and issuers.\26\
---------------------------------------------------------------------------

    \25\ See Adopting Release, supra note 1, at text following note 
236. See generally Adopting Release, supra note 1, at Section II.A.4 
(``Elimination of Proposed Opt-Out Exception'').
    \26\ See generally Adopting Release, supra note 1, at Section 
I.B.2 (``Serving the Interests of Long-Term Investors and Listed 
Companies'') and text accompanying note 15.
---------------------------------------------------------------------------

II. The Majority Has Failed To Demonstrate the Trade-Through Rule Is 
Warranted

    The Proposing Release set forth three broad objectives for a review 
of market structure: equalizing regulation of markets, updating 
antiquated rules and promoting greater order interaction.\27\ Adopted 
Regulation NMS moves beyond these objectives to establish goals for a 
trade-through rule that allow the majority to construct its own view of 
optimal market structure. The majority focuses on two types of so-
called market structure ``problems'' that it claims would be addressed 
by a trade-through rule: investor protection concerns evidenced by 
trade-through rates on Nasdaq and NYSE \28\ and a lack of displayed 
depth on Nasdaq.\29\ Neither ``problem'' has been substantiated. 
However, the majority has contrived ``problems'' in the Nasdaq market 
that conform with Congressional goals for the development of a national 
market system in order to advance its own market structure 
solutions.\30\ To achieve this result, the majority portrays successful 
market-driven innovations as intractable market structure problems that 
can only be solved by government intervention.
---------------------------------------------------------------------------

    \27\ Proposing Release, supra note 6, 69 FR at 11128-29.
    \28\ See Adopting Release, supra note 1, at text accompanying 
notes 104 and 105.
    \29\ See Adopting Release, supra note 1, at text accompanying 
note 108.
    \30\ There are two paramount objectives in the development of a 
national market system. First, the maintenance of stable and orderly 
markets with maximum capacity for absorbing trading imbalances 
without undue price movements. And second, the centralization of all 
buying and selling interest so that each investor will have the 
opportunity for the best possible execution of his order, regardless 
of where in the system it originates.
    Senate Report, supra note 3, at 7.
---------------------------------------------------------------------------

A.The OEA Study Did Not Substantiate Investor Protection Concerns.

    The majority has failed to establish that current trade-through 
rates indicate a significant investor protection problem. The majority 
has cherry-picked statistics from the results of the OEA Study that 
appear to justify the adoption of a trade-through rule, while ignoring 
data that call the need for the rule into question. We do not believe 
that current minimal trade-through rates indicate that investors are 
not obtaining best execution, that their orders are being unfairly 
treated, or that investors are otherwise suffering economic harm.
    The Reproposing and Adopting Releases interpret the OEA Study as 
establishing a seemingly high rate of trade-throughs. The Reproposing 
Release claimed that 7.9% and 7.2% of the total share volume on Nasdaq 
and the NYSE, respectively, were traded through.\31\ The Reproposing 
Release failed to point out, however, that these trade-through rates 
were calculated, not on the basis of a quotation's displayed size, but 
on the size of the order. Thus, an order executed at an inferior price 
was considered to have been traded-through at its full size even if the 
order was for a larger number of shares than were available in the 
market.\32\
---------------------------------------------------------------------------

    \31\ Reproposing Release, supra note 17, 69 FR at 77433. The OEA 
Study suggests that the 7.9% and 7.2% trade-through rates cited 
above would be ``useful in assessing the potential benefits of 
increased limit order display and liquidity that the proposed rule 
intends to promote,'' but the majority views the statistic as 
evidence of significant trade-throughs. OEA Study, supra note 20, at 
1-2.
    \32\ To illustrate, suppose a broker received a 10,000 share 
customer order to buy and a 3,000 share offer is displayed in the 
market at a price of $10. Under the OEA Study's methodology, 
executing any portion of the remaining 7,000 shares above $10 would 
be considered a trade-through, regardless of the fact that only 
3,000 shares were offered for sale in the market. OEA acknowledged 
that this was a very conservative approach with the practical effect 
of overstating the trade-through rates. See OEA Study, supra note 
20, at 2.
---------------------------------------------------------------------------

    The Adopting Release cites the same figures, but acknowledges that 
the trade-through rates for total share volume on Nasdaq and the NYSE 
drop dramatically from 7.9% and 7.2%, respectively, to 1.9% and 1.2%, 
when executions are measured against the displayed number of shares 
available.\33\ This disclosure was made only after commenters faulted 
the Commission for its selective use of statistics.\34\
---------------------------------------------------------------------------

    \33\ See Adopting Release, supra note 1, at text accompanying 
note 68. See also OEA Study, supra note 20, at text following note 
3.
    \34\ See, e.g., supra note 23 (citing comment letters).
---------------------------------------------------------------------------

    Similarly, the majority relies on the NYSE's 7.2% trade-through 
rate to attempt to show a reduction in trade-through rates hoped to be 
achieved from the new rule, which does not include the block size or 
100 share exceptions contained in the ITS trade-through rule.\35\ 
Significantly, the Adopting Release admits that, after eliminating the 
effects of both of the ITS exceptions, the NYSE trade-through rate for 
total share volume is actually 2.3%.\36\ Given the majority's 
concession that the NYSE trade-through rate is 1.2% when measured 
against displayed size,\37\ its emphasis on a possible reduction in 
trade-throughs to 2.3% is disingenuous. The majority's selective 
interpretation of the OEA Study to justify the need for a trade-through 
rule is unreasonable and calls into question the basis of the rule.
---------------------------------------------------------------------------

    \35\ See Adopting Release, supra note 1, at text accompanying 
note 71.
    \36\ See Adopting Release, supra note 1, at text accompanying 
note 71.
    \37\ See OEA Study, supra note 20, at 2.
---------------------------------------------------------------------------

    An additional finding of the OEA Study was that the majority of 
trade-throughs occurred within a penny or two of a better bid or 
offer,\38\ at an estimated total cost in 2003 of $321 million.\39\ 
These statistics overstate the agency/principal conflict because the 
OEA Study was not limited to investors owed a duty of best 
execution.\40\ Furthermore, $321 million is a mere rounding error 
compared to the dollar value of trading on both markets which totaled 
approximately $16.8 trillion in 2003.\41\ As a percent of the total 
dollar value of trading, the $321 million cost savings represents less 
than 1/100th of one percent. These percentages do not indicate a 
significant problem with trade-throughs or best execution.\42\
---------------------------------------------------------------------------

    \38\ OEA Study, supra note 20, at Tables 3 and 10.
    \39\ OEA Study, supra note 20, at note 5 and accompanying text.
    \40\ The OEA Study used data from TAQ and Nastraq, neither of 
which distinguishes among different types of investors. See OEA 
Study, supra note 20, at 1.
    \41\ See NYSE Reported Share And Dollar Volume, 2003, NYSE Fact 
Book Online (available at: http://www.nysedata.com/factbook/viewer_edition.asp?mode=table&key=2923&category=3 3) (reporting 
$9.7 trillion in share trading on the NYSE in 2003); see also World 
Federation of Exchanges, Annual Report (2004) (available at: http://www.world-exchanges.org/WFE/home.asp?menu=315&document=2174 2174) 
(reporting $7.1 trillion in share trading on Nasdaq in 2003).
    \42\ The majority asserts that: [g]iven the large number of 
trades that fail to obtain the best displayed prices (e.g., 
approximately 1 in 40 trades for both Nasdaq and NYSE stocks), the 
Commission is concerned that many of the investors that ultimately 
received the inferior price in these trades may not be aware that 
their orders did not, in fact, obtain the best price.
    Adopting Release, supra note 1, at text following note 150. The 
majority claims that: investors (and particularly retail investors) 
often may have difficulty monitoring whether their orders receive 
the best available prices, given the rapid movement of quotations in 
many NMS stocks. The Commission believes that furthering the 
interests of these investors in obtaining best execution on an 
order-by-order basis is a vitally important objective that warrants 
adoption of the Order Protection Rule.
    Adopting Release, supra note 1, at text following note 105. The 
majority fails to acknowledge that retail investors have access to 
consolidated information that allows them to monitor their 
executions. In fact, the majority argues for a single consolidator 
by noting investors need reliable consolidated information to 
monitor their executions. The majority states that ``[t]he great 
strength of the current model is that it benefits investors, 
particularly retail investors, by enabling them to assess prices and 
evaluate the best execution of their orders by obtaining data from a 
single source that is highly reliable and comprehensive.'' See 
Adopting Release, supra note 1, at text following note 565. In 
addition, the NASD and the SEC monitor brokers for compliance with 
their best execution obligations.

---------------------------------------------------------------------------

[[Page 37636]]

    Nor do we believe that the trade-through rates establish that 
investors' orders are being treated unfairly. The Reproposing and 
Adopting Releases cited statistics from the OEA Study indicating that 
in 2003, approximately 2.5% of all trades on Nasdaq and the NYSE 
traded-through the market.\43\ Notwithstanding these minimal trade-
through rates, the majority found the rates ``significant,'' with 
customer orders being ``routinely'' traded-through.\44\ Commenters 
identified possible flaws in the OEA Study, suggesting that trade-
through rates were lower than OEA's estimate.\45\ They also stated 
that, while the OEA Study was based on 2003 data, data from 2004 
reflected a decrease in trade-throughs on Nasdaq to 1.5% due to 
increased order routing, reduction in internalization rates, and 
consolidation.\46\ The majority's 2.5% trade-through rate is also 
overstated because it includes trades other than trades for retail 
customer accounts, including trades for institutions, sophisticated 
investors and intermediaries.\47\
---------------------------------------------------------------------------

    \43\ See Reproposing Release, supra note 17, 69 FR at 77433; 
Adopting Release, supra note 1, at text accompanying note 102.
    \44\ See Reproposing Release, supra note 17, 69 FR at 77428. The 
majority states that ``the order protection rule will promote a more 
level playing field for retail investors that currently see their 
smaller displayed orders bypassed by block trades.'' Adopting 
Release, supra note 1, at text following note 84. We question the 
majority's basis for asserting that retail investors are not on the 
same playing field as other investors. The statement is also 
inconsistent with the majority's previous assertion that investors 
have difficulty monitoring whether their orders receive best 
execution. See supra note 42.
    \45\ See, e.g., Fidelity Reproposal Comment Letter, supra note 
22, at 8; Nasdaq Reproposal Comment Letter, supra note 22, at 5; 
Archipelago Reproposal Comment Letter, supra note 22, at 6; UBS 
Reproposal Comment Letter, supra note 22, at 4.
    \46\ See, e.g., Nasdaq Reproposal Comment Letter, supra note 22. 
The majority unreasonably credits impending regulation for the 
decrease in internalization rates in the Nasdaq market, rather than 
increased market efficiency. See Adopting Release, supra note 1, at 
text preceding note 80.
    \47\ It is important to note, however, that the OEA Study did 
not distinguish among different investor classes. Thus, the majority 
would have no basis for determining how many orders that traded 
through the market were owed a duty of best execution nor how many 
investors were unable to monitor their executions.
---------------------------------------------------------------------------

    Based on the record before us, it appears that the trade-through 
rate on Nasdaq during 2004 was between 1% and 2%. It follows, 
therefore, that between 98% and 99% of all trades on both markets did 
not trade-through better-priced bids or offers. Given that the 
hypothetical cost of trade-throughs is less than 1/100th of 1%, the 
evidence does not indicate that investors' orders are treated unfairly.
    In sum, we believe that the numbers speak for themselves. The 
minimal trade-through results reflected in the OEA Study do not support 
the conclusion that trade-throughs are a significant problem--certainly 
not one that justifies regulatory intervention on the scale of 
Regulation NMS.

B. There Is No Evidence of a Lack of Depth on Nasdaq.

    Over the past eight years, the Nasdaq market has developed into a 
completely automated market that meets the objectives of Section 11A of 
the Exchange Act.\48\ It provides economically efficient executions for 
investors, provides fair competition and equal access for all 
investors, provides depth of book information with respect to all 
quotations and transactions in securities, and allows investors to 
enter orders directly into the market without participating with a 
dealer. The Nasdaq market is connected by private linkages that allow 
both brokers and investors to execute transactions at the best price in 
the market they choose.\49\ This has all been accomplished in the 
absence of a trade-through rule.
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 78k-1. Section 11A(a)(1)(C) provides that ``[i]t 
is in the public interest and appropriate for the protection of 
investors and the maintenance of fair and orderly markets to 
assure'':
    (i) Economically efficient execution of securities transactions;
    (ii) fair competition among brokers and dealers, among exchange 
markets, and between exchange markets and markets other than 
exchange markets;
    (iii) the availability to brokers, dealers, and investors of 
information with respect to quotations for and transactions in, 
securities;
    (iv) the practicability of brokers executing investors' orders 
in the best market; and
    (v) an opportunity * * * for investors' orders to be executed 
without the participation of a dealer.
    \49\ In the Adopting Release the majority notes approvingly:
    [w]ith respect to Nasdaq stocks, connectivity among many trading 
centers already is established through private linkages. Routing out 
to other trading centers when necessary to obtain the best prices 
for Nasdaq stocks is an integral part of the business plan of many 
trading centers, even when not affirmatively required by best 
execution responsibilities or by Commission rule.
    Adopting Release, supra note 1, at text following note 290.
---------------------------------------------------------------------------

    Congress did not mandate that the Commission go beyond the goals of 
Section 11A to design its own view of optimal market structure, yet 
this is what the majority seeks to accomplish.\50\ The majority has 
offered no substantive basis for extending the trade-through rule to 
the Nasdaq market.\51\ To justify imposing the rule on Nasdaq, 
particularly in light of the minimal trade-through rates reflected in 
the OEA Study, the majority attempts to establish a lack of market 
depth. Defining Nasdaq's ``problem'' as a lack of depth is critical for 
justifying the rule's extension to Nasdaq because increasing market 
depth was one of Congress' goals for the national market system.\52\ 
The majority relies on a staff study of comparative execution quality 
conducted by the lawyers in the Division of Market Regulation (not the 
economists in OEA),\53\ anecdotal evidence, hypothetical cost savings 
and conjecture specifically related to low fill rates to attempt to 
show that, in addition to the investor protection problem, the Nasdaq 
market suffers from a lack of market depth. This is surprising, given 
the view of many commenters that the large number of limit orders in 
Nasdaq stocks signifies that sufficient incentives exist for the 
placement of such orders and that low fill rates do not represent a 
market weakness or cause investor harm.\54\ We do not believe that 
there were complaints about a lack of depth in the Nasdaq market in the 
Commission's roundtables on market structure or the comment letters. In 
fact, many broker-dealers representing retail investors and 
institutions objected to extending the trade-through rule to 
Nasdaq.\55\
---------------------------------------------------------------------------

    \50\ ``[T]he fundamental goals of a national market system must 
include (1) providing an investor or his broker with the ability to 
be able to determine, at any given time, where a particular 
transaction can be effected at the most favorable price and (2) 
creating an incentive for multiple market makers to deal in depth on 
a continuous basis.'' Senate Report, supra note 3, at 12 (emphasis 
added).
    \51\ The Proposing Release, referring to a ``disparity'' of 
regulation on the listed and Nasdaq markets, simply asserted the 
need for a uniform trade-through rule. No rationale for why 
uniformity was important was offered. See Proposing Release, supra 
note 6, at Section II.A (``Promote Equal Regulation of Market 
Centers''), 69 FR at 11128-29. We would note that if uniformity of 
treatment were a valid goal, having no trade-through rule would 
accomplish this. In any event, uniformity was not a Congressional 
objective for the national market system:
    This is not to say that it is the goal of the legislation to 
ignore or eliminate distinctions between exchange markets and over-
the-counter markets or other inherent differences or variations in 
components of a national market system. Some present distinctions 
may tend to disappear in a national market system, but it is not the 
intention of the bill to force all markets for all securities into a 
single mold.
    Senate Report, supra note 3, at 7.
    \52\ See Senate Report, supra note 3, at 7.
    \53\ Market Regulation Study, supra note 21.
    \54\ See, e.g., Instinet Reproposal Comment Letter, supra note 
22.
    \55\ See, e.g., Schwab Reproposal Comment Letter, supra note 22; 
Ameritrade Reproposal Comment Letter, supra note 22, at 4; Comment 
Letter of Lou Klobuchar Jr., President and Chief Brokerage Officer, 
E*TRADE Financial (June 30, 2004); Fidelity Reproposal Comment 
Letter, supra note 22.

---------------------------------------------------------------------------

[[Page 37637]]

    In the Reproposing Release, Nasdaq's small average displayed share 
size and low fill rate for large marketable limit orders was 
characterized as evidencing a lack of displayed depth, a purported 
defect in its market structure that a trade-through rule on Nasdaq 
would address.\56\ In the Adopting Release, the majority argues that 
the relatively low share volume of traded-through quotations evidences 
a shortage of quoted depth.\57\ The Adopting Release concedes, however, 
that Nasdaq's low fill rate is attributable to market participants' 
liquidity probing activities, otherwise known as ``pinging.'' Generally 
speaking, institutional investors seeking liquidity may ``ping'' or 
search for non-displayed limit orders in the Nasdaq market by sending 
electronic marketable limit orders for a number of shares greater than 
a market's displayed size.\58\ If there is liquidity in reserve, 
institutional investors will receive an execution for a number of 
shares greater than the displayed size. If there is no liquidity in 
reserve, orders will receive a partial execution or be left unfilled, 
contributing to the purported low fill rate on Nasdaq. ``Pinging'' 
provides investors with an efficient and economical method for 
searching for liquidity on an anonymous basis. The practice is the 
electronic version of the search for liquidity on manual markets 
through the auction market system, without the possibility of 
information leakage that may create market impact costs for investors. 
It is a fundamental trait of any market that the knowledge of 
additional trading interest will likely affect prices. Yet the majority 
views this market-based solution for searching for liquidity as 
evidence of a regulatory ``problem'' with Nasdaq's market structure 
that a trade-through rule must address.\59\
---------------------------------------------------------------------------

    \56\ ``Thus, low fill rates demonstrate that the total displayed 
and reserve liquidity available for Nasdaq stocks at any particular 
trading center typically is small compared to the demand for 
liquidity at the inside prices.'' Adopting Release, supra note 1, at 
text following note 132.
    \57\ ``[T]he share volume of quotations that currently are 
traded-through is a symptom of the problem that the Order Protection 
Rule is designed to address `` a shortage of quoted depth * * *.'' 
Adopting Release, supra note 1, at text accompanying note 108.
    \58\ See Adopting Release, supra note 1, at text preceding note 
132.
    \59\ The majority states that the trade-through rule will 
increase displayed liquidity and ``promote market efficiency by 
reducing the uncertainty and costs associated with the need for 
market participants to ``ping'' electronic markets for liquidity 
that is held in reserve.'' Adopting Release, supra note 1, at text 
following note 132.
---------------------------------------------------------------------------

    We believe that Nasdaq's low fill rate is evidence that investors 
are actively seeking liquidity in an efficient manner. Unless the 
majority forces all liquidity to be displayed in the market, investors 
will naturally continue to search for hidden liquidity to meet their 
demand. The Adopting Release appears to suggest that Nasdaq 
participants should change their aggressive order pricing behavior and 
instead expose their orders by providing latent displayed 
liquidity.\60\ In our view, however, the rule will not be successful in 
significantly modifying market participant behavior.\61\ There are 
legitimate reasons why market participants may not want to display 
their orders. For instance, concerns about market impact will still act 
to prevent market participants from displaying the full size of their 
orders, even with a trade-through rule.\62\
---------------------------------------------------------------------------

    \60\ The majority states ``the Rule strengthens the incentive 
for the voluntary display of a greater proportion of latent trading 
interest by assuring that, when such interest is displayed, it is 
protected against most trade-throughs.'' Adopting Release, supra 
note 1, at preceding note 152.
    \61\ As we have previously noted, the 2-8% range for lower and 
upper limits of potential benefits of increased market depth assumes 
that demand will create its own supply. See supra text accompanying 
notes 32 and 33. There is no basis for OEA's assumption.
    \62\ J.P. Morgan Reproposal Comment Letter, supra note 22, at 4 
(``For any particular trade, multiple factors may bear on the 
quality of execution, including speed, certainty of execution, 
liquidity and depth, opportunities for price improvement, anonymity, 
error rates, and the quality of a trading center's program of self-
regulation. These factors all relate to costs that are not captured 
by quoted prices, such as market access and transactional fees, 
market impact costs, costs of broken or erroneous trades, and 
indirect costs such as market data costs.'').
---------------------------------------------------------------------------

    In one respect, the majority is correct that the trade-through 
rule, as modified after its adoption on April 6, 2005, will alter 
market participant behavior. By amending the rule text to remove the 
reference to ``size'' from the definition of quotation, the majority 
has substantially altered the scope of protected liquidity. We do not 
believe a change of this magnitude to a major rule should be made 
without the benefit of the Commission's usual notice and comment 
process. In our view, this change is not merely a technical amendment, 
but rather cuts to the heart of how the rule will operate.
    The trade-through rule requires trading centers to establish and 
maintain written policies and procedures designed to prevent trade-
throughs of protected quotations unless they fall within an applicable 
exception.\63\ Prior to the amendment, the plain text of the definition 
of quotation clearly included both price and size. Therefore, trading 
centers could route an order to a protected quotation's full displayed 
size and simultaneously execute an order at an inferior price. This was 
consistent with the policy goal of increasing displayed size. Under the 
amended formulation, however, the critical component of size has been 
eliminated, thus expanding the scope of liquidity falling under the 
protected quotation umbrella. Thus, under the new definition of 
quotation, trading centers cannot trade-through a protected quotation's 
price, regardless of available liquidity, without an exception. The 
practical effect is that market participants must exhaust liquidity in 
reserve prior to moving to the next price level. Ironically, this seems 
to provide more incentive to maintain liquidity in reserve, rather than 
to display it publicly, a result that would be contrary to the 
majority's stated goals.
---------------------------------------------------------------------------

    \63\ New Rule 611 states:
    (a) Reasonable policies and procedures.
    (1) A trading center shall establish, maintain, and enforce 
written policies and procedures that are reasonably designed to 
prevent trade-throughs on that trading center of protected 
quotations in NMS stocks that do not fall within an exception set 
forth in paragraph (b) of this section and, if relying on such an 
exception, that are reasonably designed to assure compliance with 
the terms of the exception.
---------------------------------------------------------------------------

III. Regulation NMS Will Not Achieve Its Goals

    The majority asserts that a uniform trade-through rule will promote 
market efficiency. By encouraging the display of limit orders, it 
argues, the rule will increase liquidity and displayed depth and lower 
transaction costs for long-term investors and issuers. At the same 
time, the majority asserts that the rule will enhance best execution 
obligations. We firmly believe, however, that the hoped-for benefits of 
the trade-through rule will not materialize.

A. A Trade-Through Rule Is Not Needed as a Backstop to Best Execution

    The majority believes that the trade-through rule will further the 
objectives of the Exchange Act by providing a ``backstop'' to a 
broker's best execution obligations and that it will ``materially 
reduce the trade-through rates in both the market for Nasdaq stocks and 
the market for exchange-listed stocks.'' \64\ Its only response to 
arguments that current trade-through rates do not justify the need for 
regulatory action is to assert that the trade-through rates found in 
the OEA Study are not insignificant and to assert that the total number 
of trade-throughs is not the sole consideration in

[[Page 37638]]

evaluating the need for the trade-through rule.\65\
---------------------------------------------------------------------------

    \64\ See Adopting Release, supra note 1, at text preceding note 
63. Furthermore, the NASD and the Commission's Office of Compliance, 
Inspections and Examinations routinely monitor execution quality and 
whether brokers are fulfilling their best execution obligations.
    \65\ See Adopting Release, supra note 1, at text following note 
102.
---------------------------------------------------------------------------

    As stated above, we find these assertions unreasonable given the 
majority's failure to establish a significant trade-through problem as 
well as its acknowledgement that trade-throughs will continue to occur 
following the rule's adoption. We note that the Adopting Release does 
not contain an estimate of the reduction in trade-throughs. Moreover, 
consistent with the objectives of Section 11A, the Nasdaq market 
provides investors with the ability to determine where they can obtain 
the best price and provides linkages that allow them to obtain the best 
price available. Given the negative consequences of the rule, which we 
discuss below, we believe that any potential reduction in the already 
low rate of trade-throughs will be minimal, at best, and will be 
outweighed by the costs of the rule. Moreover, the majority's ``one 
size fits all'' approach to best execution will prevent many investors 
from obtaining the best execution for themselves and their 
fiduciaries.\66\
---------------------------------------------------------------------------

    \66\ See, e.g., J.P. Morgan Reproposal Comment Letter, supra 
note 22, at 6 (``To disenfranchise institutional investors for whom 
best execution frequently diverges from best posted quotes by 
limiting their strategies for managing risk would be to create a 
burden that is both unfairly distributed and disproportionate to the 
limited benefits of trade-through protection.'').
---------------------------------------------------------------------------

B. Some Trade-Throughs Will Continue

    The final rule requires trading centers to establish, maintain and 
enforce written policies and procedures to prevent trade-throughs, but 
it does not prohibit trade-throughs. The rule contains numerous 
exceptions for, among others, intermarket sweeps, self-help, flickering 
quotes, volume weighted average priced (``VWAP'') trades, and stopped 
orders,\67\ which means that trade-throughs will not be eliminated. In 
addition, commenters have suggested that there will be trade-throughs, 
even with a trade-through rule.\68\ The minimal rate of trade-throughs 
in the current environment and the undoubted existence of trade-
throughs even after the rule's implementation call into question the 
likelihood that the rule will reduce trade-throughs to any significant 
degree.
---------------------------------------------------------------------------

    \67\ Rule 611(b).
    \68\ See, e.g., UBS Reproposal Comment Letter, supra note 22, at 
5; Comment Letter of Reg NMS Study Group (May 23, 2004), at 4 
(``Accidental trade-throughs may be common in a market with fleeting 
quotes and limit orders that persist for only a second or two, 
making it difficult to effectively identify and sanction deliberate 
trade-throughs.''); Comment Letter of David Cummings, Chief 
Executive Officer of Tradebot Systems, Inc. (Jan. 26, 2005) 
(``Tradebot Reproposal Comment Letter''), at 1.
---------------------------------------------------------------------------

C. The Trade-Through Rule Will Not Augment Market Depth Because It 
Provides Only Incomplete Protection of Limit Orders

    The majority states that the protection of limit orders, the 
foundation of market pricing, is one of its most important goals for 
market structure.\69\ This goal may be worthy, but Regulation NMS will 
not achieve it because the adopted trade-through rule does not protect 
all limit orders. Under the voluntary ``depth of book'' alternative 
proposed in the Reproposing Release, trade-through protection would 
have been given to all quotations that a trading center voluntarily 
transmitted to a securities information processor (``SIP''), not just 
its best bid or offer. We recognize that the full depth of book 
alternative would create its own set of problems, particularly with 
respect to its implications for centralization, technological 
complications and the size of the market data revenue pie. It would 
also have been the death knell for floor-based exchange trading. 
However, the majority's professed commitment to protecting limit orders 
is difficult to reconcile given its rejection of the full depth of book 
alternative.\70\
---------------------------------------------------------------------------

    \69\ See Adopting Release, supra note 1, at text following note 
29.
    \70\ Commenters saw through this false claim. See, e.g., Morgan 
Stanley Reproposal Comment Letter, supra note 22, at 4 (``[W]e 
cannot agree with the SEC's view that the single most important 
objective of the SEC's trade-through rule alternatives is the 
protection of limit orders, as the only effective way to accomplish 
that objective would be to impose market-wide price/time priority * 
* *.''); Comment Letter of George U. Sauter, Managing Director, The 
Vanguard Group, Inc. (Jan. 27, 2005) (``Vanguard Reproposal Comment 
Letter''), at 4 (``If one believes that the trade-through rule is 
important for the protection of investors, which we do, there is no 
logical reason why price protection should not be extended to all 
displayed liquidity. In fact, protection for just the BBO actually 
codifies trade-throughs.''); Ameritrade Reproposal Comment Letter, 
supra note 22, at 5 (``The Market BBO Alternative would protect only 
the best priced limit orders, while all other limit orders are 
unprotected and can be traded through with impunity.'').
---------------------------------------------------------------------------

    The final rule claims to protect a market's best bid or offer 
(``BBO''), but since market participants can match a trading center's 
BBO, rather than route orders to it, the rule does not actually protect 
limit orders at each market's BBO. The Adopting Release acknowledges 
that the BBO trade-through rule will not draw out every limit order, 
but asserts that it will provide investors with the appropriate 
incentives to post additional limit orders.\71\ This assertion is 
highly questionable. Given its decision to protect limit orders only at 
the top-of-book, the permissibility of internalization, and the 
numerous exceptions to the trade-through rule, the majority cannot 
credibly argue that the protection of limit orders is a high 
priority.\72\
---------------------------------------------------------------------------

    \71\ See Adopting Release, supra note 1, at text following note 
110.
    \72\ The trade-through rule will only apply during normal 
trading hours. Thus, market participants might game the system and 
avoid the trade-through rule by shifting liquidity to after-hours 
trading sessions.
---------------------------------------------------------------------------

    The majority is careful to characterize the trade-through rule's 
objective of increasing market depth as ``modest,'' translating into a 
hypothetical $755 million in cost savings in 2003 for long-term 
investors.\73\ This amount is based upon a hypothetical 5% improvement 
in depth and liquidity or an average reduction of 1.87 basis points in 
price impact and liquidity search costs.\74\ The majority provides no 
basis, however, for positing a 5% improvement in depth and liquidity, 
except to characterize it as the ``current share volume of trade-
through transactions that does not interact with displayed liquidity.'' 
\75\ Although it is apparently intended to show an order of magnitude, 
there is no basis for the 5% estimate.
---------------------------------------------------------------------------

    \73\ See Adopting Release, supra note 1, at 303. The majority 
explains:
    The Rule is designed to increase the perceived benefits of order 
display, against which the negatives are balanced. As a result, the 
market participant that currently displays only 500 shares of its 
50,000-share trading interest might be willing to display 1000 
shares. The collective effect of many market participants reaching 
the same conclusion would be a material increase in the total 
displayed depth in the market, thereby improving the transparency of 
price discovery and reducing investor transaction costs.
    Adopting Release, supra note 1, at text following note 110.
    \74\ See Adopting Release, supra note 1, at text following note 
303.
    \75\ See Adopting Release, supra note 1, at text following note 
303.
---------------------------------------------------------------------------

    Further, the majority fails to provide an estimate of the expected 
reductions in trade-throughs or indicate specifically how the new 
displayed depth will be generated. It speculates that ``greater 
displayed liquidity will at least lower the search costs associated 
with trying to find liquidity,'' \76\ and goes on to make unfounded 
assumptions claiming that ``[i]ncreased liquidity, in turn, could lead 
market participants to interact more often with displayed orders, which 
would lead to greater use of limit orders, and thus begin the cycle 
again.'' \77\ The majority fails to address how internalization, free-
riding or market impact costs will factor into the display of 
additional

[[Page 37639]]

limit orders. Instead, it provides only a theoretical response to an 
extremely complex question.
---------------------------------------------------------------------------

    \76\ See Adopting Release, supra note 1, at text following note 
160.
    \77\ See Adopting Release, supra note 1, at text following note 
160.
---------------------------------------------------------------------------

IV. The Majority's Distinction Between Long-Term and Short-Term 
Investors is Arbitrary and Unreasonable

    Essential to the majority's argument that a trade-through rule is 
necessary to augment market depth is its decision to favor the 
interests of long-term investors and issuers for purposes of market 
structure design.\78\ The majority interprets Section 11A of the 
Exchange Act as requiring the Commission to facilitate the national 
market system--not for the protection of ``investors,'' but for the 
protection of ``long-term investors.'' \79\ We find the majority's 
parsing of the term ``investor'' arbitrary and unreasonable. In our 
view, all investors are entitled to efficient executions and access to 
the best markets. This is not the case, however, under Regulation 
NMS.\80\
---------------------------------------------------------------------------

    \78\ See Adopting Release, supra note 1, at Section I.B.2 
(``Serving the Interests of Long-Term Investors and Listed 
Companies''). In the 1975 Act Amendments, Congress did not exhibit 
such favoritism:
    The purpose of this title is to insure that our Nation's capital 
markets continue to be the best in existence * * * by establishing a 
framework for a national market systems in which all qualified 
persons throughout our country may be linked together electronically 
so that they may compete and may bring to the marketplace their 
capital so as to make for broader, deeper and more liquid capital 
markets.
    H.R. Rep. No. 94-123, supra note 3, at 90.
    \79\ See Adopting Release, supra note 1, at text preceding note 
15; see generally Adopting Release, supra note 1, at Section I.B.2 
(``Serving the Interests of Long-Term Investors and Listed 
Companies''). The majority cites the legislative history of the 
adoption of the Exchange Act in 1934 to support this position, but 
that history is not relevant. See Adopting Release, supra note 1, at 
text accompanying notes 20 and 23. The term ``investor'' as 
interpreted by the Commission was contained in Section 11A of the 
1975 Act Amendments directing the Commission to facilitate the 
national market system. The legislation did not include a definition 
of the term.
    \80\ The Adopting Release does not credit commenters' claim that 
a trade-through rule is not needed on the Nasdaq market because that 
market is efficient. See Adopting Release, supra note 1, at text 
preceding note 61. The majority unreasonably views this claim as 
suspect ``when market efficiency is examined from the perspective of 
transaction costs of long-term investors, as opposed to short-term 
traders.'' Adopting Release, supra note 1, at text following note 
63.
---------------------------------------------------------------------------

    The majority characterizes short-term investors, or traders, as 
holding securities for a matter of seconds, minutes or hours.\81\ It 
concedes that short-term investors provide valuable liquidity to long-
term investors,\82\ yet acknowledges that the rule may harm short-term 
investors and market intermediaries.\83\ What the majority fails to 
recognize is that, by harming short term investors, the rule may also 
negatively affect long-term investors who may face increased spreads 
and decreased liquidity. Liquidity provided by short-term investors 
narrows spreads and gives long-term investors better executions. 
Because short-term investors are willing to take risks that strengthen 
the marketplace and benefit long-term investors, Congress clearly could 
not have intended for short-term investors to be harmed through the 
Commission's facilitation of the national market system. In fact, 
Congress prioritized the removal of barriers to competition to increase 
the participation of market makers and increase the competitive trading 
of securities.\84\
---------------------------------------------------------------------------

    \81\ See Adopting Release, supra note 1, at note 22 and 
accompanying text.
    \82\ See Adopting Release, supra note 1, at text following note 
19.
    \83\ See Adopting Release, supra note 1, at text following note 
22.
    \84\ One of the fundamental purposes underlying the national 
market system contemplated by S. 249 is to enhance the competitive 
structure of the securities markets in order to foster the risk-
taking function of market makers and thereby to provide free market 
incentives to active participation in the flow of orders. The 
competitive structure and incentives to participation thus provided 
should supplement, and ultimately may be able to replace, most 
affirmative requirements to deal imposed by regulation.
    Senate Report, supra note 3, at 14. The trade-through rule 
creates comparable barriers to off-board trading restrictions, which 
were among the barriers Congress sought to remove.
---------------------------------------------------------------------------

    The majority also fails to take into account that long-term and 
short-term investors are not mutually exclusive groups. Investors can 
be long-term and short-term investors at the same time or they may be a 
long-term investor one moment and, for a variety of reasons, become a 
short-term investor the next. The overlapping nature of these undefined 
categories highlights the arbitrary nature of the majority's 
distinction. The length of time an individual owns a stock or intends 
to own a stock at any particular moment is not a relevant factor in 
distinguishing among groups of investors.
    The majority claims that the trade-through rule ensures that 
investors get the best price. We have indicated above why we believe 
this claim significantly overstates the problem the rule is intended to 
address. By making price the sole criterion for determining how and 
where orders will be executed, the trade-through rule also restricts 
investor choice and ability to obtain best execution. As one commenter 
explained:

    Indeed, based on years of empirical evidence and substantial 
quantitative research into the components of transaction costs, it 
is our strong belief that price is just one element in overall 
execution quality. Institutional traders often need to trade off 
price for liquidity, speed of execution, likelihood of completion, 
and other attributes. We believe investors should have the choice 
over where to execute their orders, considering these other 
attributes, and that regulatory reform should continue to encourage 
market centers to compete in all these dimensions of execution 
quality.\85\
---------------------------------------------------------------------------

    \85\ Barclays Reproposal Comment Letter, supra note 22, at 2-3.

    The majority claims that the limitation on investor choice inherent 
in the trade-through rule is in the public interest and is needed to 
protect retail and long-term investors that may be harmed by trade-
throughs. Before restricting investors' ability to obtain the best 
execution in a manner that satisfies their investment needs, the 
majority should be required not only to show current harm, but to 
demonstrate the benefits provided by the trade-through rule.\86\
---------------------------------------------------------------------------

    \86\ See Senate Report, supra note 3, at 12 (``In other words, 
in the national market system, investors should be able to obtain 
the best execution of their orders and be assured that because of 
open competition among market makers the total market for each 
security is as liquid and orderly as the characteristics of that 
security warrant.'').
---------------------------------------------------------------------------

    The majority's distinction between the interests of long- and 
short-term investors simply provides a way for it to attempt to justify 
its policy choices, without any basis in fact, and it sets a dangerous 
precedent. Once codified, the concept may leach into other rulemakings 
and alter the basic ownership principles governing the market. Clearly, 
the interests of long- and short-term investors are inextricably 
linked. In the words of the Proposing Release: ``A fair and efficient 
national market system must serve the interests of both types of 
investors.'' \87\ In the absence of Regulation NMS, fair and efficient 
markets would develop to provide economically efficient execution of 
securities transactions for all investors, not just those favored by 
the Commission.\88\
---------------------------------------------------------------------------

    \87\ Reproposing Release, supra note 17, 69 FR at 77439.
    \88\ The majority is selective in its reliance on the long- and 
short-term investor distinction. In rejecting the proposed opt-out, 
the majority claims that advocates of the opt-out ``have failed to 
consider the interests of all investors--both those who submit 
marketable orders and those who submit limit orders.'' Adopting 
Release, supra note 1, at text following note 247.
---------------------------------------------------------------------------

V. The Rule Will Have Negative Repercussions

    We believe that, not only will the trade-through rule not achieve 
its purported benefits, it will have negative unintended consequences. 
The complexity of the rule structure invites exploitation that may 
create unforeseen

[[Page 37640]]

market distortions. Commenters indicated that the BBO trade-through 
rule may introduce market inefficiencies, competitive barriers, and 
unnecessary costs, while stifling innovation.
    Market participants and academics warned the Commission of 
unintended consequences,\89\ including: (i) Decreased price discovery 
and quantity discovery,\90\ (ii) increased gaming opportunities,\91\ 
(iii) the lowest common denominator problem,\92\ (iv) increased market 
fragmentation,\93\ and (v) increased volatility.\94\ The lack of 
consensus about the likely impact of Regulation NMS among industry 
participants, academics and investors provides further evidence of the 
risks attendant to the rule's implementation. Our concerns about these 
negative consequences are aggravated by the rule's questionable 
enforceability.\95\
---------------------------------------------------------------------------

    \89\ See, e.g., Comment Letter of Marc E. Lackritz, President, 
Securities Industry Assoc. (Feb 1, 2005) (``SIA Reproposal Comment 
Letter''), at 10; Comment Letter of James A. Duncan, Chairman, and 
John C. Giesea, President and Chief Executive Officer, Security 
Traders Assoc. (Jan. 19, 2005); J.P. Morgan Reproposal Comment 
Letter, supra note 22, at 7; Paul L. Davis and Robert A. Schwartz, 
Report, Comments on SEC Reg NMS (Jan. 26, 2005) (attachment to TIAA 
CREF Reproposal Comment Letter, supra note 22), at 7; Battalio-
Jennings Study, supra note 34, at 5 (``[T]he proposed trade-through 
rule may have negative unintended consequences.''); Comment Letter 
of James J. Angel, Assoc. Professor of Finance, McDonough School of 
Business, Georgetown University (Jan. 25, 2005) (``Angel Reproposal 
Comment Letter''), at 1.
    \90\ See, e.g., TIAA CREF Reproposal Comment Letter, supra note 
22, at 2 (expressing concern that ``both of the proposed trade-
through rules will compromise'' price and quantity discovery).
    \91\ See, e.g., J.P. Morgan Reproposal Comment Letter, supra 
note 22, at 11.
    \92\ See, e.g., Instinet Reproposal Comment Letter, supra note 
22, at 17; Merrill Lynch Reproposal Comment Letter, supra note 22, 
at 5.
    \93\ See, e.g., J.P. Morgan Reproposal Comment Letter, supra 
note 22, at 10 (``[T]he incentive structure created by the Top of 
Book Alternative could also lead to increased market fragmentation 
despite the SEC's intent to the contrary.''); Citigroup Reproposal 
Comment Letter, supra note 6, at 5 (explaining that the top of the 
book alternative ``could cause market participants to choose market 
centers for execution that are more likely to have less liquidity 
and order flow so that the market participant's order has a greater 
probability of being at the top of the book (best bid/offer) and 
therefore receiving increased protection. * * * Ultimately, we feel 
this could result in increased fragmentation with each broker-
dealer's order flow being dispersed throughout the eleven protected 
market centers.''); Tradebot Reproposal Comment Letter, supra note 
68, at 2 (``It is not widely understood yet, but I think a trade 
through rule with automated quotes would * * * increas[e] market 
fragmentation. * * *'').
    \94\ See, e.g., J.P. Morgan Reproposal Comment Letter, supra 
note 22, at 6 (``A trade-through rule that essentially forces 
investors to perform sweeps is likely to increase volatility in the 
marketplace, particularly for relatively illiquid securities.''); 
Vanguard Reproposal Comment Letter, supra note 70, at 4 (``The BBO 
alternative would produce greater volatility, as some executions 
would occur at inferior prices.''); Automated Trading Desk 
Reproposal Comment Letter, supra note 22, at 3 (``The proposed rule 
will create added market volatility due to behavioral changes by 
block positioners. * * *'').
    \95\ OEA, in its study on trade-throughs, remarked on the 
complexity of identifying actual trade-throughs, a necessary 
predicate to the enforcement of the rule. OEA Study, supra note 20, 
at 1 (``While trade-through identification seems straightforward, in 
practice it is complicated by quickly changing quotes, system time 
lags, data limitations, and imperfect access to markets.''). See 
also UBS Reproposal Comment Letter, supra note 22, at 5 
(``[E]nforceability will be unachievable (correctly noted by the OEA 
Study) due to the inability to accurately identify when, due to 
quotation changes, system imperfections and data discrepancies, a 
trade-through has even occurred.''); Morgan Stanley Reproposal 
Comment Letter, supra note 22, at 14 (``In order to monitor and 
enforce a trade-through rule, it is essential that the Commission 
promulgate standards for an intermarket clock. The existing clock 
synchronization standards, which differ by market, combined with 
penny trading increments, would render it virtually impossible to 
effectively monitor compliance with the proposed trade-through 
rule.'').
---------------------------------------------------------------------------

A. The Rule Will Limit Competition and Stifle Innovation

    The majority speaks continually of the importance of encouraging 
two types of competition--competition among orders and competition 
among markets, and believes that the trade-through rule promotes 
competition on both scores. We find no mention of different types of 
competition in the language of Section 11A, the source of the 
Commission's authority in this area, and we believe the rule is anti-
competitive.
1. Competition Among Markets
    In adopting the trade-through rule, the majority has opted for 
government-controlled competition over competitive market forces to 
determine the appropriate market structure. Section 11A plainly states, 
however, that a national market system should foster competition among 
broker-dealers and among markets. Today, broker-dealers, electronic 
communications networks (``ECNs'') and SROs compete in the Nasdaq 
market on the basis of technology, execution quality and cost. 
Competition among market makers increased significantly following the 
Commission's adoption of Rule 11Ac1-5, which required market centers to 
publish execution quality statistics.\96\ This information permitted 
brokers to make more informed order routing decisions, consistent with 
their best execution obligations. At the same time, overall execution 
quality for retail customers improved as competition among executing 
broker-dealers on the basis of execution quality became a means of 
attracting retail order flow. Likewise, competition between markets and 
ECNs drove technological innovation as a means of attracting orders and 
liquidity to their markets.
---------------------------------------------------------------------------

    \96\ See Securities Exchange Act Release No. 43590 (Nov. 17, 
2000), 65 FR 43590 (Dec. 1, 2000).
---------------------------------------------------------------------------

    Under the trade-through rule, competition among market makers may 
decrease. Given the rule's sole focus on price, incentives to improve 
execution quality above and beyond the trade-through rule's mandated 
execution methodology may be reduced. Further, by limiting order 
routing decisions to the price of protected quotations, the trade-
through rule sacrifices competition among SROs and ECNs, which will 
have a negative impact on innovation. Instead of allowing markets to 
compete for order flow, the trade-through rule forces order flow to the 
SRO markets. The majority believes that competitive pressures will 
continue to drive change since orders may still be internalized, and 
priority for routing decisions can be made when SROs are displaying the 
same price. We believe, however, that the trade-through rule will 
restrict competitive forces and reduce markets to the lowest common 
denominator by dampening the incentives for markets to compete on the 
basis of improved technology and services and reduced costs. With the 
government managing all aspects of the competition, it is difficult to 
credit the majority's claim that the trade-through rule promotes 
competition. In our view, the trade-through rule limits competition 
among markets.
    Market share may well shift following implementation of the trade-
through rule, but not because the rule promotes competition. To the 
extent that we observe shifting market share, it will be attributable 
to limit orders being redistributed among protected SRO quotations. 
Market participants may game the system by distributing orders to what 
might normally be their second-choice market, so that their orders will 
be protected as top-of-book at the second-choice market. To the extent 
that investors spread orders among the various SROs to obtain as much 
top-of-book protection as possible, any resulting shift in market share 
would occur, not as a result of increased market competition, but as a 
result of the Commission's attempt to engineer market structure by 
imposing a trade-through rule.\97\
---------------------------------------------------------------------------

    \97\ See, e.g., J.P. Morgan Reproposal Comment Letter, supra 
note 22, at 10 (``The result likely would be that market 
participants would engage in an economically inefficient competition 
to develop costly computer systems that route and re-route limit 
orders to various markets based on the probability of achieving 
trade-through protection.''); Citigroup Reproposal Comment Letter, 
supra note 6, at 5 (``[T]his type of market regulation may serve to 
support certain market centers that otherwise may be incapable of 
competing because of poor technology and inferior execution.'').

---------------------------------------------------------------------------

[[Page 37641]]

2. Competition Among Orders
    The majority believes that by protecting limit orders, that is, 
restricting pricing decisions, it will create the appropriate 
incentives for investors to display more of their interest to buy or 
sell, which will decrease volatility and implicit transaction costs. 
However, the trade-through rule restricts competition among orders by 
requiring a government-mandated method of trading. Disfavoring short-
term investors could upset the market's liquidity equilibrium and 
decrease competition among orders because ``short-term'' investors 
provide much needed liquidity to the market through their willingness 
to buy and sell stock.\98\
---------------------------------------------------------------------------

    \98\ See supra Section IV.
---------------------------------------------------------------------------

    Unrestricted market and order competition in the Nasdaq market has 
achieved several objectives under Section 11A, including increased 
direct order interaction, reduced execution costs and improved 
execution quality for all investors. In the absence of any valid 
justification for extending the trade-through rule to Nasdaq, the 
majority is forced to argue that Nasdaq's vigorous order competition 
reflects a weakness in market depth and liquidity that requires a 
trade-through rule. As discussed above, the use of electronic methods 
of price and size discovery on Nasdaq is evidence of a healthy, 
competitive market, not evidence of structural weakness.\99\
---------------------------------------------------------------------------

    \99\ See supra Section II.B.
---------------------------------------------------------------------------

    By adopting a trade-through rule, the majority has shown itself 
willing to sacrifice competition among markets to attempt to increase 
competition among orders. If increasing order competition were its 
goal, however, then the majority should have afforded full protection 
of limit orders by imposing price-time priority. It is questionable how 
order competition will increase under a rule that applies a price 
priority structure that is rife with exceptions. The negligible 
protection afforded to limit orders under the trade-through rule simply 
does not square with the degree of increased order competition that the 
majority hopes will materialize. If anything, the rule's compromised 
approach favoring long-term investors may decrease liquidity, and thus 
decrease order competition.
3. Barriers to Competition
    The trade-through rule creates barriers to competition.\100\ We are 
concerned that these ``regulatory restraints'' will prevent new 
competitors from entering the market and place unnecessary burdens on 
existing trading centers.\101\ Under the rule, only SRO quotations are 
protected. Through the SRO registration process, the Commission 
controls the number of SROs in the national market system. This barrier 
to entry will likely increase if the Commission adopts proposed 
regulations that would place restrictions on SRO ownership and 
substantially increase regulatory burdens pertaining to SRO governance, 
reporting and recordkeeping requirements.\102\
---------------------------------------------------------------------------

    \100\ See, e.g., SIA Reproposal Comment Letter, supra note 89, 
at 9 (``[T]he SEC's two Alternatives err too far in the direction of 
ensuring intermarket interactions, thereby threatening intermarket 
competition, discouraging innovation, and limiting investor choice. 
As a result, we are concerned that the TOB and DOB Alternatives 
ultimately may cause significant harm to investors and imperil the 
preeminence of the U.S. markets. Specifically, we believe that the 
TOB and DOB Alternatives will drive the markets toward one uniform 
market model. Indeed, both proposals push the markets toward 
intermarket competition that is based solely on displayed price * * 
* [B]oth Alternatives raise the specter of competition-stifling, 
micro-management of market structure by the government.''); J.P. 
Morgan Reproposal Comment Letter, supra note 22, at 7 (``However, 
such incentives would likely be stronger the greater the extent of 
the regulatory license provided by the trade-through rule.''); TIAA 
CREF Reproposal Comment Letter, supra note 22, at 8-9 and 11; 
Citigroup Reproposal Comment Letter, supra note 6, at 2 and 5; 
Comment Letter of Daniel M. Clifton, Executive Director, American 
Shareholders Assoc. (Jan. 26, 2005), at 2; Comment Letter of J. Greg 
Mills, Managing Director, Head of Global Equity Trading, RBC Capital 
Markets Corp. (Jan. 26, 2005) (``RBC Reproposal Comment Letter''), 
at 3; Instinet Reproposal Comment Letter, supra note 22, at 5; 
Archipelago Reproposal Comment Letter, supra note 22, at 9; UBS 
Reproposal Comment Letter, supra note 22, at 3.
    \101\ See Senate Report, supra note 3, at 13 (``Unfortunately, 
because of excessive and unnecessary regulatory restraints, 
competition in the securities industry has not been as vigorous and 
as effective in advancing the public interest as it could be.'').
    \102\ Securities Exchange Act Release No. 50699 (Nov. 18, 2004), 
69 FR 71126 (Dec. 8, 2004).
---------------------------------------------------------------------------

    The Commission's involvement in implementing the access and 
automated market provisions of Regulation NMS will create additional 
barriers to entry. The access provisions require that the Commission 
approve the application of each new participant in the NASD's Automated 
Display Facility (``ADF''), outline the requirements of ``substantially 
equivalent'' access, and determine whether trading centers engage in 
unfairly discriminatory practices. The Commission will also be involved 
in determining which markets comply with the definition of an automated 
market, involving the Commission in highly technical and subjective 
judgments, which may neither be fair nor expedient.
    We see troubling parallels between the barriers to entry that we 
foresee under the trade-through rule and the barriers to entry created 
by the Commission's criteria for recognition of credit rating agencies 
as nationally recognized statistical rating organizations 
(``NRSROs'').\103\ The delay in obtaining a no-action letter from the 
SEC staff by applicants for NRSRO status, a process that often takes 
several years, has raised barriers to entry for credit rating agencies. 
We are concerned that bureaucratic delay may create similar barriers to 
entry for market participants seeking to register as an SRO, new ADF 
participants and SROs seeking to make changes to their market 
operations.\104\
---------------------------------------------------------------------------

    \103\ Securities Exchange Act Release No. 51572 (Apr. 19, 2005), 
70 FR 21306 (Apr. 25, 2005).
    \104\ Nasdaq's application for exchange registration has been 
pending since March 15, 2001. Securities Exchange Act Release No. 
44396 (June 7, 2001), 66 FR 31952 (June 13, 2001).
---------------------------------------------------------------------------

4. Stifling Innovation
    Innovation may be another casualty of the trade-through rule. 
Decreased competition and increased regulatory barriers create an 
environment that stifles innovation, depriving investors of the 
benefits of innovation, including efficiencies and cost savings. 
Unfortunately, as we saw in the listed market, where technology was 
antiquated and price discovery hampered, it is difficult to determine 
whether a regulatory regime impedes innovation until a marketplace is 
competitively disadvantaged.
    By requiring the Commission or its staff to approve changes to an 
SRO's market operations, Regulation NMS essentially codifies current 
technologies and methods of trading through the exceptions to the 
trade-through rule and controls future innovation.\105\ Bureaucratic 
delay creates a competitive barrier that may impede the future 
development of trading and order routing systems. In other words, the 
future development of efficient and effective methods of committing 
capital and pricing securities may be inhibited.
---------------------------------------------------------------------------

    \105\ Schwab Reproposal Comment Letter, supra note 22, at 2 (``A 
centralized routing algorithm stifles innovation of new mechanisms 
for handling order.''); Archipelago Reproposal Comment letter, supra 
note 22, at 5; Angel Reproposal Comment Letter, supra note 89, at 2.
---------------------------------------------------------------------------

    What we find disturbing about the majority's policy determinations 
in Regulation NMS is that they are contrary to prior Commission 
statements regarding the importance of fostering innovation and 
competition. In Regulation ATS, for example, the Commission designed a 
regulatory framework for alternative trading systems (``ATSs'') that 
``encourage[d] market innovation while ensuring basic

[[Page 37642]]

investor protections.'' \106\ To help reduce competitive impediments to 
innovation by SROs, the Commission approved a temporary exemption 
permitting SROs to operate new trading systems without filing for 
approval under certain circumstances.\107\
---------------------------------------------------------------------------

    \106\ Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 
63 FR 70844, at 70847 (Dec. 22, 1998).
    \107\ Id. The Commission stated that the pilot was ``to provide 
registered exchanges and national securities associations with a 
greater opportunity to compete with alternative trading systems 
registered as broker-dealers and with foreign markets.'' Id. at note 
29.
---------------------------------------------------------------------------

    Likewise, in the order approving Nasdaq's SuperMontage, the 
Commission acknowledged that ``competition and innovation are essential 
to the health of the securities markets. Indeed, competition is one of 
the hallmarks of the national market system.'' \108\ It stated that the 
regulatory structure was designed to ``provide all market centers with 
structural flexibility in order to enhance competition between market 
centers, while promoting market fairness, efficiency, and 
transparency.'' \109\ In analyzing the competitive issues involved in 
approving SuperMontage, the Commission stressed that:
---------------------------------------------------------------------------

    \108\ Securities Exchange Act Release No. 43863 (Jan. 19, 2001), 
66 FR 8020, at 8049 (Jan. 26, 2001).
    \109\ Id. at 8052.

    Nasdaq and traditional exchanges must have the flexibility to 
rethink their structures to permit appropriate responses to the 
rapidly changing marketplace. 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.'' \110\
---------------------------------------------------------------------------

    \110\ Id. at note 471 and accompanying text (citing Senate 
Report, supra note 3).

    The Commission found SuperMontage consistent with the goals of 
promoting ``price discovery, best execution, liquidity, and market 
innovation, while continuing to preserve competition among market 
centers.'' \111\ Under this policy guidance, the markets automated and 
real competition emerged, due in large part to the explosive growth of 
the ECNs, which have been the greatest catalyst for increased 
competition and technological advances in the Nasdaq market. Under the 
trade-through rule, ECNs will be able to compete only if they display 
quotations through an SRO and offer substantially equivalent access. 
Moreover, the fact that dominant markets can match BBOs undercuts the 
majority's argument that competition among markets will increase.
---------------------------------------------------------------------------

    \111\ Id. at 8055.
---------------------------------------------------------------------------

    Unfortunately, the majority fails to use past experience as a 
guide. In adopting the trade-through rule, the majority has reversed 
Commission policy, opting for government-controlled competition, a 
failure under ITS, instead of unfettered competition, the more 
successful approach over time as evidenced by the Nasdaq market. The 
Nasdaq market has developed into an efficient, automated and highly 
competitive marketplace. Competition among markets trading Nasdaq 
securities has fulfilled the objectives of Section 11A by creating a 
fully automated and connected marketplace, decreasing execution costs, 
and increasing market data distribution. Efficiencies born of 
competition have benefited investors and issuers alike. The majority's 
adoption of the trade-through rule assists one market to step forward, 
while forcing other markets to take two giant steps backward.

B. Additional Regulation Is Needed to Address Problems Created by the 
Trade-Through Rule

    To have its trade-through rule, the majority has been compelled to 
engage in rulemaking that otherwise would have been unnecessary. The 
Commission has historically analyzed a broker's best execution 
obligation on the basis of several factors, including execution price, 
speed of execution, the size of the order, the trading characteristics 
of the security involved, the availability of accurate information 
affecting choices as to the most favorable market center for execution 
and the availability of technological aids to process such information, 
and the cost and difficulty associated with achieving an execution in a 
particular market center.\112\ One of the consequences of limiting 
investor choice to the sole criterion of price is that the Commission 
must ensure that markets have comparable access to these prices. This 
has required the Commission to adopt a cap on access fees so that 
market participants are not held hostage by outlier markets displaying 
the best price, but charging excessive access fees.
---------------------------------------------------------------------------

    \112\ Newton v. Merrill Lynch, 135 F.3d 266, 270 n.2 (3d Cir. 
1998)(citing Securities Exchange Act Release No. 33026 (Oct. 6, 
1993), 58 FR 52934 (Oct. 13, 1993).
---------------------------------------------------------------------------

    As noted above, Regulation NMS will also require Commission 
involvement in implementation of access standards and approval for new 
ADF participants. Key standards under trade-through exceptions, 
including standards for automatic execution, will also require 
determinations by the Commission and its staff, many involving 
interpretation of subjective standards. The end result is a highly 
regulated and micromanaged market that limits competition and 
innovation. As one commenter observed:

    [T]he rule will require lots of filings from SROs, and years of 
intense fighting over details. It is likely that the Commission 
staff will end up making numerous important decisions on the 
important micro-details of market structure with lots of unintended 
consequences that will take decades to understand and fix.\113\
---------------------------------------------------------------------------

    \113\ Angel Reproposal Comment Letter, supra note 89, at 2.

    Indeed, the majority concedes that a trade-through rule may 
``lessen the competitive discipline'' because brokers will not be able 
to avoid markets that do not provide quality execution services.\114\ 
The majority would replace this competitive discipline with increased 
regulatory oversight. The Commission now must screen new entrants' 
ability to meet access requirements and standards for automatic 
execution through the SRO registration process or the 19b-4 approval 
process for new ADF participants. The majority notes that the self-
regulatory function will also be important in monitoring compliance 
with all Exchange Act and SRO rules, including compliance with the 
trade-through rule.\115\ Finally, the Adopting Release notes that 
``[e]ffective implementation of the Order Protection Rule also will 
depend on the Commission's taking any action that is necessary and 
appropriate to address trading centers that fail to meet fully their 
regulatory requirements.'' \116\ This would include taking enforcement 
actions against trading centers that fail to meet regulatory 
requirements.
---------------------------------------------------------------------------

    \114\ See Adopting Release, supra note 1, at text following note 
243.
    \115\ See Adopting Release, supra note 1, at text following note 
244.
    \116\ Adopting Release, supra note 1, at text following note 
244.
---------------------------------------------------------------------------

    Instead of relying on competitive forces to discipline market 
access and execution services, Regulation NMS establishes a regulatory 
back-up plan for outlier SROs. We believe the better approach would 
have been to clarify best execution guidance, outlining the appropriate 
balancing of factors when routing orders. In any event, the trade-
through rule, which does not provide protection to manual quotes, 
complicates the best execution analysis because manual quotations may 
not be disregarded. Furthermore, guidance on best execution will still 
be needed to assist brokers in fulfilling their

[[Page 37643]]

obligations for assessing the depth of book and manual quotations.\117\
---------------------------------------------------------------------------

    \117\ See, e.g., SIA Reproposal Comment Letter, supra note 89, 
at 15 (``[W]e are concerned that broker-dealers will be required, as 
a business and legal matter, to take account of the full depth-of-
book as well as manual quotes in providing best execution to their 
customers. Although the SEC states only that best execution 
standards will not change, the SEC will have changed the entire 
market structure, which would appear to necessitate a re-evaluation 
of best execution standards. * * * [W]e are concerned that broker-
dealers will be held liable by customers and regulatory examiners, 
far beyond the requirements of the trade-through rule, to a best 
execution standard based on manual quotes.''); Comment Letter of 
Bernard L. Madoff and Peter B. Madoff, Bernard L. Madoff Investment 
Securities LLC (Feb. 3, 2005), at 5 (``[W]e urge that the Commission 
clarify its position by providing specific guidance as to the 
interplay between the trade-through and the best execution 
requirement.''); RBC Reproposal Comment Letter, supra note 100, at 
4; Merrill Lynch Reproposal Comment Letter, supra note 22, at 6; UBS 
Reproposal Comment Letter, supra note 22, at 2.
---------------------------------------------------------------------------

C. Implementation Will Be Costly

    The majority's cost-benefit analysis underestimates the costs 
associated with implementation and compliance, while overestimating the 
benefits. Even by the majority's own estimation, the benefits of 
Regulation NMS will likely be modest. But these modest benefits will 
come at a very high price. Some of the costs of Regulation NMS will be 
measured in terms of the dollars it will cost trading centers to modify 
their policies and procedures and internal systems and monitor 
compliance with the trade-through rule on an ongoing basis.\118\ The 
cost-benefit analysis estimates start-up costs at $143.8 million, with 
average annual ongoing costs of approximately $22 million.\119\ Market 
participants will also experience significant costs in terms of the 
time and effort they will spend negotiating with our staff on the 
numerous interpretive issues and in explaining to our examination staff 
that apparent trade-through violations are not really violations.\120\ 
Thus, even if there are no trade-throughs, there will still be a burden 
on trading centers to prove the absence of trade-throughs.\121\
---------------------------------------------------------------------------

    \118\ See, e.g., Deutsche Bank Reproposal Comment Letter, supra 
note 22, at 5 (``In sum, we are concerned that the adoption of 
Regulation NMS, unless carefully crafted with sensitivity to 
practical implementation difficulties and expenses, holds the 
potential to force upon broker-dealers complex challenges and 
burdensome costs, the scale of which may not be fully appreciated by 
the Commission.''); SIA Reproposal Comment Letter, supra note 89, at 
11; Citigroup Reproposal Comment Letter, supra note 6, at 2; Knight 
Trading Reproposal Comment Letter, supra note 22, at 5.
    \119\ See Adopting Release, supra note 1, at text following note 
782.
    \120\ As UBS explained, the difficulties associated with 
inspecting for violations of the rule are likely to result in a 
shifting of the burden to firms to prove that they did not violate 
the rule:
    [W]e foresee a process, not unlike many current ``sweep'' 
regulatory actions in which the SEC (or a SRO) will provide each 
firm with a list containing hundreds of ``exceptions'' for which the 
regulatory surveillance systems have detected a potential trade-
through violation. In following current examination practice, a firm 
will be given an opportunity to demonstrate to the regulator why it 
believes that it did not trade through the best posted price (thus 
the firm will be deemed guilty of these violations unless it can 
satisfactorily demonstrate its innocence). Due to exceptions to the 
rule, technological limitations, and latency in delivery and receipt 
of market updates and quotations, there will be a substantial number 
of ``false positives'' that would have to be disproved. The likely 
end result of this review will be a justifiable reason for 98% of 
the exceptions, but firms such as UBS would, most likely, receive a 
regulatory sanction for their inability to demonstrate guilt or 
innocence for the remaining 2%.
    UBS Reproposal Comment Letter, supra note 22, at 5. See also 
CIBC Reproposal Comment Letter, supra note 22, at 4 (``It will 
result in wasted resources sifting through market data to eliminate 
false trade-throughs, and trade-throughs for economically 
insignificant sums. We also believe that this task will be 
inordinately expensive, both in terms of the hard dollars required 
to build systems and pay for market data to do surveillance and the 
lost opportunity cost of resources that could be spent investigating 
execution quality in less liquid stocks.'').
    \121\ One commenter cautioned against underestimating costs. See 
Deutsche Bank Reproposal Comment Letter, supra note 22, at 4 
(``[W]hat in principle may appear to be a rather straightforward 
measure, most assuredly involves significant changes to a broker-
dealer's trading, technology, operations, supervisory and compliance 
platforms. * * * In our experience to date with Regulation SHO, 
which was a fairly incremental initiative that built upon existing 
SRO rules and adopted a fraction of the original Commission 
proposal, our costs (represented by hundreds of collective hours * * 
*) have been real and significant.''
---------------------------------------------------------------------------

VI. Market Data Reforms Do Not Address the Real Problem

    While the discussion above focuses on the trade-through rule, we 
also believe there are serious problems with the market data reforms 
included in Regulation NMS. The availability of market data is critical 
because market data provides transparency within the market and allows 
investors to evaluate the quality of their executions. Regulation NMS 
does not address the larger issues surrounding market data, and the 
majority has indicated that these issues will be addressed in a 
different forum.
    We have concerns about the market data reforms in Regulation NMS, 
even though they are limited, and a particular concern with respect to 
the codification of the single consolidator model. By entrenching the 
single consolidator model, the majority grants a monopoly for the 
consolidation of market data, which erects another barrier to 
encouraging competitive solutions for market data consolidation. We 
intend to advocate a reconsideration of this decision by our colleagues 
when the Commission considers the market data issue in general.
    We are also concerned about the majority's failure to address the 
level of market data fees. The size of market data revenues and lack of 
accountability for the use of these revenues by the SROs creates market 
distortions and inefficient allocation of resources.\122\ By continuing 
to fail to address the reasonableness of the rates charged by the 
markets, the majority sidesteps serious questions about whether 
government-sponsored monopolies should be allowed to charge excessive 
rents to cross-subsidize other functional costs, and if so, how they 
should be held accountable for the appropriate use of such funds. What 
is needed is a heightened sense of accountability for the use of market 
data revenues and an incentive for the exchanges to increase 
efficiencies.
---------------------------------------------------------------------------

    \122\ See, e.g., Hearing on Proposed Regulation NMS Before the 
Securities and Exchange Commission (Apr. 21, 2004) (``Regulation NMS 
Hearings''), at 223-24 (testimony of Robert Greifeld, President and 
Chief Executive Officer, Nasdaq Stock Market) (``Currently that cost 
[of market data] for professional investors is around $20. * * * 
There was no great wisdom in that number, and we look at the number 
today, that number is too high. * * * With the current structure, 
then, data is not provided at a low enough cost and it [creates] 
unintended results and distortions in our market. The market centers 
today are the beneficiaries of that excessive rent * * *.''); 
Regulation NMS Hearings, at 229 (testimony of Jeffrey T. Brown, 
General Counsel, Schwab Soundview Capital Markets) (``[L]ast year, 
the market data cartels took in $424 million in revenue and had 
expenses of $38 million. * * * [T]hat's a profit margin of over a 
thousand percent. * * * [T]hat excess revenue manifests itself in 
the types of practices that you're concerned with, * * * tape 
shredding, market data rebates, excessive pay to executives. And 
there's clearly a link * * * between market data revenue and these 
practices.'').
---------------------------------------------------------------------------

    Supporters of the current pricing schedule indicate that the extra 
revenues are needed to fund the regulatory functions performed by 
exchanges. Even with the current high levels of market data fees, our 
enforcement docket does not demonstrate that higher funding has led to 
effective regulatory oversight by SROs.\123\ Critics contend that the 
exchanges charge an excessive rate for

[[Page 37644]]

consolidating and distributing market data. They note that the relative 
opaqueness of the market data pricing process inhibits public scrutiny 
on the current cost of consolidated market information.
---------------------------------------------------------------------------

    \123\ See, e.g., Securities Exchange Act Release No. 51163 (Feb. 
9, 2005) (Report of Investigation pursuant to Section 21(a) of the 
Securities Exchange Act of 1934 relating to violations by MarketXT, 
an NASD member, and registered broker-dealer, which were not 
adequately addressed by Nasdaq, as overseen by its parent, NASD); 
Securities Exchange Act Release No. 51524 (Apr. 12, 2005) and SEC 
Press Release 2005-53 (April 12, 2005) (instituting and 
simultaneously settling an enforcement action against the NYSE, 
finding that the NYSE, ``over the course of nearly four years, 
failed to police specialists, who engaged in widespread and unlawful 
proprietary trading on the floor of the NYSE'').
---------------------------------------------------------------------------

    It is difficult to argue that, in an era of heightened disclosure 
requirements, a virtual public utility should not be required to openly 
justify and account for the use of public funds. Moreover, having 
chosen to maintain the current single processor system, the majority, 
if it is to accomplish its mission of promoting transparency and 
protecting investors, while allowing competition to flourish, must 
accept the responsibility for scrutinizing rates charged for market 
data and monitoring the heavy hand of monopoly power.\124\
---------------------------------------------------------------------------

    \124\ The Senate bill required SIPs which act as exclusive 
processors to register with the Commission and provided the 
Commission with the authority to require the registration of other 
categories of SIPs. The reference to exclusive processors did not 
constitute a mandate for a single securities information processor 
at any stage in the processing of quotation or transactional data, 
but merely recognized that where SROs utilize an exclusive 
processor, that processor takes on certain of the characteristics of 
a public utility and should be regulated accordingly.
    Conference Report, supra note 4, at 93.
---------------------------------------------------------------------------

Conclusion

    We do not believe that Regulation NMS is the appropriate policy 
choice. Instead of facilitating a national market system in which 
technology, competition and innovation will produce benefits for all 
investors, Regulation NMS saddles the marketplace with anachronistic 
regulation that reduces investor choice and raises investor costs. In 
the name of investor protection and uniformity, the majority has opted 
for greater regulation rather than competition to facilitate what it 
perceives to be fair treatment of customer orders and deep and liquid 
markets. However, the majority has failed to establish evidence of 
investor protection concerns, and the goal of uniformity could have 
been achieved by having no trade-through rule.
    Since the Commission voted on Regulation NMS, mergers have been 
announced between the NYSE and Archipelago and between Nasdaq and The 
Instinet Group.\125\ The timing of these announcements so soon after 
the adoption of the rule has led some to credit Regulation NMS with 
enhancing competition and equalizing regulation among markets. We 
believe the timing can be more accurately explained by the markets' 
simple desire for closure with respect to Regulation NMS. Intensifying 
competitive pressures, combined with the Commission's focus on market 
structure, created an environment in which the markets' strategic 
business plans likely could not be finalized until the regulatory risk 
was resolved. In the end, it was not so much the substance of 
Regulation NMS that was important, but the fact that the regulation was 
final.
---------------------------------------------------------------------------

    \125\ See, e.g., Aaron Lucchetti et al., NYSE to Acquire 
Electronic Trader and Go Public, Wall St. J., Apr. 21, 2005, at A1; 
Aaron Lucchetti, Nasdaq Chief Plays Hardball in Instinet Deal, Wall 
St. J., Apr. 25, 2005, at C1.
---------------------------------------------------------------------------

    Unfortunately for the marketplace, this version of Regulation NMS 
that the majority has adopted is far from final. Imprecise definitions, 
the acknowledged need for future interpretations that the majority has 
seen fit to delegate to an opaque process of staff guidance, and 
uncertainty regarding future examination and enforcement standards 
combine to produce a regulatory framework that will keep market 
participants guessing and seeking clarification from our staff. From 
our experience with analogous situations, we fear that the inevitable 
delays in obtaining guidance, the attendant regulatory uncertainty, and 
concomitant costs will harm a competitive marketplace.
    Far from enhancing competition, we believe that Regulation NMS will 
have anticompetitive effects. Increasing consolidation in the 
securities industry as a result of the proposed mergers and the 
increased barriers to entry created by the trade-through rule magnify 
our concerns about the competitive impact of Regulation NMS going 
forward.
    For the reasons stated above, we respectfully dissent.


    Dated: June 9, 2005.
Cynthia A. Glassman,
Commissioner.
Paul S. Atkins,
Commissioner.
[FR Doc. 05-11802 Filed 6-28-05; 8:45 am]
BILLING CODE 8010-01-P