[Federal Register Volume 75, Number 13 (Thursday, January 21, 2010)]
[Proposed Rules]
[Pages 3593-3614]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-1045]

[[Page 3593]]


Part III

Securities and Exchange Commission


17 CFR Part 242

Concept Release on Equity Market Structure; Proposed Rule

Federal Register / Vol. 75 , No. 13 / Thursday, January 21, 2010 / 
Proposed Rules

[[Page 3594]]



17 CFR Part 242

[Release No. 34-61358; File No. S7-02-10]
RIN 3235-AK47

Concept Release on Equity Market Structure

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comments.


SUMMARY: The Securities and Exchange Commission (``Commission'') is 
conducting a broad review of the current equity market structure. The 
review includes an evaluation of equity market structure performance in 
recent years and an assessment of whether market structure rules have 
kept pace with, among other things, changes in trading technology and 
practices. To help further its review, the Commission is publishing 
this concept release to invite public comment on a wide range of market 
structure issues, including high frequency trading, order routing, 
market data linkages, and undisplayed, or ``dark,'' liquidity. The 
Commission intends to use the public's comments to help determine 
whether regulatory initiatives to improve the current equity market 
structure are needed and, if so, the specific nature of such 

DATES: Comments should be received on or before April 21, 2010.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments:

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File No. S7-02-10 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments:

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File No. S7-02-10. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549 on official business days between the hours of 10 a.m. and 3 p.m. 
All comments received will be posted without change; we do not edit 
personal identifying information from submissions. You should submit 
only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Arisa Tinaves, Special Counsel, at 
(202) 551-5676, Gary M. Rubin, Attorney, at (202) 551-5669, Division of 
Trading and Markets, Securities and Exchange Commission, 100 F Street, 
NE., Washington, DC 20549-7010.


Table of Contents

I. Introduction
II. Exchange Act Requirements for a National Market System
III. Overview of Current Market Structure
    A. Trading Centers
    1. Registered Exchanges
    2. ECNs
    3. Dark Pools
    4. Broker-Dealer Internalization
    B. Linkages
    1. Consolidated Market Data
    2. Trade-Through Protection
    3. Broker Routing Services
IV. Request for Comments
    A. Market Structure Performance
    1. Long-Term Investors
    a. Market Quality Metrics
    b. Fairness of Market Structure
    2. Other Measures
    B. High Frequency Trading
    1. Strategies
    a. Passive Market Making
    b. Arbitrage
    c. Structural
    d. Directional
    2. Tools
    a. Co-Location
    b. Trading Center Data Feeds
    3. Systemic Risks
    C. Undisplayed Liquidity
    1. Order Execution Quality
    2. Public Price Discovery
    3. Fair Access and Regulation of ATSs
    D. General Request for Comments

I. Introduction

    The secondary market for U.S.-listed equities has changed 
dramatically in recent years. In large part, the change reflects the 
culmination of a decades-long trend from a market structure with 
primarily manual trading to a market structure with primarily automated 
trading. When Congress mandated the establishment of a national market 
system for securities in 1975, trading in U.S.-listed equities was 
dominated by exchanges with manual trading floors. Trading equities 
today is no longer as straightforward as sending an order to the floor 
of a single exchange on which a stock is listed. As discussed in 
section III below, the current market structure can be described as 
dispersed and complex: (1) Trading volume is dispersed among many 
highly automated trading centers that compete for order flow in the 
same stocks; and (2) trading centers offer a wide range of services 
that are designed to attract different types of market participants 
with varying trading needs.
    A primary driver and enabler of this transformation of equity 
trading has been the continual evolution of technologies for 
generating, routing, and executing orders. These technologies have 
dramatically improved the speed, capacity, and sophistication of the 
trading functions that are available to market participants. Changes in 
market structure also reflect the markets' response to regulatory 
actions such as Regulation NMS, adopted in 2005,\1\ the Order Handling 
Rules, adopted in 1996,\2\ as well as enforcement actions, such as 
those addressing anti-competitive behavior by market makers in NASDAQ 

    \1\ Securities Exchange Act Release No. 51808 (June 9, 2005), 70 
FR 37496 (June 29, 2005) (``Regulation NMS Release'').
    \2\ Securities Exchange Act Release No. 37619A (September 6, 
1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules 
    \3\ See, e.g., In the Matter of National Association of 
Securities Dealers, Inc., Administrative Proceeding File No. 3-9056, 
Securities Exchange Act Release No. 37538 (August 8, 1996).

    The transformation of equity trading has encompassed all types of 
U.S.-listed stocks. In recent years, however, it is perhaps most 
apparent in stocks listed on the New York Stock Exchange (``NYSE''), 
which constitute nearly 80% of the capitalization of the U.S. equity 
markets.\4\ In contrast to stocks listed on the NASDAQ Stock Market LLC 
(``NASDAQ''), which for more than a decade have been traded in a highly 
automated fashion at many different trading centers,\5\ NYSE-listed 
stocks were traded primarily on the floor of the NYSE in a manual 
fashion until October 2006. At that time, NYSE began to offer

[[Page 3595]]

fully automated access to its displayed quotations.\6\ An important 
impetus for this change was the Commission's adoption of Regulation NMS 
in 2005, which eliminated the trade-through protection for manual 
quotations that nearly all commenters believed was seriously 

    \4\ In November 2009, for example, NYSE-listed stocks 
represented approximately 78% of the market capitalization of the 
Wilshire 5000 Total Market Index. Wilshire Associates, http://wilshire.com/Indexes/Broad/Wilshire5000/Characteristics.html 
(November 17, 2009).
    \5\ NASDAQ itself offered limited automated execution 
functionality until the introduction of SuperMontage in 2002. See 
Securities Exchange Act Release No. 46429 (August 29, 2002), 67 FR 
56862 (September 5, 2002) (Order with Respect to the Implementation 
of NASDAQ's SuperMontage Facility). Prior to 2002, however, many 
electronic communication networks (``ECNs'') and market makers 
trading NASDAQ stocks provided predominantly automated executions.
    \6\ See Securities Exchange Act Release No. 53539 (March 22, 
2006), 71 FR 16353 (March 31, 2006) (File No. SR-NYSE-2004-05) 
(approving proposal to create a ``Hybrid Market'' by, among other 
things, increasing the availability of automated executions); Pierre 
Paulden, Keep the Change, Institutional Investor (December 19, 2006) 
(``Friday, October 6, was a momentous day for the New York Stock 
Exchange. That morning the Big Board broke with 214 years of 
tradition when it began phasing in a new hybrid market structure 
that can execute trades electronically, bypassing face-to-face 
auctions on its famed floor.''). Prior to the Hybrid Market, NYSE 
offered limited automated executions.
    \7\ Regulation NMS Release, 70 FR at 37505 n. 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 

    The changes in the nature of trading for NYSE-listed stocks have 
been extraordinary, as indicated by the comparisons of trading in 2005 
and 2009 in Figures 1 through 5 below:

    Figure 1--NYSE executed approximately 79.1% of the consolidated 
share volume in its listed stocks in January 2005, compared to 25.1% in 
October 2009.\8\

    \8\ NYSE Euronext, ``NYSE Euronext Announces Trading Volumes for 
October 2009 (November 6, 2009) (``Tape A matched market share for 
NYSE was 25.1% in October 2009, above the 24.5% market share 
reported in October 2008'') (available at http://www.nyse.com/press/125741917814.html); Securities Exchange Act Release No. 59039 
(December 2, 2008), 73 FR 74770, 74782 (December 9, 2008) (File No. 
SR-NYSEArca-2006-21) (``Given the competitive pressures that 
currently characterize the U.S. equity markets, no exchange can 
afford to take its market share percentages for granted--they can 
change significantly over time, either up or down. * * * For 
example, the NYSE's reported market share of trading in NYSE-listed 
stocks declined from 79.1% in January 2005 to 30.6% in June 2008.'') 
(citations omitted).

    Figure 2--NYSE's average speed of execution for small, immediately 
executable (marketable) orders was 10.1

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seconds in January 2005, compared to 0.7 seconds in October 2009.\9\

    \9\ NYSE Euronext, Rule 605 Reports for January 2005 and October 
2009 (available at http://www.nyse.com/equities/nyseequities/1201780422054.html) (NYSE average speed of execution for small (100-
499 shares) market orders and marketable limit orders was 10.1 
seconds in January 2005 and 0.7 seconds in October 2009).

    Figure 3--Consolidated average daily share volume in NYSE-listed 
stocks was 2.1 billion shares in 2005, compared to 5.9 billion shares 
(an increase of 181%) in January through October 2009.\10\

    \10\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues 
2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).

    Figure 4--Consolidated average daily trades in NYSE-listed stocks 
was 2.9 million trades in 2005, compared to 22.1 million trades (an 
increase of 662%) in January through October 2009.\11\

    \11\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues 
2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).

    Figure 5--Consolidated average trade size in NYSE-listed stocks was 
724 shares in 2005, compared to 268 shares in January through October 

    \12\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues 
2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).

    The foregoing statistics for NYSE-listed stocks are intended solely 
to illustrate the sweeping changes that are characteristic of trading 
in all U.S.-listed equities, including NASDAQ-listed stocks and other 
equities such as exchange-traded funds (``ETFs''). They are not 
intended to indicate whether these changes have led to a market 
structure that is better or worse for long-term investors--an important 
issue on which comment is requested in section IV.A.1 below. Rather, 
the statistics for NYSE-listed stocks provide a useful illustration 
simply because the changes occurred both more rapidly and more recently 
for NYSE-listed stocks than other types of U.S.-listed equities.
    To more fully understand the effects of these and other changes in 
equity trading, the Commission is conducting a comprehensive review of 
equity market structure. It is assessing whether market structure rules 
have kept pace with, among other things, changes in trading technology 
and practices. The review already has led to several rulemaking 
proposals that address particular issues and that are intended 
primarily to preserve the integrity of longstanding market structure 
principles. One proposal would eliminate the exception for flash orders 
from the Securities Exchange Act of 1934 (``Exchange Act'') quoting 
requirements.\13\ Another would address certain practices associated 
with non-public trading interest, including dark pools of 
liquidity.\14\ In addition, the Commission today is proposing for 
public comment an additional market structure initiative to address the 
risk management controls of broker-dealers with market access.\15\

    \13\ Securities Exchange Act Release No. 60684 (September 18, 
2009), 74 FR 48632 (September 23, 2009) (``Flash Order Release'').
    \14\ Securities Exchange Act Release No. 60997 (November 13, 
2009), 74 FR 61208 (November 23, 2009) (``Non-Public Trading 
Interest Release'').
    \15\ Securities Exchange Act Release No. [citation unavailable] 
(``Market Access Release'').

    The Commission is continuing its review. It recognizes that market 
structure issues are complex and require a broad understanding of 
statutory requirements, economic principles, and practical trading 
considerations. Given this complexity, the Commission believes that its 
review would be greatly assisted by receiving the benefit of public 
comment on a broad range of market structure issues. It particularly is 
interested in hearing the views of all types of investors and other 
market participants and in receiving as much data and analysis as 
possible in support of commenters' views.
    Commenters' views on both the strengths and weaknesses of the 
current market structure are sought. Views on both strengths and 
weaknesses can help identify new initiatives that would enhance the 
strengths or improve on the weaknesses, avoid changes that would 
unintentionally cause more harm than good, and suggest whether any 
current rules are no longer necessary or are counterproductive to the 
objectives of the Exchange Act. As discussed in section II below, 
Congress mandated that the national market system should achieve a 
range of objectives--efficient execution of transactions, fair 
competition among markets, price transparency, best execution of 
investor orders, and the interaction of investor orders when consistent 
with efficiency and best execution. Additionally, the Commission's 
mission includes the protection of investors and the facilitation of 
capital formation. Appropriately achieving each of these objectives 
requires a balanced market structure that can accommodate a wide range 
of participants and trading strategies.
    This release is intended to facilitate public comment by first 
giving a basic overview of the legal and factual elements of the 
current equity market structure and then presenting a wide range of 
issues for comment. The Commission cautions that it has not reached any 
final conclusions on the issues presented for comment. The discussion 
and questions in this release should not be interpreted as slanted in 
any particular way on any particular issue. The Commission intends to 
consider carefully all comments and to complete its review in a timely 
fashion. At that point, it will determine whether there are any 
problems that require a regulatory initiative and, if so, the nature of 
that initiative. Moreover, a new regulatory requirement would first be 
published in the form of a proposal that would give the public an 
opportunity to comment on the specifics of the proposal prior to 

II. Exchange Act Requirements for a National Market System

    In Section 11A of the Exchange Act,\16\ Congress directed the 
Commission to facilitate the establishment of a national market system 
in accordance with specified findings and objectives. The initial 
Congressional findings were that the securities markets are an 
important national asset that must be preserved and strengthened, and 
that new data processing and communications techniques create the 
opportunity for more efficient and effective market operations. 
Congress then proceeded to mandate a national market system composed of 
multiple competing markets that are linked through technology. In 
particular, Congress found that it is in the public interest and 
appropriate for the protection of investors and the maintenance of fair 
and orderly markets to assure five objectives:

    \16\ 15 U.S.C. 78k-1.

    (1) Economically efficient execution of securities transactions;
    (2) Fair competition among brokers and dealers, among exchange 
markets, and between exchange markets and markets other than exchange 
    (3) The availability to brokers, dealers, and investors of 
information with respect to quotations and transactions in securities;
    (4) The practicability of brokers executing investors' orders in 
the best market; and
    (5) An opportunity, consistent with efficiency and best execution, 
for investors' orders to be executed without the participation of a 
    The final Congressional finding was that these five objectives 
would be fostered by the linking of all markets for qualified 
securities through communication and data processing facilities. 
Specifically, Congress found that such linkages would foster 
efficiency; enhance competition;

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increase the information available to brokers, dealers, and investors; 
facilitate the offsetting (matching) of investors' orders; and 
contribute to the best execution of investors' orders.
    Over the years, these findings and objectives have guided the 
Commission as it has sought to keep market structure rules up-to-date 
with continually changing economic conditions and technology advances. 
This task has presented certain challenges because, as noted previously 
by the Commission, the five objectives set forth in Section 11A can, at 
times, be difficult to reconcile.\17\ In particular, the objective of 
matching investor orders, or ``order interaction,'' can be difficult to 
reconcile with the objective of promoting competition among markets. 
Order interaction promotes a system that ``maximizes the opportunities 
for the most willing seller to meet the most willing buyer.'' \18\ When 
many trading centers compete for order flow in the same stock, however, 
such competition can lead to the fragmentation of order flow in that 
stock. Fragmentation can inhibit the interaction of investor orders and 
thereby impair certain efficiencies and the best execution of 
investors' orders. Competition among trading centers to provide 
specialized services for investors also can lead to practices that may 
detract from public price transparency. On the other hand, mandating 
the consolidation of order flow in a single venue would create a 
monopoly and thereby lose the important benefits of competition among 
markets. The benefits of such competition include incentives for 
trading centers to create new products, provide high quality trading 
services that meet the needs of investors, and keep trading fees low.

    \17\ See, e.g., Securities Exchange Act Release No. 42450 
(February 3, 2000), 65 FR 10577, 10580 (February 28, 2000) 
(``Fragmentation Concept Release'') (``[A]lthough the objectives of 
vigorous competition on price and fair market center competition may 
not always be entirely congruous, they both serve to further the 
interests of investors and therefore must be reconciled in the 
structure of the national market system.'').
    \18\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975).

    The Commission's task has been to facilitate an appropriately 
balanced market structure that promotes competition among markets, 
while minimizing the potentially adverse effects of fragmentation on 
efficiency, price transparency, best execution of investor orders, and 
order interaction.\19\ An appropriately balanced market structure also 
must provide for strong investor protection and enable businesses to 
raise the capital they need to grow and to benefit the overall economy. 
Given the complexity of this task, there clearly is room for reasonable 
disagreement as to whether the market structure at any particular time 
is, in fact, achieving an appropriate balance of these multiple 
objectives. Accordingly, the Commission believes it is important to 
monitor these issues and, periodically, give the public, including the 
full range of investors and other market participants, an opportunity 
to submit their views on the matter. This concept release is intended 
to provide such an opportunity.

    \19\ See S. Rep. 94-75, 94th Cong., 1st Sess. 2 (1975) (``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 of 
centralized trading of securities in the interest of both efficiency 
and investor protection.''); Regulation NMS Release, 70 FR at 37499 
(``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.'').

III. Overview of Current Market Structure

    This section provides a brief overview of the current equity market 
structure. It first describes the various types of trading centers that 
compete for order flow in NMS stocks \20\ and among which liquidity is 
dispersed. It then describes the primary types of linkages between or 
involving these trading centers that are designed to enable market 
participants to trade effectively. This section attempts to highlight 
the features of the current equity market structure that may be most 
salient in presenting issues for public comment and is not intended to 
serve as a full description of the U.S. equity markets.

    \20\ Rule 600(b)(47) of Regulation NMS defines ``NMS stock'' to 
mean any NMS security other than an option. Rule 600(b)(46) defines 
``NMS security'' to mean any security for which trade reports are 
made available pursuant to an effective transaction reporting plan. 
In general, NMS stocks are those that are listed on a national 
securities exchange.

A. Trading Centers

    A good place to start in describing the current market structure is 
by identifying the major types of trading centers and giving a sense of 
their current share of trading volume in NMS stocks. Figure 6 below 
provides this information with estimates of trading volume in September 
2009: \21\

    \21\ Sources of estimated trading volume percentages: NASDAQ; 
NYSE Group; BATS; Direct Edge; data compiled from Forms ATS for 3d 
quarter 2009.

Figure 6

Trading Centers and Estimated % of Share Volume in NMS Stocks September 

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                          Registered Exchanges
NASDAQ.......................................................       19.4
NYSE.........................................................       14.7
NYSE Arca....................................................       13.2
BATS.........................................................        9.5
NASDAQ OMX BX................................................        3.3
Other........................................................        3.7
    Total Exchange...........................................       63.8
2 Direct Edge................................................        9.8
3 Others.....................................................        1.0
    Total ECN................................................       10.8
    Total Displayed Trading Center...........................       74.6
                               Dark Pools
Approximately 32 \22\........................................        7.9
                      Broker-Dealer Internalization
More than 200 \23\...........................................       17.5
    Total Undisplayed Trading Center.........................       25.4

    Figure 6 identifies two types of trading centers that display 
quotations in the consolidated quotation data that is widely 
distributed to the public--registered exchanges and ECNs.\24\ These 
displayed trading centers execute approximately 74.6% of share volume. 
Figure 6 also identifies two types of undisplayed trading centers--dark 
pools and broker-dealers that execute trades internally--that execute 
approximately 25.4% of share volume. These four types of trading 
centers are described below.

    \22\ Data compiled from Forms ATS submitted to Commission for 3d 
quarter 2009.
    \23\ More than 200 broker-dealers (excluding ATSs) have 
identified themselves to FINRA as market centers that must provide 
monthly reports on order execution quality under Rule 605 of 
Regulation NMS (list available at http://apps.finra.org/datadirectory/1/marketmaker.aspx).
    \24\ Consolidated quotation data is described in section 
III.B.1. below.

1. Registered Exchanges
    Registered exchanges collectively execute approximately 63.8% of 
share volume in NMS stocks, with no single exchange executing more than 
19.4%. Registered exchanges must undertake self-regulatory 
responsibility for their members and file their proposed rule changes 
for approval with the Commission. These proposed rule changes publicly 
disclose, among other things, the trading services and fees of 
    The registered exchanges all have adopted highly automated trading 
systems that can offer extremely high-speed, or ``low-latency,'' order 
responses and executions. Published average response times at some 
exchanges, for example, have been reduced to less than 1 
millisecond.\25\ Many exchanges offer individual data feeds that 
deliver information concerning their orders and trades directly to 
customers. To further reduce latency in transmitting market data and 
order messages, many exchanges also offer co-location services that 
enable exchange customers to place their servers in close proximity to 
the exchange's matching engine. Exchange data feeds and co-location 
services are discussed further in section IV.B.2. below.

    \25\ See, e.g., BATS Exchange, Inc., http://batstrading.com/resources/features/bats_exchange_Latency.pdf (June 2009) (average 
latency (time to accept, process, and acknowledge or fill order) of 
320 microseconds; NASDAQ, http://www.nasdaqtrader.com/trader.aspx?id=inet (December 12, 2009) (average latency (time to 
accept, process, and acknowledge or fill order) of 294 

    Registered exchanges typically offer a wide range of order types 
for trading on their automated systems. Some of their order types are 
displayable in full if they are not executed immediately. Others are 
undisplayed, in full or in part. For example, a reserve order type will 
display part of the size of an order at a particular price, while 
holding the balance of the order in reserve and refreshing the 
displayed size as needed. In general, displayed orders are given 
execution priority at any given price over fully undisplayed orders and 
the undisplayed size of reserve orders.\26\

    \26\ See, e.g., BATS Exchange, Inc., Rule 11.12 (equally priced 
trading interest executed in time priority in the following order: 
(1) Displayed size of limit orders; (2) non-displayed limit orders; 
(3) pegged orders; (4) mid-point peg orders; (5) reserve size of 
orders; and (6) discretionary portion of discretionary orders); 
NASDAQ Rule 4757(a)(1) (book processing algorithm executes trading 
interest in the following order: (1) Displayed orders; (2) non-
displayed orders and the reserve portion of quotes and reserve 
orders (in price/time priority among such interest); and (3) the 
discretionary portion of discretionary orders.

    In addition, many exchanges have adopted a ``maker-taker'' pricing 
model in an effort to attract liquidity providers. Under this model, 

[[Page 3599]]

resting orders that offer (make) liquidity at a particular price 
receive a liquidity rebate if they are executed, while incoming orders 
that execute against (take) the liquidity of resting orders are charged 
an access fee. Rule 610(c) of Regulation NMS caps the amount of the 
access fee for executions against the best displayed prices of an 
exchange at 0.3 cents per share. Exchanges typically charge a somewhat 
higher access fee than the amount of their liquidity rebates, and 
retain the difference as compensation. Sometimes, however, exchanges 
have offered ``inverted'' pricing and pay a liquidity rebate that 
exceeds the access fee.
    Highly automated exchange systems and liquidity rebates have helped 
establish a business model for a new type of professional liquidity 
provider that is distinct from the more traditional exchange specialist 
and over-the-counter (``OTC'') market maker. In particular, proprietary 
trading firms and the proprietary trading desks of multi-service 
broker-dealers now take advantage of low-latency systems and liquidity 
rebates by submitting large numbers of non-marketable orders (often 
cancelling a very high percentage of them), which provide liquidity to 
the market electronically. As discussed in section IV.B. below, these 
proprietary traders often are labeled high-frequency traders, though 
the term does not have a settled definition and may encompass a variety 
of strategies in addition to passive market making.
2. ECNs
    The five ECNs that actively trade NMS stocks collectively execute 
approximately 10.8% of share volume. Almost all ECN volume is executed 
by two ECNs operated by Direct Edge, which has submitted applications 
for registration of its two trading platforms as exchanges.\27\ ECNs 
are regulated as alternative trading systems (``ATSs''). Regulation of 
ATSs is discussed in the next section below in connection with dark 
pools, which also are ATSs. The key characteristic of an ECN is that it 
provides its best-priced orders for inclusion in the consolidated 
quotation data, whether voluntarily or as required by Rule 301(b)(3) of 
Regulation ATS. In general, ECNs offer trading services (such as 
displayed and undisplayed order types, maker-taker pricing, and data 
feeds) that are analogous to those of registered exchanges.

    \27\ Securities Exchange Act Release No. 60651 (September 11, 
2009), 74 FR 47827 (September 17, 2009) (Notice of filing of 
applications for registration as national securities exchanges by 
EDGX Exchange, Inc. and EDGA Exchange, Inc.).

3. Dark Pools
    Dark pools are ATSs that, in contrast to ECNs, do not provide their 
best-priced orders for inclusion in the consolidated quotation data. In 
general, dark pools offer trading services to institutional investors 
and others that seek to execute large trading interest in a manner that 
will minimize the movement of prices against the trading interest and 
thereby reduce trading costs.\28\ There are approximately 32 dark pools 
that actively trade NMS stocks, and they executed approximately 7.9% of 
share volume in NMS stocks in the third quarter of 2009.\29\ ATSs, both 
dark pools and ECNs, fall within the statutory definition of an 
exchange, but are exempted if they comply with Regulation ATS. 
Regulation ATS requires ATSs to be registered as broker-dealers with 
the Commission, which entails becoming a member of the Financial 
Industry Regulatory Authority (``FINRA'') and fully complying with the 
broker-dealer regulatory regime. Unlike a registered exchange, an ATS 
is not required to file proposed rule changes with the Commission or 
otherwise publicly disclose its trading services and fees. ATSs also do 
not have any self-regulatory responsibilities, such as market 
surveillance. The regulatory differences between registered exchanges 
and ATSs are addressed further in section IV.C.3. below.

    \28\ See Non-Public Trading Interest Release, 74 FR at 61208-
    \29\ Data compiled from Forms ATS submitted to Commission for 3d 
quarter 2009. Some OTC market makers offer dark liquidity primarily 
in a principal capacity and do not operate as ATSs. For purposes of 
this release, these trading centers are not defined as dark pools 
because they are not ATSs. These trading centers may, however, offer 
electronic dark liquidity services that are analogous to those 
offered by dark pools.

    Dark pools can vary quite widely in the services they offer their 
customers. For example, some dark pools, such as block crossing 
networks, offer specialized size discovery mechanisms that attempt to 
bring large buyers and sellers in the same NMS stock together 
anonymously and to facilitate a trade between them. The average trade 
size of these block crossing networks can be as high as 50,000 
shares.\30\ Most dark pools, though they may handle large orders, 
primarily execute trades with small sizes that are more comparable to 
the average size of trades in the public markets, which was less than 
300 shares in July 2009.\31\ These dark pools that primarily match 
smaller orders (though the matched orders may be ``child'' orders of 
much larger ``parent'' orders) execute more than 90% of dark pool 
trading volume.\32\ The majority of this volume is executed by dark 
pools that are sponsored by multi-service broker-dealers. These broker-
dealers also offer order routing services, trade as principal in the 
sponsored ATS, or both.

    \30\ See, e.g., http://www.liquidnet.com/about/liquidStats.html 
(average U.S. execution size in July 2009 was 49,638 shares for 
manually negotiated trades via Liquidnet's negotiation product); 
(average trade size of 50,000 shares in Pipeline).
    \31\ See, e.g., http://www.nasdaqtrader.com/trader/aspx?id=marketshare (average size of NASDAQ matched trades in July 
2009 was 228 shares); http://nyxdata.com/nysedata/asp/factbook (NYSE 
Group average trade size in all stocks traded in July 2009 was 267 
    \32\ Data compiled from Forms ATS submitted to Commission for 3d 
quarter 2009.

4. Broker-Dealer Internalization
    The other type of undisplayed trading center is a non-ATS broker-
dealer that internally executes trades, whether as agent or principal. 
Notably, many broker-dealers may submit orders to exchanges or ECNs, 
which then are included in the consolidated quotation data. The 
internalized executions of broker-dealers, however, primarily reflect 
liquidity that is not included in the consolidated quotation data. 
Broker-dealer internalization accordingly should be classified as 
undisplayed liquidity. There are a large number of broker-dealers that 
execute trades internally in NMS stocks--more than 200 publish 
execution quality statistics under Rule 605 of Regulation NMS.\33\ 
Broker-dealer internalization accounts for approximately 17.5% of share 
volume in NMS stocks.

    \33\ See supra note 23.

    Broker-dealers that internalize executions generally fall into two 
categories--OTC market makers and block positioners. An OTC market 
maker is defined in Rule 600(b)(52) of Regulation NMS as ``any dealer 
that holds itself out as being willing to buy 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.'' ``Block 
size'' is defined in Rule 600(b)(9) as an order of at least 10,000 
shares or for a quantity of stock having a market value of at least 
$200,000. A block positioner generally means any broker-dealer in the 
business of executing, as principal or agent, block size trades for its 
customers. To facilitate trades, block positioners often commit their 
own capital to trade as principal with at least some part of the 
customer's block order.
    Broker-dealers that act as OTC market makers and block positioners 

[[Page 3600]]

their business primarily by directly negotiating with customers or with 
other broker-dealers representing customer orders. OTC market makers, 
for example, appear to handle a very large percentage of marketable 
(immediately executable) order flow of individual investors that is 
routed by retail brokerage firms. A review of the order routing 
disclosures required by Rule 606 of Regulation NMS of eight broker-
dealers with significant retail customer accounts reveals that nearly 
100% of their customer market orders are routed to OTC market 
makers.\34\ The review also indicates that most of these retail brokers 
either receive payment for order flow in connection with the routing of 
orders or are affiliated with an OTC market maker that executes the 
orders. The Rule 606 Reports disclose that the amount of payment for 
order flow generally is 0.1 cent per share or less.\35\

    \34\ Review of Rule 606 Reports for 2d quarter 2009 of eight 
broker-dealers with substantial number of retail customer accounts.
    \35\ Id.

B. Linkages

    Given the dispersal of liquidity across a large number of trading 
centers of different types, an important question is whether trading 
centers are sufficiently linked together in a unified national market 
system. Thus far in this release, the term ``dispersed'' has been used 
to describe the current market structure rather than ``fragmented.'' 
The term ``fragmentation'' connotes a negative judgment that the 
linkages among competing trading centers are insufficient to achieve 
the Exchange Act objectives of efficiency, price transparency, best 
execution, and order interaction. Whether fragmentation is in fact a 
problem in the current market structure is a critically important issue 
on which comment is requested in section IV below in a variety of 
contexts. This section will give an overview of the primary types of 
linkages that operate in the current market structure--consolidated 
market data, trade-through protection, and broker routing services.
1. Consolidated Market Data
    When Congress mandated a national market system in 1975, it 
emphasized that the systems for collecting and distributing 
consolidated market data would ``form the heart of the national market 
system.'' \36\ As described further below, consolidated market data 
includes both: (1) Pre-trade transparency--real-time information on the 
best-priced quotations at which trades may be executed in the future 
(``consolidated quotation data''); and (2) post-trade transparency--
real-time reports of trades as they are executed (``consolidated trade 
data''). As a result, the public has ready access to a comprehensive, 
accurate, and reliable source of information for the prices and volume 
of any NMS stock at any time during the trading day. This information 
serves an essential linkage function by helping assure that the public 
is aware of the best displayed prices for a stock, no matter where they 
may arise in the national market system. It also enables investors to 
monitor the prices at which their orders are executed and assess 
whether their orders received best execution.

    \36\ H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975).

    Consolidated market data is collected and distributed pursuant to a 
variety of Exchange Act rules and joint-industry plans. With respect to 
pre-trade transparency, Rule 602 of Regulation NMS requires exchange 
members and certain OTC market makers that exceed a 1% trading volume 
threshold to provide their best-priced quotations to their respective 
exchanges or FINRA, and these self-regulatory organizations (``SROs''), 
in turn, are required to make this information available to vendors. 
Rule 604 of Regulation NMS requires exchange specialists and OTC market 
makers to display certain customer limit orders in their best-priced 
quotations provided under Rule 602. In addition, Rule 301(b)(3) of 
Regulation ATS requires an ATS that displays orders to more than one 
person in the ATS and exceeds a 5% trading volume threshold to provide 
its best-priced orders for inclusion in the quotation data made 
available under Rule 602.\37\

    \37\ The Commission has proposed lowering the trading volume 
threshold for order display obligations from 5% to 0.25%. Non-Public 
Trading Interest Release, 74 FR at 61213.

    Importantly, the Commission's rules do not require the display of a 
customer limit order if the customer does not wish the order to be 
displayed.\38\ Customers have the freedom to display or not display 
depending on their trading objectives. On the other hand, the selective 
display of orders generally is prohibited in order to prevent the 
creation of significant private markets and two-tiered access to 
pricing information.\39\ Accordingly, the display of orders to some 
market participants generally will require that the order be included 
in the consolidated quotation data that is widely available to the 

    \38\ Rule 604 of Regulation NMS, for example, explicitly 
recognizes the ability of customers to control whether their limit 
orders are displayed to the public. Rule 604(b)(2) provides an 
exception from the limit order display requirement for orders that 
are placed by customers who expressly request that the order not be 
displayed. Rule 604(b)(4) provides an exception for all block size 
orders unless the customer requests that the order be displayed.
    \39\ See, e.g., Rule 301(b)(3) of Regulation ATS; Rule 602(a)(1) 
of Regulation NMS; Order Handling Rules Release, 61 FR at 48307 
(``Although offering benefits to some market participants, 
widespread participation in these hidden markets has reduced the 
completeness and value of publicly available quotations contrary to 
the purposes of the NMS.'').

    With respect to post-trade transparency, Rule 601 of Regulation NMS 
requires the equity exchanges and FINRA to file a transaction reporting 
plan regarding transactions in listed equity securities. The members of 
these SROs are required to comply with the relevant SRO rules for trade 
reporting. FINRA's trade reporting requirements apply to all ATSs that 
trade NMS stocks, both ECNs and dark pools, as well as to broker-
dealers that internalize. FINRA currently requires members to report 
their trades as soon as practicable, but no later than 90 seconds.\40\ 
FINRA has proposed to reduce the reporting time period to 30 seconds, 
noting that more than 99.9% of transactions are reported to FINRA in 30 
seconds or less.\41\

    \40\ Securities Exchange Act Release No. 60960 (November 6, 
2009), 74 FR 59272, 59273 (November 17, 2009) (File No. SR-FINRA-
2009-061) (in its description of the proposed rule change, FINRA 
stated that ``[a]lthough members would have 30 seconds to report, 
FINRA reiterates that--as is the case today--members must report 
trades as soon as practical and cannot withhold trade reports, e.g., 
by programming their systems to delay reporting until the last 
permissible second'').
    \41\ Id. (from February 23, 2009 through February 27, 2009, 
99.90% of trades submitted to a FINRA Facility for public reporting 
were reported in 30 seconds or less).

    Finally, Rule 603(b) of Regulation NMS requires the equity 
exchanges and FINRA to act jointly pursuant to one or more effective 
national market system plans to disseminate consolidated information, 
including an NBBO, on quotations for and transactions in NMS stocks. It 
also requires that consolidated information for each NMS stock be 
disseminated through a single plan processor.
    To comply with these requirements, the equity exchanges and FINRA 
participate in three joint-industry plans (``Plans'').\42\ Pursuant to 
the Plans, three

[[Page 3601]]

separate networks distribute consolidated market data for NMS stocks: 
(1) Network A for securities with their primary listing on the NYSE; 
(2) Network B for securities with their primary listing on exchanges 
other than the NYSE or NASDAQ; and (3) Network C for securities with 
their primary listing on NASDAQ. The three Networks establish fees for 
the data, which must be filed for Commission approval. The three 
Networks collect the applicable fees and, after deduction of Network 
expenses (which do not include the costs incurred by SROs to generate 
market data and provide such data to the Networks), allocate the 
remaining revenues to the SROs. The revenues, expenses, and allocations 
for each of the three Networks are set forth in Table 1 below:\43\

    \42\ The three joint-industry plans are: (1) The CTA Plan, which 
is operated by the Consolidated Tape Association and disseminates 
transaction information for securities with their primary listing on 
exchanges other than NASDAQ; (2) the CQ Plan, which disseminates 
consolidated quotation information for securities with their primary 
listing on exchanges other than NASDAQ; and (3) the NASDAQ UTP Plan, 
which disseminates consolidated transaction and quotation 
information for securities with their primary listing on NASDAQ. The 
CTA Plan and CQ Plan are available at http://www.nyxdata.com/nysedata/default.aspx?tabid=227. The NASDAQ UTP Plan is available at 
    \43\ The Network financial information for 2008 is preliminary 
and unaudited.

                          Table 1--2008 Financial Information for Networks A, B, and C
                                          Network A          Network B          Network C            Total
Revenues............................       $209,218,000       $119,876,000       $134,861,000       $463,955,000
Expenses............................          6,078,000          3,066,000          5,729,000         14,873,000
Net Income..........................        203,140,000        116,810,000        129,132,000        449,082,000
    NASDAQ..........................         47,845,000         34,885,000         60,614,000        143,343,000
    NYSE Arca.......................         37,080,000         38,235,000         26,307,000        101,622,000
    NYSE............................         68,391,000                  0                  0         68,391,000
    FINRA...........................         24,325,000         16,458,000         20,772,000         61,555,000
    NSX.............................          7,100,000         11,575,000         17,123,000         35,798,000
    ISE.............................         15,260,000          1,477,000          1,883,000         18,620,000
    NYSE Amex.......................              1,000          9,760,000             14,000          9,775,000
    BATS............................          2,356,000          2,770,000          1,538,000          6,664,000
    CBOE............................             80,000          1,046,000            433,000          1,559,000
    CHX.............................            565,000            574,000            298,000          1,437,000
    Phlx............................            134,000             30,000            146,000            310,000
    BSE.............................              3,000  .................              4,000              7,000

    In addition to providing quotation and trade information to the 
three Networks for distribution in consolidated data, many exchanges 
and ECNs offer individual data feeds directly to customers that include 
information that is provided in consolidated data. The individual data 
feeds of exchanges and ECNs also can include a variety of other types 
of information, such as ``depth-of-book'' quotations at prices inferior 
to their best-priced quotations. Rule 603(a) of Regulation NMS requires 
all exchanges, ATSs, and other broker-dealers that offer individual 
data feeds to make the data available on terms that are fair and 
reasonable and not unreasonably discriminatory. Exchanges, ATSs, and 
other broker-dealers are prohibited from providing their data directly 
to customers any sooner than they provide their data to the plan 
processors for the Networks.\44\ The fact that trading center data 
feeds do not need to go through the extra step of consolidation at a 
plan processor, however, means that such data feeds can reach end-users 
faster than the consolidated data feeds. The average latencies of the 
consolidation function at plan processors (from the time the processor 
receives information from the SROs to the time it distributes 
consolidated information to the public) are as follows: (1) Network A 
and Network B--less than 5 milliseconds for quotation data and less 
than 10 milliseconds for trade data; and (2) Network C--5.892 
milliseconds for quotation data and 6.680 milliseconds for trade 
data.\45\ The individual trading center data feeds are discussed below 
in section IV.B.2.b.

    \44\ Regulation NMS Release, 70 FR at 37567 (``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.''). The plan processor for the CTA Plan and CQ Plan is 
the Securities Industry Automation Corporation (``SIAC''). The plan 
processor for the NASDAQ UTP Plan is NASDAQ.
    \45\ Sources: SIAC for Network A and Network B; NASDAQ for 
Network C.

2. Trade-Through Protection
    Another important type of linkage in the current market structure 
is the protection against trade-throughs provided by Rule 611 of 
Regulation NMS. A trade-through is the execution of a trade at a price 
inferior to a protected quotation for an NMS stock. A protected 
quotation must be displayed by an automated trading center, must be 
disseminated in the consolidated quotation data, and must be an 
automated quotation that is the best bid or best offer of an exchange 
or FINRA. Importantly, Rule 611 applies to all trading centers, not 
just those that display protected quotations. Trading center is defined 
broadly in Rule 600(b)(78) to include, among others, all exchanges, all 
ATSs (including ECNs and dark pools), all OTC market makers, and any 
other broker-dealer that executes orders internally, whether as agent 
or principal.
    Rule 611(a)(1) requires all trading centers to establish, maintain, 
and enforce written policies and procedures that are reasonably 
designed to prevent trade-throughs of protected quotations, subject to 
the exceptions set forth in Rule 611(b). Protection against trade-
throughs is an important linkage among trading centers because it 
provides a baseline assurance that: (1) Marketable orders will receive 
at least the best displayed price, regardless of the particular trading 
center that executes the order or where the best price is displayed in 
the national market system; and (2) quotations that are displayed at 
one trading center will not be bypassed by trades with inferior prices 
at any trading center in the national market system.
    Rule 611 also helps promote linkages among trading centers by 
encouraging them, when they do not have available trading interest at 
the best price, to route marketable orders to a trading center that is 
displaying the best price. Although Rule 611 does not directly require 
such routing services (a trading center can, for example, cancel and 
return an order when it does not have the best price), competitive 
factors have

[[Page 3602]]

led many trading centers to offer routing services to their customers. 
Prior to Rule 611, exchanges routed orders through an inflexible, 
partially manual system called the Intermarket Trading System 
(``ITS'').\46\ With Regulation NMS, however, the Commission adopted a 
``private linkages'' approach that relies exclusively on brokers to 
provide routing services, both among exchanges and between customers 
and exchanges. These broker routing services are discussed next.

    \46\ See Regulation NMS Release, 70 FR at 37538-37539 
(``Although ITS promotes access among participants that is uniform 
and free, it also is often slow and limited.'').

3. Broker Routing Services
    In a dispersed and complex market structure with many different 
trading centers offering a wide spectrum of services, brokers play a 
significant role in linking trading centers together into a unified 
national market system. Brokers compete to offer the sophisticated 
technology tools that are needed to monitor liquidity at many different 
venues and to implement order routing strategies. To perform this 
function, brokers may monitor the execution of orders at both displayed 
and undisplayed trading centers to assess the availability of 
undisplayed trading interest. Brokers may, for example, construct real-
time ``heat maps'' in an effort to discern and access both displayed 
and undisplayed liquidity at trading centers throughout the national 
market system.
    Using their knowledge of available liquidity, many brokers offer 
smart order routing technology to access such liquidity. Many brokers 
also offer sophisticated algorithms that will take the large orders of 
institutional investors and others, divide a large ``parent'' order 
into many smaller ``child'' orders, and route the child orders over 
time to different trading centers in accordance with the particular 
trading strategy chosen by the customer. Such algorithms may be 
``aggressive,'' for example, and seek to take liquidity quickly at many 
different trading centers, or they may be ``passive,'' and submit 
resting orders at one or more trading centers and await executions at 
favorable prices.
    To the extent they help customers cope with the dispersal of 
liquidity among a large number of trading centers of different types 
and achieve the best execution of their customers' orders, the routing 
services of brokers can contribute to the broader policy goal of 
promoting efficient markets.
    Under the private linkages approach adopted by Regulation NMS, 
market participants obtain access to the various trading centers 
through broker-dealers that are members or subscribers of the 
particular trading center.\47\ Rule 610(a) of Regulation NMS, for 
example, prohibits an SRO trading facility from imposing unfairly 
discriminatory terms that would prevent or inhibit any person from 
obtaining efficient access through an SRO member to the displayed 
quotations of the SRO trading facility. Rule 610(c) limits the fees 
that a trading center can charge for access to its displayed quotations 
at the best prices. Rule 611(d) requires SROs to establish, maintain, 
and enforce rules that restrict their members from displaying 
quotations that lock or cross previously displayed quotations.

    \47\ See Regulation NMS Release, 70 FR at 37540 (``[M]any 
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 

    Section 6(a)(2) of the Exchange Act requires registered exchanges 
to allow any qualified and registered broker-dealer to become a member 
of the exchange--a key element in assuring fair access to exchange 
services. In contrast, the access requirements that apply to ATSs are 
much more limited. Regulation ATS includes two distinct types of access 
requirements: (1) order display and execution access in Rule 301(b)(3); 
and (2) fair access to ATS services in general in Rule 301(b)(5). An 
ATS must meet order display and execution access requirements if it 
displays orders to more than one person in the ATS and exceeds a 5% 
trading volume threshold.\48\ An ATS must meet the general fair access 
requirement if it exceeds a 5% trading volume threshold. If an ATS 
neither displays orders to more than one person in the ATS nor exceeds 
a 5% trading volume threshold, Regulation ATS does not impose access 
requirements on the ATS.

    \48\ The Commission has proposed reducing the threshold for 
order display and execution access to 0.25%. Non-Public Trading 
Interest Release, 74 FR at 61213. It has not proposed to change the 
threshold for fair access in general.

    An essential type of access that should not be overlooked is the 
fair access to clearance and settlement systems required by Section 17A 
of the Exchange Act. If brokers cannot efficiently clear and settle 
transactions at the full range of trading centers, they will not be 
able to perform their linkage function properly.
    The linkage function of brokers also is supported by a broker's 
legal duty of best execution. This duty requires a broker to obtain the 
most favorable terms reasonably available when executing a customer 
order.\49\ Of course, this legal duty is not the only pressure on 
brokers to obtain best execution. The existence of strong competitive 
pressure to attract and retain customers encourages brokers to provide 
high quality routing services to their customers. In this regard, Rules 
605 and 606 of Regulation NMS are designed to support competition by 
enhancing the transparency of order execution and routing practices. 
Rule 605 requires market centers to publish monthly reports of 
statistics on their order execution quality. Rule 606 requires brokers 
to publish quarterly reports on their routing practices, including the 
venues to which they route orders for execution. As the Commission 
emphasized when it adopted the rules in 2000, ``[b]y increasing the 
visibility of order execution and routing practices, the rules adopted 
today are intended to empower market forces with the means to achieve a 
more competitive and efficient national market system for public 
investors.'' \50\ In section IV.A.1.b. below, comment is requested on 
whether Rules 605 and 606 should be updated for the current market 

    \49\ See, e.g., Regulation NMS Release, 70 FR at 37537-37538 
(discussion of duty of best execution).
    \50\ Securities Exchange Act Release No. 43590 (November 17, 
2000), 65 FR 75414, 75415 (December 1, 2000) (Disclosure of Order 
Execution and Routing Practices).

IV. Request for Comments

    This section will focus on three categories of issues that the 
Commission particularly wishes to present for comment--the performance 
of the current market structure, high frequency trading, and 
undisplayed liquidity. The Commission emphasizes, however, that it is 
interested in receiving comments on all aspects of the equity market 
structure that the public believes are important. The discussion in 
this release should not be construed as in any way limiting the scope 
of comments that will be considered.
    This concept release focuses on the structure of the equity markets 
and does not discuss the markets for other types of instruments that 
are related to equities, such as options and OTC derivatives. The 
limited scope of this release is designed to focus on a discrete set of 
issues that have gained increased prominence in the equity markets. 
Comment is requested, however, on the extent to which the issues 
identified in this release are intertwined with other markets. For 
example, market participants may look to alternative instruments if 
they believe the equity markets are not optimal for their trading

[[Page 3603]]

objectives. Should the Commission consider the extent to which 
instruments substitute for one another in evaluating equity market 
    In addition, comment is requested on the impact of globalization on 
market structure. How does global competition for trading activity 
impact the U.S. market structure? Should global competition affect the 
approach to regulation in the U.S.? Will trading activity and capital 
tend to move either to the U.S. or overseas in response to different 
regulation in the U.S.? How should the Commission consider these 
globalization issues in its review of market structure?

A. Market Structure Performance

    The secondary markets for NMS stocks are essential to the economic 
success of the country and to the financial well-being of individual 
Americans. High quality trading markets promote capital raising and 
capital allocation by establishing prices for securities and by 
enabling investors to enter and exit their positions in securities when 
they wish to do so.\51\ The Commission wishes to request comment 
broadly on how well or poorly the current market structure is 
performing its vital economic functions.

    \51\ See, e.g., S. Report 94-75 at 3 (``The rapid attainment of 
a national market system as envisaged by this bill is important, 
therefore, not simply to provide greater investor protection and 
bolster sagging investor confidence but also to assure that the 
country maintains a strong, effective and efficient capital raising 
and capital allocating system in the years ahead. The basic goals of 
the Exchange Act remain salutary and unchallenged: to provide fair 
and honest mechanisms for the pricing of securities, to assure that 
dealing in securities is fair and without undue 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.'').

    In recent months, the Commission has heard a variety of concerns 
about particular aspects of the current market structure, as well as 
the view that recent improvements to the equity markets have benefitted 
both individual and institutional investors. The concerns about market 
structure often have related to high frequency trading and various 
types of undisplayed liquidity. Prior to discussing these particular 
areas of concern in this release, the Commission believes it is 
important to assess more broadly the performance of the market 
structure, particularly for long-term investors and for businesses 
seeking to raise capital. Assessing overall market structure 
performance should help provide context for particular concerns, as 
well as the nature of any regulatory response that may be appropriate 
to address concerns.
1. Long-Term Investors
    In assessing the performance of the current equity market structure 
and whether it is meeting the relevant Exchange Act objectives, the 
Commission is particularly focused on the interests of long-term 
investors. These are the market participants who provide capital 
investment and are willing to accept the risk of ownership in listed 
companies for an extended period of time. Unlike long-term investors, 
professional traders generally seek to establish and liquidate 
positions in a shorter time frame. Professional traders with these 
short time frames often have different interests than investors 
concerned about the long-term prospects of a company.\52\ For example, 
short-term professional traders may like short-term volatility to the 
extent it offers more trading opportunities, while long-term investors 
do not. The net effect of trading strategies pursued by various short-
term professional traders, however, may not increase volatility and may 
work to dampen volatility.

    \52\ See Regulation NMS Release, 70 FR at 37500 (``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 exercises 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.'') (citation 

    Nevertheless, the interests of investors and professional traders 
may at times be aligned. Indeed, the collective effect of professional 
traders competing to profit from short-term trading strategies can work 
to the advantage of long-term investors. For example, as just noted, 
short-term trading strategies may work to dampen short-term volatility. 
Professional traders with an informed view of prices can promote 
efficient pricing. Professional traders competing to provide liquidity 
may narrow spreads and give investors the benefit of better prices when 
they simply want to trade immediately at the best available price.
    Given the difference in time horizons, however, the trading needs 
of long-term investors and short-term professional traders often may 
diverge. Professional trading is a highly competitive endeavor in which 
success or failure may depend on employing the fastest systems and the 
most sophisticated trading strategies that require major expenditures 
to develop and operate. Such systems and strategies may not be 
particularly useful, in contrast, for investors seeking to establish a 
long-term position rather than profit from fleeting price movements. 
Where the interests of long-term investors and short-term professional 
traders diverge, the Commission repeatedly has emphasized that its duty 
is to uphold the interests of long-term investors.\53\

    \53\ See, e.g., Flash Order Release, 74 FR at 48635-48636; 
Regulation NMS Release, 70 FR at 37499-37501; Fragmentation Concept 
Release, 65 FR at 10581 n. 26; see also S. Rep. No. 73-1455, 73rd 
Cong., 2d Sess. 5 (1934) (``Transactions in securities on organized 
exchanges and over-the-counter 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 
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.'').

    Comment is requested on the practicality of distinguishing the 
interests of long-term investors from those of short-term professional 
traders when assessing market structure issues. In what circumstances 
should an investor be considered a ``long-term investor''? If a time 
component is needed to define this class of investor, how should the 
Commission determine the length of expected ownership that renders an 
investor ``long-term''? Under what circumstances would a distinction 
between a long-term investor and a short-term professional trader 
become unclear, and how prevalent are these circumstances? To the 
extent that improved market liquidity and depth promote the interests 
of long-term investors by leading to reduced transaction costs, what 
steps should the Commission consider taking to promote market liquidity 
and depth?
    Long-term investors include individuals that invest directly in 
equities and institutions that invest on behalf of many individuals. 
The Commission is interested in hearing how all types of individual 
investors and all sizes of institutional investors--small, medium, and 
large--are faring in the current market structure. For example, has the 
current market structure become so dispersed and complex that only the 
largest institutions can afford to deploy their own highly 
sophisticated trading tools? If so, are smaller institutions able to 
trade effectively? Some broker-dealers offer sophisticated trading 
tools, such as smart routing and algorithmic trading. How accessible 
are these trading tools to smaller institutions? Are the costs of 
paying for these tools so high that they are effectively inaccessible? 
Moreover, to the extent that a competitive advantage flows from these 

[[Page 3604]]

tools, does that competitive advantage help to promote and enable 
competition, beneficial innovation, and, ultimately, enhanced market 
quality? Is there a risk that certain competitive advantages may reduce 
competition or lead to detrimental innovations? To what extent is it 
important for market participants to be allowed to gain competitive 
advantages, such as by using more sophisticated trading tools?
    In addition, the Commission recognizes that there is wide variation 
in types of equity securities and that there may be important 
differences in market performance among the different types. With 
respect to corporate equities, for example, the Commission is 
interested in how market structure impacts stocks of varying levels of 
market capitalization (for example, top tier, large, middle, and 
small). A vital function of the equity markets is to support the 
capital raising function, including capital raising by small companies. 
The Commission recognizes that small company stocks may trade 
differently than large company stocks and requests comment specifically 
on how the market structure performs for smaller companies and whether 
it supports the capital raising function for them.
a. Market Quality Metrics
    Given these broad concerns for all types of long-term investors and 
the full range of equities, what are useful metrics for assessing the 
performance of the current market structure? In the past, the 
Commission and its staff have considered a wide variety of metrics, 
most of which have applied to smaller orders (such as 10,000 shares or 
less).\54\ These metrics have included measures of spreads--the 
difference between the prices that buyers pay and sellers receive when 
they are seeking to trade immediately at the best prices. Spread 
measures include quoted spreads, effective spreads (which reflects 
whether investors receive prices that are better than, equal to, or 
worse than quoted spreads), and realized spreads (which reflects how 
investors are affected by subsequent price movements in a stock). 
Another often used metric has been speed of execution.\55\

    \54\ See, e.g., Memorandum to File from Office of Economic 
Analysis dated December 15, 2004 regarding comparative analysis of 
execution quality on NYSE and NASDAQ based on a matched sample of 
stocks (``Comparative Analysis of Execution Quality'') (available at 
http://www.sec.gov/spotlight/regnms.htm); Memorandum to File from 
Office of Economic Analysis dated December 15, 2004 regarding 
Analysis of Volatility for Stocks Switching from Nasdaq to NYSE 
(available at http://www.sec.gov/spotlight/regnms.htm); Office of 
Economic Analysis, Report on Comparison of Order Executions Across 
Equity Market Structures (January 8, 2001) (``Report on Comparison 
of Order Executions'') (available at http://www.sec.gov/news/studies/ordrxmkt.htm); Commission, Report on the Practice of 
Preferencing (April 15, 1997) (available at http://www.sec.gov/news/studies/studiesarchive/1997archive.shtml).
    \55\ When assessing market structure during the development of 
Regulation NMS, for example, Commission staff used Rule 605 data to 
measure quoted spreads, effective spreads, realized spreads, price 
impact, net price improvement, execution speed, and fill rates. All 
of the cost values were calculated both in terms of absolute value 
(cents) and in terms of proportional costs as a percentage of stock 
prices. Comparative Analysis of Execution Quality at 8-9.

    Short-Term Volatility. Spreads and speed of execution may not, 
however, give a full picture of execution quality, even for the small 
orders of individual investors that generally will be fully executed in 
one transaction (unlike the large orders of institutional investors 
that may require many smaller executions). For example, short-term 
price volatility may harm individual investors if they are persistently 
unable to react to changing prices as fast as high frequency traders. 
As the Commission previously has noted, long-term investors may not be 
in a position to assess and take advantage of short-term price 
movements.\56\ Excessive short-term volatility may indicate that long-
term investors, even when they initially pay a narrow spread, are being 
harmed by short-term price movements that could be many times the 
amount of the spread.

    \56\ Fragmentation Concept Release, 65 FR at 10581 n. 26 (``In 
theory, short-term price swings that hurt investors on one side of 
the market can benefit investors on the other side of the market. In 
practice, professional traders, who have the time and resources to 
monitor market dynamics closely, are far more likely than investors 
to be on the profitable side of short-term price swings (for 
example, by buying early in a short-term price rise and selling 
early before the price decline).'').

    The Commission has used a variety of measures of short-term 
volatility, including variance ratios (for example, 5 minute return 
variance to 60 minute return variance, 1 day return variance to 1 week 
return variance, and 1 day return variance to 4 week return 
variance).\57\ Variance ratios are useful because they focus on short-
term volatility that may be directly related to market structure 
quality, as opposed to long-term volatility that may be much more 
affected by fundamental economic forces that are independent of market 
structure quality. Another possible metric for assessing whether 
investors are harmed by short-term volatility is realized spread, which 
indicates whether prices moved for or against the submitter of the 
order after the order was executed. Rule 605, for example, measures 
realized spreads based on quotations 5 minutes after the time of order 

    \57\ Variance ratios are calculated by comparing return 
variances for a short time period with return variances for a longer 
time period. One of the advantages of this measure of volatility is 
that ``there is a built-in control for the underlying uncertainty as 
to the `true' value of the stock. For example, the high variance of 
returns on technology stocks is to be expected given the high 
uncertainty as to their future cash flows. The point is that this 
uncertainty will manifest itself in both the daily and weekly return 
variances. When [Commission staff] divide the weekly return by the 
daily return, the natural uncertainty associated with the stock 
`washes out' and [Commission staff] are left with a measure 
associated with transaction costs or some other form of 
inefficiency.'' Report on Comparison of Order Executions, supra note 
54, at 18.

    Finally, the Commission has evaluated various measures of the depth 
that is immediately available to fill orders. These metrics include 
fill rates for limit orders, quoted size at the inside prices, the 
effect of reserve size and undisplayed size at the inside prices or 
better, and quoted depth at prices away from the inside.
    Metrics for Smaller Orders. Comment is requested on whether these 
metrics that focus on the execution of smaller orders continue to be 
useful. Which metrics are most useful in today's market structure? Are 
there other useful metrics not listed above? Are there other relevant 
metrics that reflect how individual investors are likely to trade? For 
example, a significant number of individual investor orders are 
submitted after regular trading hours when such investors have an 
opportunity to evaluate their portfolios. These orders typically are 
executed at opening prices. What are the best metrics for assessing 
whether individual investor orders are executed fairly and efficiently 
at the opening? Are there other particular times or contexts in which 
retail investors often trade and, if so, what are the best metrics for 
determining whether they are treated fairly and efficiently in those 
contexts as well?
    Measuring Institutional Investor Transaction Costs. Most of the 
Commission's past analyses of market performance have focused on the 
execution of smaller orders (for example, less than 10,000 shares), 
rather than attempting to measure the overall transaction costs of 
institutional investors to execute large orders (for example, greater 
than 100,000 shares). Measuring the transaction costs of institutional 
investors that need to trade in large size can be extremely 
complex.\58\ These large orders often are

[[Page 3605]]

broken up into smaller child orders and executed in a series of 
transactions. Metrics that apply to small order executions may miss how 
well or poorly the large order traded overall. Direct measures of large 
order transaction costs typically require access to institutional order 
data that is not publicly available. In this regard, a few trading 
analytics firms with access to institutional order data publish 
periodic analyses of institutional investor transaction costs.\59\ 
These analyses allow such costs to be tracked over time to determine 
whether they are improving or worsening. Comment is requested on these 
published analyses generally and whether they accurately reflect the 
transaction costs experienced by institutional investors. Are there 
other studies or analyses of institutional trading costs that the 
Commission should consider? Comment is requested in general on other 
means for assessing the transaction costs of institutional investors in 
the current market structure. For example, are any of the measures of 
short-term volatility discussed above useful for assessing the 
transactions costs of larger orders and, if so, how?

    \58\ See generally Investment Company Act Release No. 26313 
(December 18, 2003), 68 FR 74820, 74821 (December 24, 2003) (Request 
for Comments on Measures to Improve Disclosure of Mutual Fund 
Transaction Costs) (``The Commission is aware of the need for 
transparency of mutual fund fees and expenses and committed to 
improving disclosure of the costs that are borne by mutual fund 
investors; but it is mindful of the complexities associated with 
identifying, measuring, and accounting for transaction costs.'').
    \59\ See, e.g., U.S. Government Accountability Office, 
``Securities Markets: Decimal Pricing Has Contributed to Lower 
Trading Costs and a More Challenging Trading Environment,'' at 96 
(May 2005) (``We obtained data from three leading firms that collect 
and analyze information about institutional investors' trading 
costs. These trade analytics firms * * * obtain trade data directly 
from institutional investors and brokerage firms and calculate 
trading costs, including market impact costs (the extent to which 
the security changes in price after the investor begins trading), 
typically for the purpose of helping investors and traders limit 
costs of trading. These firms also aggregate client data so as to 
approximate total average trading costs for all institutional 
investors. Generally, the client base represented in aggregate cost 
data can be used to make generalizations about the institutional 
investor industry.''); see also Pam Abramowitz, Technology Drives 
Trading Costs, Institutional Investor (November 4, 2009) (13th 
annual survey of transaction costs conducted for Institutional 
Investor Magazine by Elkins/McSherry); Elkins McSherry LLC, 
``Trading Cost Averages and Volatility Continued to Decline in 
3Q09'' (November 2009) (available at https://www.elkinsmcsherry.com/em/pdfs/Newsletters/Nov_2009_newsletter.pdf); Investment 
Technology Group, Inc., ``ITG Global Trading Cost Review: 2009 Q2'' 
(September 15, 2009) (available at http://www.itg.com/news_events/papers/ITGGlobalTradingCostReview_2009Q2.pdf).

    Trend of Market Quality Metrics. With respect to all of the metrics 
that are useful for assessing market structure performance for long-
term investors, the Commission is interested in whether commenters 
believe they show improvement or worsening in recent years. For 
example, do the relevant metrics indicate that market quality has 
improved or worsened over the last ten years and the last five years? 
Have markets improved or worsened more recently, since January 2009? 
Which of the recent developments in market structure do you consider to 
have the greatest effect on market quality? The Commission wishes to 
hear about any current regulations that may be harming, rather than 
improving, market quality. Specifically, how could any current 
regulations be modified to fit more properly with the current market?
    Recognizing that there is no such thing as a perfect market 
structure that entirely eliminates transaction costs, the Commission 
believes that an understanding of trends is important because they 
provide a useful, pragmatic touchstone for assessing the goals with 
respect to market structure performance.\60\

    \60\ A very recent study, for example, examined trading activity 
trends through the end of 2008. Chordia, Tarun, Richard Roll, & 
Avanidar Subrahmanyam, Why Has Trading Volume Increased? (January 6, 
2010). It focused on comparisons of pre- and post-decimal trading in 
NYSE-listed stocks (subperiods from 1993-2000 and 2001-2008). Among 
the study's findings are that average effective spreads decreased 
significantly (from 10.2 cents to 2.2 cents for small trades 
(<$10,000) and from 10.7 cents to 2.7 cents for large trades 
(>$10,000)), while average depth available at the inside bid and 
offer declined significantly (from 11,130 shares to 2797 shares).

    Effect of Broad Economic Forces. The Commission notes that many 
metrics of market performance may be affected by broad economic forces, 
such as the global financial crisis during the Autumn of 2008, that 
operate independently of market structure. Periods of high volatility 
may be associated with high intermediation costs. This may reflect both 
compensation for risk assumed by liquidity providers and the higher 
demand for immediacy by long-term investors. How should the effect of 
these economic forces be adjusted for in assessing the performance of 
market structure over the last ten years, five years, and the last 
year? For example, the CBOE Volatility Index (``VIX'') reached record 
levels during 2008.\61\ The VIX is sometimes referred to as the ``fear 
index'' because it measures expected volatility of the S&P 500 Index 
over the next 30 calendar days.\62\ To what extent are metrics of 
market structure performance correlated with the VIX or other analogous 
measures of volatility? Is the level of the VIX largely independent of 
market structure quality or are the level of the VIX and market 
structure quality interdependent? Given that the VIX measures expected 
volatility over the next 30 days, how important is the VIX to long-term 

    \61\ See infra note 81 and accompanying text.
    \62\ See Chicago Board Options Exchange, ``The CBOE Volatility 
Index--VIX,'' at 1, 4 (``VIX measures 30-day expected volatility of 
the S&P 500 Index. The components of VIX are near- and next-term put 
and call options, usually in the first and second SPX contract 
months.'') (available at http://www.cboe.com/micro/vix/vixwhite.pdf).

b. Fairness of Market Structure
    The Commission requests comment on whether the current market 
structure is fair for long-term investors. For example, the speed of 
trading has increased to the point that the fastest traders now measure 
their latencies in microseconds. Is it necessary or economically 
feasible for long-term investors to expend resources on the very 
fastest and most highly sophisticated systems or otherwise obtain 
access to these systems? If not, does the fact that professional 
traders likely always will be able to trade faster than long-term 
investors render the equity markets unfair for these investors? Or do 
the different trading needs and objectives of long-term investors mean 
that the disparities in speed in today's market structure are not 
significant to the interests of such investors? In addition, what 
standards should the Commission apply in assessing the fairness of the 
equity markets? For example, is it unfair for market participants to 
obtain a competitive advantage by investing in technology and human 
resources that enable them to trade more effectively and profitably 
than others?
    Rules 605 and 606 and Other Tools to Protect Investor Interests. In 
assessing the fairness of the current market structure, the Commission 
is interested in whether long-term investors and their brokers have the 
tools they need to protect their own interests in a dispersed and 
complex market structure. Do, for example, broker-dealers provide 
routing tools to their agency customers that are as powerful and 
effective as the routing tools they may use for their proprietary 
trading? If not, is this difference in access to technology unfair to 
long-term investors? Or is a broker-dealer's ability to develop and use 
more powerful and effective trading tools a competitive advantage that 
spurs competition and beneficial innovation?
    In addition, comment is requested on Rules 605 and 606, which were 
adopted in 2000. Do these rules need to be updated and, if so, in what 
respects? Do Rule 605 and Rule 606 reports continue to provide useful 
information for investors and their brokers in assessing the quality of 
order execution and routing practices? The Commission

[[Page 3606]]

notes that Rule 606 statistics reveal that brokers with significant 
retail customer accounts send the great majority of non-directed 
marketable orders to OTC market makers that internalize executions, 
often pursuant to payment for order flow arrangements.\63\ Do 
individual investors understand and pay attention to Rule 605 and 606 
statistics? If not, what market participants, if any, make decisions 
based on this data? Are those decisions beneficial to individual 

    \63\ See supra note 34 and accompanying text.

    Rule 605 currently requires that the speed of execution for 
immediately executable orders (market orders and marketable limit 
orders) be disclosed to the tenth of a second. Do investors and brokers 
need more finely tuned statistics, such as hundredths or thousandths of 
a second? For non-marketable limit orders with prices that render them 
not immediately executable at the best displayed prices, the shortest 
time category is 0-9 seconds. Would a shorter time period be useful for 
investors that use non-marketable limit orders? In addition, Rule 605 
does not include any statistics measuring the execution quality of 
orders submitted for execution at opening or closing prices. Would such 
statistics be helpful to investors? Rule 605 also does not include any 
statistics measuring commission costs of orders, access fees, or 
liquidity rebates. Would such statistics be helpful to investors?
    Rule 605 does not require disclosure of the amount of time that 
canceled non-marketable orders are displayed in the order book of 
trading center before cancellation. Considering the high cancellation 
percentage of non-marketable orders, should Rule 605 require the 
disclosure of the average time that canceled orders were displayed in 
the order book? Conversely, should Rule 605 exclude or otherwise 
distinguish canceled orders with a very limited duration (such as less 
than one second)?
    Moreover, Rules 605 and 606 were drafted primarily with the 
interests of individual investors in mind and are focused on the 
execution of smaller orders. Orders with large sizes, for example, are 
excluded from both rules.\64\ Should the rules be updated to address 
the interests of institutional investors in efficiently executing large 
orders (whether in one large trade or many smaller trades)? If so, what 
metrics would be useful for institutional investors?

    \64\ Orders with a size of 10,000 shares or greater are exempt 
from Rule 605 reporting. See generally Staff Legal Bulletin 12R: 
Frequently Asked Questions About Rule 11Ac1-5 (Revised), now 
Regulation NMS Rule 605, Question 26: Exemption of Block Orders 
(available at http://www.sec.gov/divisions/marketreg/disclosure.htm). Rule 606 requires broker-dealers to report on their 
routing of ``non-directed orders,'' which is defined in Rule 
600(b)(48) as limited to customer orders. ``Customer order'' is 
defined in Rule 600(b)(18) of Regulation NMS to exclude an order in 
NMS stocks with a market value of at least $200,000. See generally 
Staff Legal Bulletin 13A: Frequently Asked Questions About Rule 
11Ac1-6, now Regulation NMS Rule 606, Question 6: Definition of 
Customer Orders--Large Order Exclusion (available at http://www.sec.gov/divisions/marketreg/disclosure.htm).

    Intermarket sweep orders (``ISOs'') are mostly used by 
institutional traders.\65\ Rule 605 disclosures do not report regular 
orders and ISOs separately.\66\ Would a distinction between ISO and 
non-ISO marketable orders benefit individual and/or institutional 
investors? Should any other order types be treated differently in Rule 
605 reports?

    \65\ Intermarket sweep orders are exceptions provided in Rule 
611(b)(5) and (6) that enable an order router to sweep one or more 
price levels simultaneously at multiple trading centers without 
violating trade-through restrictions. As defined in Rule 600(b)(30) 
of Regulation NMS, intermarket sweep orders must be routed to 
execute against the full displayed size of any protected quotation 
that otherwise would be traded through by the orders. In addition, a 
single ISO can be routed to the best displayed price at the time of 
routing to help assure an execution even if quotations change after 
the order is routed. See Responses to Frequently Asked Questions 
Concerning Rule 611 and Rule 610 of Regulation NMS, Question 4.04 
(April 4, 2008 Update) (available at http://www.sec.gov/divisions/marketreg/nmsfaq610-11.htm).
    \66\ An ISO is excluded from a Rule 605 report as requiring 
special handling if it has a limit price that is inferior to the 
NBBO at the time of order receipt. All other ISOs should be included 
in a Rule 605 report, absent another applicable exclusion. Id. at 
Question 7.06.

    More broadly, are there any approaches to improving the 
transparency of the order routing and order execution practices for 
institutional investors that the Commission should consider? For 
example, do institutional investors currently have sufficient 
information about the smart order routing services and order algorithms 
offered by their brokers? Would a regulatory initiative to improve 
disclosure of these broker services be useful and, if so, what type of 
initiative should the Commission pursue?
2. Other Measures
    The Commission requests comment on any other measures of market 
structure performance that the public believes the Commission should 
consider. For example, are there useful metrics for assessing the 
quality of price discovery in equity markets, such as how efficiently 
prices respond to new information? In addition, what is the best 
approach for assessing whether the secondary markets are appropriately 
supporting the capital-raising function for companies of all sizes?

B. High Frequency Trading

    One of the most significant market structure developments in recent 
years is high frequency trading (``HFT''). The term is relatively new 
and is not yet clearly defined. It typically is used to refer to 
professional traders acting in a proprietary capacity that engage in 
strategies that generate a large number of trades on a daily basis. 
These traders could be organized in a variety of ways, including as a 
proprietary trading firm (which may or may not be a registered broker-
dealer and member of FINRA), as the proprietary trading desk of a 
multi-service broker-dealer, or as a hedge fund (all of which are 
referred to hereinafter collectively as a ``proprietary firm''). Other 
characteristics often attributed to proprietary firms engaged in HFT 
are: (1) The use of extraordinarily high-speed and sophisticated 
computer programs for generating, routing, and executing orders; (2) 
use of co-location services and individual data feeds offered by 
exchanges and others to minimize network and other types of latencies; 
(3) very short time-frames for establishing and liquidating positions; 
(4) the submission of numerous orders that are cancelled shortly after 
submission; and (5) ending the trading day in as close to a flat 
position as possible (that is, not carrying significant, unhedged 
positions over-night). Estimates of HFT volume in the equity markets 
vary widely, though they typically are 50% of total volume or 
higher.\67\ By any measure, HFT is a dominant component of the current 
market structure and is likely to affect nearly all aspects of its 

    \67\ See, e.g., Jonathan Spicer and Herbert Lash, Who's Afraid 
of High-Frequency Trading?, Reuters.com, December 2, 2009 (available 
at http://www.reuters.com/article/idUSN173583920091202) (``High-
frequency trading now accounts for 60 percent of total U.S. equity 
volume, and is spreading overseas and into other markets.''); Scott 
Patterson and Geoffrey Rogow, What's Behind High-Frequency Trading, 
Wall Street Journal, August 1, 2009 (``High frequency trading now 
accounts for more than half of all stock-trading volume in the 

    The Commission today is proposing an initiative to address a 
discrete HFT concern that the Commission already has identified. It 
would address the use of various types of arrangements to obtain the 
fastest possible market access.\68\ This concept release is intended to 
request comment on the full range of concerns with respect to HFT,

[[Page 3607]]

in contrast to the discrete concerns the Commission already has 

    \68\ Market Access Release, supra note 15.

    The lack of a clear definition of HFT, however, complicates the 
Commission's broader review of market structure issues. The lack of 
clarity may, for example, contribute to the widely varying estimates of 
HFT volume in today's equity markets. Although the term itself clearly 
implies a large volume of trades, some concerns that have been raised 
about particular strategies used by proprietary firms may not 
necessarily involve a large number of trades. Indeed, any particular 
proprietary firm may simultaneously be employing many different 
strategies, some of which generate a large number of trades and some 
that do not. Conceivably, some of these strategies may benefit market 
quality and long-term investors and others could be harmful.
    In sum, the types of firms engaged in professional trading and the 
types of strategies they employ can vary considerably. Rather than 
attempt any single, precise definition of HFT, this release will focus 
on particular strategies and tools that may be used by proprietary 
firms and inquire whether these strategies and tools raise concerns 
that the Commission should address.
1. Strategies
    Comment generally is requested on the strategies employed by 
proprietary firms in the current market structure. What are the most 
frequently used strategies? What are the key features of each strategy? 
What technology tools and other market structure components (such as 
exchange fee structures) are necessary to implement each strategy? Have 
any of these strategies been a competitive response to particular 
market structure components or to particular problems or challenges in 
the current market structure? Does implementation of a specific 
strategy benefit or harm market structure performance and the interests 
of long-term investors? Is it possible to reliably identify harmful 
strategies through, for example, such metrics as adding or taking 
liquidity, or trading with (momentum) or against (contrarian) 
prevailing price movements? Are there regulatory tools that would 
address harmful strategies while at the same time have a minimal impact 
on beneficial strategies?
    Do commenters believe that the overall use of harmful strategies by 
proprietary firms is sufficiently widespread that the Commission should 
consider a regulatory initiative to address the problem? What type of 
regulatory initiative would be most effective? For example, should 
there be a minimum requirement on the duration of orders (such as one 
second) before they can be cancelled, whether across the board, in 
particular contexts, or when used by particular types of traders? If 
so, what would be an appropriate time period? Should the use of 
``pinging'' orders by all or some traders to assess undisplayed 
liquidity be prohibited or restricted in all or some contexts? \69\

    \69\ A ``pinging'' order is an immediate-or-cancel order that 
can be used to search for and access all types of undisplayed 
liquidity, including dark pools and undisplayed order types at 
exchanges and ECNs. The trading center that receives an immediate-
or-cancel order will execute the order immediately if it has 
available liquidity at or better than the limit price of the order 
and otherwise will immediately respond to the order with a 
cancellation. As noted in section IV.B.1.d. below, there is an 
important distinction between using tools such as pinging orders as 
part of a normal search for liquidity with which to trade and using 
such tools to detect and trade in front of large trading interest as 
part of an ``order anticipation'' trading strategy.

    The use of certain strategies by some proprietary firms has, in 
many trading centers, largely replaced the role of specialists and 
market makers with affirmative and negative obligations.\70\ Has market 
quality improved or suffered from this development? How important are 
affirmative and negative obligations to market quality in today's 
market structure? Are they more important for any particular equity 
type or during certain periods, such as times of stress? Should some or 
all proprietary firms be subject to affirmative or negative trading 
obligations that are designed to promote market quality and prevent 
harmful conduct? Is there any evidence that proprietary firms increase 
or reduce the amount of liquidity they provide to the market during 
times of stress?

    \70\ Affirmative and negative obligations generally are intended 
to promote market quality. Affirmative obligations might include a 
requirement to consistently display high quality, two-sided 
quotations that help dampen price moves, while negative obligations 
might include a restriction on ``reaching across the market'' to 
execute against displayed quotations and thereby cause price moves.

    As noted above, the Commission wishes to request comment broadly on 
all strategies used by proprietary firms. To help present issues for 
comment, but without limiting the broad request, this release next will 
briefly discuss four broad types of trading strategies that often are 
associated with proprietary firms--passive market making, arbitrage, 
structural, and directional. The discussion of directional strategies 
will focus on two directional strategies that may pose particular 
problems for long-term investors--order anticipation and momentum 
ignition. The Commission notes that many of the trading strategies 
discussed below are not new. What is new is the technology that allows 
proprietary firms to better identify and execute trading strategies.
a. Passive Market Making
    Passive market making primarily involves the submission of non-
marketable resting orders (bids and offers) that provide liquidity to 
the marketplace at specified prices. While the proprietary firm 
engaging in passive market making may sometimes take liquidity if 
necessary to liquidate a position rapidly, the primary sources of 
profits are from earning the spread by buying at the bid and selling at 
the offer and capturing any liquidity rebates offered by trading 
centers to liquidity-supplying orders. If the proprietary firm is 
layering the book with multiple bids and offers at different prices and 
sizes, this strategy can generate an enormous volume of orders and high 
cancellation rates of 90% of more. The orders also may have an 
extremely short duration before they are cancelled if not executed, 
often of a second or less.
    Although proprietary firms that employ passive market making 
strategies are a new type of market participant, the liquidity 
providing function they perform is not new. Professional traders with a 
permanent presence in the marketplace, standing ready to buy and sell 
on an ongoing basis, are a perennial type of participant in financial 
markets. Proprietary firms largely have replaced more traditional types 
of liquidity providers in the equity markets, such as exchange 
specialists on manual trading floors and OTC market makers that trade 
directly with customers. In contrast, proprietary firms generally are 
not given special time and place privileges in exchange trading (nor 
are they subject to the affirmative and negative trading obligations 
that have accompanied such privileges). In addition, proprietary firms 
typically do not trade directly with customer order flow, but rather 
trade by submitting orders to external trading venues such as exchanges 
and ATSs.\71\

    \71\ It is possible for a single firm to provide liquidity in a 
variety of different forms. Some firms, for example, may blur the 
distinction between proprietary firms and OTC market makers by both 
trading actively in external trading centers and operating trading 
centers themselves that offer customers direct electronic access to 
their liquidity.

    Proprietary firms participate in the marketplace in some ways that 
are similar to both exchange specialists and OTC market makers. Indeed, 
a single firm or its affiliates may operate simultaneously in all three 
capacities. For example, proprietary traders are like

[[Page 3608]]

exchange specialists in the sense that they transact most of their 
volume in public markets where their orders will trade with all comers. 
Unlike the traditional floor specialists, however, they do not have 
time and place advantages, except insofar as their sophistication and 
size enables them to employ the fastest, most powerful systems for 
generating, routing, and cancelling orders and thereby most take 
advantage of the current highly automated market structure (including 
such tools as individual trading center data feeds and co-location 
discussed below in section IV.B.2.). Proprietary traders are analogous 
to OTC market makers in that they have considerable flexibility in 
trading without significant negative or affirmative obligations for 
overall market quality. But unlike an OTC market maker, a proprietary 
firm typically does not trade directly with customers. The proprietary 
firm therefore may not have ongoing relationships with customers that 
can pressure the proprietary trader to provide liquidity in tough 
trading conditions or less actively traded stocks.
    Quality of Liquidity. The Commission requests comment on the 
passive market making strategies of proprietary firms. To what extent 
do proprietary firms engage in the types of strategies described above? 
Do they provide valuable liquidity to the market for top-tier, large, 
medium, and small capitalization stocks? Has market quality improved or 
worsened as traditional types of liquidity providers have been replaced 
by proprietary firms? Does the very brief duration of many of their 
orders significantly detract from the quality of liquidity in the 
current market structure? For example, are their orders accurately 
characterized as phantom liquidity that disappears when most needed by 
long-term investors and other market participants? Or, is the 
collective result of many different proprietary firms engaging in 
passive market making a relatively stable quoted market in which there 
are many quotation updates (primarily updates to size of the NBBO), but 
relatively few changes in the price of the NBBO? What types of data are 
most useful in assessing the quality of liquidity provided by 
proprietary firms?
    Liquidity Rebates. One important aspect of passive market making is 
the liquidity rebates offered by many exchanges and ECNs when resting 
orders that add liquidity are accessed by those seeking to trade 
immediately by taking liquidity. The Commission requests comment on the 
volume of high frequency trading geared toward earning liquidity 
rebates and on the benefits or drawbacks of such trading. Are liquidity 
rebates unfair to long-term investors because they necessarily will be 
paid primarily to proprietary firms engaging in passive market making 
strategies? Or do they generally benefit long-term investors by 
promoting narrower spreads and more immediately accessible liquidity? 
Do liquidity rebates reward proprietary firms for any particular types 
of trading that do not benefit long-term investors or market quality? 
For example, are there risk-free trading strategies driven solely by 
the ability to recoup a rebate that offer little or no utility to the 
marketplace? Are these strategies most likely when a trading center 
offers inverted pricing and pays a liquidity rebate that is higher than 
its access fee for taking liquidity? Does the distribution of 
consolidated market data revenues pursuant to the Plans lead to the 
current trading center pricing schedules? If so, would there be any 
benefits to restructuring the Plans and, if so, how?
b. Arbitrage
    An arbitrage strategy seeks to capture pricing inefficiencies 
between related products or markets. For example, the strategy may seek 
to identify discrepancies between the price of an ETF and the 
underlying basket of stocks and buy (sell) the ETF and simultaneously 
sell (buy) the underlying basket to capture the price difference. Many 
of the trades necessary to execute an arbitrage strategy are likely to 
involve taking liquidity, in contrast to the passive market making 
strategy that primarily involves providing liquidity. In this respect, 
it is quite possible for a proprietary firm using an arbitrage strategy 
to trade with a proprietary firm using a passive market making 
strategy, and for both firms to end up profiting from the trade. 
Arbitrage strategies also generally will involve positions that are 
substantially hedged across different products or markets, though the 
hedged positions may last for several days or more.
    The Commission requests comment on arbitrage strategies and whether 
they benefit or harm the interests of long-term investors and market 
quality in general. To what extent do proprietary firms engage in the 
types of strategies described above? For example, what is the volume of 
trading attributable to arbitrage involving ETFs (both in the ETF 
itself and in any underlying securities) and has the increasing 
popularity of ETFs in recent years significantly affected volume and 
trading patterns in the equity markets? If so, has the impact of ETF 
trading been positive or negative for long-term investors and overall 
market quality?
    In addition, to what extent are arbitrage strategies focused on 
capturing pricing differences among the many different trading centers 
in NMS stocks? For example, do these arbitrage strategies significantly 
depend on latencies among trading center data feeds and the 
consolidated market data feeds? Are these strategies beneficial for 
long-term investors and market structure quality? If not, how should 
such strategies be addressed?
c. Structural
    Some proprietary firm strategies may exploit structural 
vulnerabilities in the market or in certain market participants. For 
example, by obtaining the fastest delivery of market data through co-
location arrangements and individual trading center data feeds 
(discussed below in section IV.B.2.), proprietary firms theoretically 
could profit by identifying market participants who are offering 
executions at stale prices. In addition, some market participants offer 
guarantee match features to guarantee the NBBO up to a certain limit. A 
proprietary firm could enter a small limit order in one part of the 
market to set up a new NBBO, after which the same proprietary firm 
triggers guaranteed match trades in the opposite direction.\72\ Are 
proprietary firms able to profitably exploit these structural 
vulnerabilities? To what extent do proprietary firms engage in the 
types of strategies described above? What is the effect of this trading 
on market quality?

    \72\ The Commission has found that similar conduct is 
manipulative, in violation of Section 10(b) of the Exchange Act and 
Rule 10b-5 thereunder. See Terrance Yoshikawa, Securities Exchange 
Act Release No. 53731 (April 26, 2006) (Commission opinion affirming 
NASD disciplinary action).

d. Directional
    Neither passive market making nor arbitrage strategies generally 
involve a proprietary firm taking a significant, unhedged position 
based on an anticipation of an intra-day price movement of a particular 
direction. There may, however, be a wide variety of short-term 
strategies that anticipate such a movement in prices. Some 
``directional'' strategies may be as straightforward as concluding that 
a stock price temporarily has moved away from its ``fundamental value'' 
and establishing a position in anticipation that the price will return 
to such value. These speculative strategies often may contribute to the 
quality of price discovery in a stock.\73\

    \73\ See, e.g., Sanford Grossman & Joseph Stiglitz, On the 
Impossibility of Informationally Efficient Markets, American 
Economic Review (June 1980) (``We propose here a model in which 
there is an equilibrium degree of disequilibrium: prices reflect the 
information of informed individuals (arbitrageurs) but only 
partially, so that those who expend resources do receive 
compensation. How informed the price system is depends on the number 
of individuals who are informed, but the number of individuals who 
are informed is itself an endogenous variable in the model.'').


[[Page 3609]]

    The Commission requests comment on two types of directional 
strategies that may present serious problems in today's market 
structure--order anticipation and momentum ignition.
    Order Anticipation Strategies. One example of an order anticipation 
strategy is when a proprietary firm seeks to ascertain the existence of 
one or more large buyers (sellers) in the market and to buy (sell) 
ahead of the large orders with the goal of capturing a price movement 
in the direction of the large trading interest (a price rise for buyers 
and a price decline for sellers).\74\ After a profitable price 
movement, the proprietary firm then may attempt to sell to (buy from) 
the large buyer (seller) or be the counterparty to the large buyer's 
(seller's) trading. In addition, the proprietary firm may view the 
trading interest of the large buyer (seller) as a free option to trade 
against if the price moves contrary to the proprietary firm's position.

    \74\ See Larry Harris, Trading and Exchanges: Market 
Microstructure for Practitioners (2003) at 222, 245 (``Harris 
Treatise'') (``Order anticipators are speculators who try to profit 
by trading before others trade. They make money when they correctly 
anticipate how other traders will affect prices or when they can 
extract option values from the orders that other traders offer to 
the market.'') (emphasis in original).

    Of course, any proprietary firm or other person that violates a 
duty to a large buyer or seller or misappropriates their order 
information and then uses the information for its own trading to the 
detriment of the large buyer and seller has engaged in misconduct that 
already is prohibited, such as forms of front running. Regulatory 
authorities currently examine for, investigate, and prosecute this type 
of misconduct and will continue to do so. The Commission requests 
comment on any regulatory change that would limit the potential for 
proprietary firms to profit from misconduct with respect to the trading 
activities of large buyers and sellers.
    The type of order anticipation strategy referred to in this release 
involves any means to ascertain the existence of a large buyer (seller) 
that does not involve violation of a duty, misappropriation of 
information, or other misconduct. Examples include the employment of 
sophisticated pattern recognition software to ascertain from publicly 
available information the existence of a large buyer (seller), or the 
sophisticated use of orders to ``ping'' different market centers in an 
attempt to locate and trade in front of large buyers and sellers.
    It is important to recognize the distinction between order 
anticipation and a normal search for liquidity to implement a trading 
strategy. When a proprietary firm employs an order anticipation 
strategy and detects a large buyer (seller), it will first attempt to 
buy (sell), and the proprietary firm largely will be indifferent to 
whether the party is a buyer or a seller. In contrast, long-term 
investors searching for liquidity to trade against will be seeking 
specifically either to establish a position or to liquidate a position. 
If buying, the long-term investor will attempt to find large selling 
interest and buy from it or, if selling, will attempt to find large 
buying interest and sell to it. Both the long-term investor and the 
large buyer (seller) benefit from the liquidity seeking strategy, in 
contrast to the order anticipation strategy where the large buyer 
(seller) is harmed when the proprietary firm initially trades in front 
of the large buyer (seller).
    Order anticipation is a not a new strategy. Indeed, a 2003 treatise 
on market structure described order anticipation as follows: ``Order 
anticipators are parasitic traders. They profit only when they can prey 
on other traders. They do not make prices more informative, and they do 
not make markets more liquid. * * * Large traders are especially 
vulnerable to order anticipators.''\75\ An important issue for purposes 
of this release is whether the current market structure and the 
availability of sophisticated, high-speed trading tools enable 
proprietary firms to engage in order anticipation strategies on a 
greater scale than in the past. Alternatively, is it possible that the 
widespread use of high-speed trading tools by a variety of proprietary 
firms and institutions limits the ability of market participants to 
engage in profitable order anticipation strategies? Does your answer 
depend on whether top tier, large, medium, or small market 
capitalization stocks are considered?

    \75\ Harris Treatise at 251 (emphasis in original).

    The Commission requests comment on all aspects of order 
anticipation strategies. Do commenters believe that order anticipation 
significantly detracts from market quality and harms institutional 
investors (for example, does it represent a substantial transfer of 
wealth from the individuals represented by institutional investors to 
proprietary firms)? Do commenters believe that order anticipation has 
become more or less prevalent in recent years? If more prevalent, is 
the use of proprietary firm strategies an important factor in this 
development? If commenters believe order anticipation has become more 
prevalent, are there ways to distinguish order anticipation from other 
beneficial trading strategies? Are there regulatory tools that would 
effectively address concerns about order anticipation, without 
unintentionally interfering with other strategies that may be 
beneficial for long-term investors and market quality?
    Momentum Ignition Strategies. Another type of directional strategy 
that may raise concerns in the current market structure is momentum 
ignition. With this strategy, the proprietary firm may initiate a 
series of orders and trades (along with perhaps spreading false rumors 
in the marketplace) in an attempt to ignite a rapid price move either 
up or down. For example, the trader may intend that the rapid 
submission and cancellation of many orders, along with the execution of 
some trades, will ``spoof'' the algorithms of other traders into action 
and cause them to buy (sell) more aggressively. Or the trader may 
intend to trigger standing stop loss orders that would help cause a 
price decline. By establishing a position early, the proprietary firm 
will attempt to profit by subsequently liquidating the position if 
successful in igniting a price movement. This type of strategy may be 
most harmful in less actively traded stocks, which may receive little 
analyst or other public attention and be vulnerable to price movements 
sparked by a relatively small amount of volume.
    Of course, any market participant that manipulates the market has 
engaged in misconduct that already is prohibited. The Commission and 
other regulatory authorities already employ their examination and 
enforcement resources to detect violations and bring appropriate 
proceedings against the perpetrators. This concept release is focused 
on the issue of whether additional regulatory tools are needed to 
address illegal practices, as well as any other practices associated 
with momentum ignition strategies. For example, while spreading false 
rumors to cause price moves is illegal, such rumors can be hard to find 
(if not spread in writing), and it can be difficult to ascertain the 
identity of those who spread rumors to cause price moves.
    The Commission requests comment on whether momentum ignition 
strategies are a significant problem in the current market structure. 
To what extent do proprietary firms engage in the types of strategies 
described above?

[[Page 3610]]

Does, for example, the speed of trading and ability to generate a large 
amount of orders across multiple trading centers render this type of 
strategy more of a problem today? If momentum ignition strategies have 
caused harm, are there objective indicia that would reliably identify 
problematic strategies? Are there regulatory tools (beyond the 
currently applicable anti-fraud and anti-manipulation provisions) that 
would effectively reduce or eliminate the use of momentum ignition 
strategies while at the same time have a minimal impact on other 
strategies that are beneficial to long-term investors and market 
2. Tools
    This section will focus on two important tools that often are used 
by proprietary firms to implement their short-term trading strategies--
co-location and trading center data feeds.
a. Co-Location
    Many proprietary firm strategies are highly dependent upon speed--
speed of market data delivery from trading center servers to servers of 
the proprietary firm; speed of decision processing of trading engines 
of the proprietary firm; speed of access to trading center servers by 
servers of the proprietary firm; and speed of order execution and 
response by trading centers. Speed matters both in the absolute sense 
of achieving very small latencies and in the relative sense of being 
faster than competitors, even if only by a microsecond. Co-location is 
one means to save micro-seconds of latency.
    Co-location is a service offered by trading centers that operate 
their own data centers and by third parties that host the matching 
engines of trading centers. The trading center or third party rents 
rack space to market participants that enables them to place their 
servers in close physical proximity to a trading center's matching 
engine. Co-location helps minimize network and other types of latencies 
between the matching engine of trading centers and the servers of 
market participants.
    The Commission believes that the co-location services offered by 
registered exchanges are subject to the Exchange Act. Exchanges that 
intend to offer co-location services must file proposed rule changes 
and receive approval of such rule changes in advance of offering the 
services to customers.\76\ The terms of co-location services must not 
be unfairly discriminatory, and the fees must be equitably allocated 
and reasonable.\77\

    \76\ Section 3(a)(27) of the Exchange Act defines ``rules of an 
exchange'' as, among other things, a stated policy, practice, or 
interpretation of the exchange that the Commission has by rule 
determined to be rules of the exchange. Rule 19b-4(b) under the 
Exchange Act defines ``stated policy, practice, or interpretation'' 
to mean, in part, [a]ny material aspect of the operation of the 
facilities of the self-regulatory organization.'' The Commission 
views co-location services as being a material aspect of the 
operation of the facilities of an exchange.
    \77\ Section 6(b)(4) and (5) of the Exchange Act.

    Fairness of Co-Location Services. Beyond these basic statutory 
requirements, the Commission broadly requests comment on co-location 
and whether it benefits or harms long-term investors and market 
quality. For example, does co-location provide proprietary firms an 
unfair advantage because they generally will have greater resources and 
sophistication to take advantage of co-location services than other 
market participants, including long-term investors? If so, specify how 
this disparity harms long-term investors. Conversely, does co-location 
offer benefits to long-term investors? For example, do co-location 
services enable liquidity providers to operate more efficiently and 
thereby increase the quality of liquidity they provide to the markets? 
Please quantify any harm or benefits, if possible. Is it fair for some 
market participants to pay to obtain better access to the markets than 
is available to those not in a position to pay for or otherwise obtain 
co-location services? Aside from physical proximity, are there other 
aspects of services offered by exchanges to co-location participants 
that may lead to unfair access concerns?
    In addition, are brokers generally able to obtain and use co-
location services on behalf of their customers? If so, are long-term 
investors harmed by not being able to use co-location directly? Are co-
location fees so high that they effectively create a barrier for 
smaller firms? Do commenters believe that co-location services 
fundamentally differ from other respects in which market participants 
can obtain latency advantages, particularly if co-location services are 
not in short supply and are available to anyone on terms that are fair 
and reasonable and not unreasonably discriminatory?
    If commenters believe that co-location services create unfair 
access to trading, should the Commission prohibit or restrict 
exchanges, and other trading centers, such as ATSs, from offering co-
location services? If exchanges and other trading centers were no 
longer permitted to provide the services, would third parties, who may 
be outside the Commission's regulatory authority, be encouraged to 
obtain space close to an exchange's data center and rent such space to 
market participants? Alternatively, could exchanges and other trading 
centers batch process all orders each second and, if so, what would be 
the effect of such a policy on market quality?
    The Commission also requests comment on exchanges and other trading 
centers that place their trading engines in data facilities operated by 
third parties. Such parties are not regulated entities subject to the 
access and other requirements of the Exchange Act and Commission rules. 
Could this disparity create competitive disadvantages among trading 
centers? Should the third party data centers be considered facilities 
of the exchange or trading center? Alternatively, should the Commission 
require trading centers to obtain contractual commitments from third 
parties to provide any co-location services on terms consistent with 
the Exchange Act and Commission rules?
    With respect to those market participants that purchase co-location 
services, should exchanges and other trading centers be subject to 
specific requirements to help assure that all participants are treated 
in a manner that is not unfairly discriminatory? Latency can arise from 
a variety of sources, such as cable length and capacity, processing 
capabilities, and queuing. Is it possible for trading centers to 
guarantee equal latency across all market participants that use 
comparable co-location services? Should the Commission require latency 
transparency--the disclosure of information that would enable market 
participants to make informed decisions about their speed of access to 
an exchange or other trading center? Such disclosures could include, 
for example, periodic public reports on the latencies of the fastest 
market participants (on an anonymous basis), as well as private reports 
directly to individual market participants of their specific latencies. 
If latency disclosure should be required, what information should be 
disclosed and in what manner?
    Affirmative or Negative Trading Obligations. Finally, the 
Commission requests comment on whether all or some market participants 
(such as proprietary firms) that obtain co-location services should be 
subject to any affirmative or negative obligations with respect to 
their trading behavior. Such obligations historically were applied to 
exchange specialists that enjoyed a unique time and place advantage on 
the floor of an exchange. Are co-location services analogous to the 
specialist advantages? Or does the wider availability of co-location 
services to many market participants distinguish co-located market 
participants from

[[Page 3611]]

exchange specialists? If all or some co-location participants should be 
subject to trading obligations, what should be the nature of such 
obligations? For example, should some or all co-location participants 
be prohibited from aggressively taking liquidity and moving prices 
always or only under specified circumstances? If only under specified 
circumstances, what should those include or exclude? Should some or all 
co-location participants ever be required to provide liquidity on an 
ongoing basis or in certain contexts?
b. Trading Center Data Feeds
    Another important tool widely used by proprietary firms is the 
individual data feeds offered by many exchanges and ECNs. As discussed 
in section III.B.1. above, the consolidated data feeds include the 
best-priced quotations of all exchanges and certain ATSs and all 
reported trades. The individual data feeds of exchanges and ECNs 
generally will include their own best-priced quotations and trades, as 
well as other information, such as inferior-priced orders included in 
their depth-of-book. When it adopted Regulation NMS in 2005, the 
Commission did not require exchanges, ATSs, and other broker-dealers to 
delay their individual data feeds to synchronize with the distribution 
of consolidated data, but prohibited them from independently 
transmitting their own data any sooner than they transmitted the data 
to the plan processors.\78\

    \78\ Regulation NMS Release, 70 FR at 37567.

    Given the extra step required for SROs to transmit market data to 
plan processors, and for plan processors to consolidate the information 
and distribute it the public, the information in the individual data 
feeds of exchanges and ECNs generally reaches market participants 
faster than the same information in the consolidated data feeds. The 
extent of the latency depends, among other things, on the speed of the 
systems used by the plan processors to transmit and process 
consolidated data and on the distances between the trading centers, the 
plan processors, and the recipients. As noted above,\79\ the Commission 
understands that the average latency of plan processors for the 
consolidated data feeds generally is less than 10 milliseconds. This 
latency captures the difference in time between receipt of data by the 
plan processors from the SROs and distribution of the data by the plan 
processors to the public.

    \79\ See supra note 45 and accompanying text.

    Latency of Consolidated Data. The Commission requests comment on 
all aspects of the latency between consolidated data feeds and 
individual trading center data feeds. What have market participants 
experienced in terms of the degree of latency between trading center 
and consolidated data? Is the latency as small as possible given the 
necessity of the consolidation function, or could plan processor 
systems be improved to significantly reduce the latency from current 
levels, while still retaining the high level of reliability required of 
plan processors?
    More broadly, is the existence of any latency, or the disparity in 
information transmitted, fair to investors or other market participants 
that rely on the consolidated market data feeds and do not use 
individual trading center data feeds? If so, should the unfairness be 
addressed by a requirement that trading center data be delayed for a 
sufficient period of time to assure that consolidated data reaches 
users first? Would such a mandated delay adequately address unfairness? 
Would a mandatory delay seriously detract from the efficiency of 
trading and harm long-term investors and market quality? Should the 
Commission require that additional information be included in the 
consolidated market data feeds?
    Odd-Lot Transactions. Finally, the consolidated trade data 
currently does not include reports of odd lot orders or odd lot 
transactions (transactions with sizes of less than 1 round lot, which 
generally is 100 shares). It appears that a substantial volume of 
trading (approximately 4%) may be attributable to odd lot transactions. 
Why is the volume of odd lots so high? Should the Commission be 
concerned about this level of activity not appearing in the 
consolidated trade data? Has there been an increase in the volume of 
odd lots recently? If so, why? Do market participants have incentives 
to strategically trade in odd lots to circumvent the trade disclosure 
or other regulatory requirements? Would these trades be important for 
price discovery if they were included in the consolidated trade data? 
Should these transactions be required to be reported in the 
consolidated trade data? Why?
3. Systemic Risks
    Stepping back from the particular strategies and tools used by 
proprietary traders, comment is requested more broadly on whether HFT 
poses significant risks to the integrity of the current equity market 
structure. For example, do the high speed and enormous message traffic 
of automated trading systems threaten the integrity of trading center 
operations? Also, many proprietary firms potentially could engage in 
similar or connected trading strategies that, if such strategies 
generated significant losses at the same time, could cause many 
proprietary firms to become financially distressed and lead to large 
fluctuations in market prices. To the extent that proprietary firms 
obtain financing for their trading activity from broker-dealers or 
other types of financial institutions, the significant losses of many 
proprietary firms at the same time also could lead to more widespread 
financial distress.\80\

    \80\ A broker-dealer conducting a general securities business 
that is required to register with the Commission under Section 15(b) 
of the Exchange Act must comply with the Commission's net capital 
rule, Exchange Act Rule 15c3-1. Under Rule 15c3-1, broker-dealers 
are required to maintain, at all times, a minimum amount of net 
capital. This means that firms must be able to demonstrate that they 
have sufficient net capital for intra-day positions. In addition, if 
a broker-dealer is engaged in proprietary trading on margin, it may 
be subject to certain provisions of Regulation T, 12 CFR 220.1, et 
seq., as well as SRO margin rules applicable to broker-dealers. See, 
e.g., NYSE Rule 431(e)(5) (specialists' and market makers' 
accounts), (e)(6)(A) (broker/dealer accounts), (e)(6)(B) (Joint Back 
Office Arrangements) and NASD Rule 2520(e)(5), (e)(6)(A) and 
(e)(6)(B). Moreover, high frequency traders who are not broker-
dealers must comply with the SRO day trading rules if they meet the 
definition of ``pattern day trader.'' NYSE Rule 431(f)(8)(B) and 
NASD Rule 2520(f)(8)(B).

    Comment also is requested on whether proprietary traders help 
promote market integrity by providing an important source of liquidity 
in difficult trading conditions. The Commission notes that, from an 
operational standpoint, the equity markets performed well during the 
world-wide financial crisis in the Autumn of 2008 when volume and 
volatility spiked to record highs.\81\ Unlike some financial crises in 
the past, the equity markets continued to operate smoothly and 
participants generally were able to trade at currently displayed prices 
(though most investors likely suffered significant losses from the 
general decline of market prices). Does

[[Page 3612]]

the 2008 experience indicate that systemic risk is appropriately 
minimized in the current market structure? If not, what further steps 
should the Commission take to address systemic risk? Should, for 
example, all proprietary firms be required to register as broker-
dealers and become members of FINRA to help assure that their 
operations are subject to full regulatory oversight? Moreover, does the 
current regulatory regime adequately address the particular concerns 
raised by proprietary firms and their trading strategies and tools?

    \81\ See, e.g., NYSE Euronext, Consolidated Volume in NYSE 
Listed Issues 2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx) (consolidated 
average daily volume in NYSE-listed stocks reached a then-record 
high of 7.1 billion shares in October 2008, compared to an average 
of 3.4 billion shares for the year 2007); Pam Abramowitz, Technology 
Drives Trading Costs, Institutional Investor (November 4, 2009) 
(``[V]olatility has fallen substantially over the past six to nine 
months as equity markets have rallied. * * * [The] VIX, which hit an 
all-time high of 89.53 in October 2008, averaged 25.49 in the third 
quarter of 2009, close to its precrisis historical average of 
20.3''); Tom Lauricella, Volatility Requires New Strategies, Wall 
Street Journal (October 20, 2008) (``The stock market's collapse and 
unprecedented daily price swings are forcing investors of all 
stripes to rethink their strategies, all the while looking for any 
hints that the financial markets will stabilize. * * * So far this 
month, there have been 10 days where the Dow Jones Industrial 
Average ricocheted in a range of more than 5% * * *'').

C. Undisplayed Liquidity

    As noted in section III.A. above, undisplayed liquidity is trading 
interest that is available for execution at a trading center, but is 
not included in the consolidated quotation data that is widely 
disseminated to the public. Undisplayed liquidity also is commonly 
known as ``dark'' liquidity. The Commission recently published 
proposals to address certain practices with respect to undisplayed 
liquidity. These include the use of actionable indications of interest, 
or ``IOIs,'' to attract order flow, the lowering of the trading volume 
threshold that would trigger ATS order display obligations, and the 
real-time disclosure of the identity of ATSs on the public reports of 
their executed trades.\82\ This release is intended to request comment 
on a wide range of issues with respect to undisplayed liquidity in all 
of its forms.

    \82\ See Non-Public Trading Interest Release, 74 FR at 61209-

    Undisplayed liquidity in general is not a new phenomenon. Market 
participants that need to trade in large size, such as institutional 
investors, always have faced a difficult trading dilemma. On the one 
hand, if they prematurely reveal the full extent of their large trading 
interest to the market, then market prices are likely to run away from 
them (a price rise for those seeking to buy and a price decline for 
those seeking to sell), which would greatly increase their transaction 
costs and reduce their overall investment returns. On the other hand, 
if an institutional investor that wants to trade in large size does 
nothing, then it will not trade at all. Finding effective and 
innovative ways to trade in large size with minimized transaction costs 
is a perennial challenge for institutional investors, the brokers that 
represent their orders in the marketplace, and the trading centers that 
seek to execute their orders.
    A primary source of dark liquidity for many years was found on the 
manual trading floors of exchanges. The floor brokers ``worked'' the 
large orders of their customers by executing such orders in a number of 
smaller transactions without revealing to potential counterparties the 
total size of the order. One consequence of the decline in market share 
of the NYSE floor in recent years is that this historically large 
undisplayed liquidity pool in NYSE-listed stocks appears to have 
largely migrated to other types of venues. As discussed in section 
III.A.3. above, a recent form of undisplayed liquidity is the dark 
pool--an ATS that does not display quotations in the consolidated 
quotation data. Other sources of undisplayed liquidity are broker-
dealers that internalize orders \83\ and undisplayed order types of 
exchanges and ECNs.

    \83\ As noted in section III.A.2. above, many broker-dealers may 
submit orders to exchanges or ECNs, which then are included in the 
consolidated quotation data. The internalized executions of broker-
dealers, however, primarily reflect liquidity that is not included 
in the consolidated quotation data and are appropriately classified 
as undisplayed liquidity.

    Although they offer liquidity that is not included in the 
consolidated quotation data, dark pools and OTC market makers generally 
trade with reference to the best displayed quotations and execute 
orders at prices that are equal to or better than the NBBO. Indeed, all 
dark pools and OTC market makers are covered by the trade-through 
restrictions of Rule 611 and, subject to limited exceptions, cannot 
execute transactions at prices that are inferior to the best displayed 
    The Commission requests comment on all forms of undisplayed 
liquidity in the current market structure. It particularly wants to 
present three issues for comment--the effect of undisplayed liquidity 
on order execution quality, the effect of undisplayed liquidity on 
public price discovery, and fair access to sources of undisplayed 
1. Order Execution Quality
    It appears that a significant percentage of the orders of 
individual investors are executed at OTC market makers, and that a 
significant percentage of the orders of institutional investors are 
executed in dark pools. Comment is requested on the order execution 
quality provided to these long-term investors. Given the strong 
Exchange Act policy preference in favor of price transparency and 
displayed markets, do dark pools and OTC market makers offer 
substantial advantages in order execution quality to long-term 
investors? If so, do these advantages justify the diversion of a large 
percentage of investor order flow away from the displayed markets that 
play a more prominent role in providing public price discovery? If 
investors were limited in their ability to use undisplayed liquidity, 
how would trading behavior change, if at all? What types of activity 
might evolve to replace undisplayed liquidity if its use were 
    Individual Investors. Liquidity providers generally consider the 
orders of individual investors very attractive to trade with because 
such investors are presumed on average to not be as informed about 
short-term price movements as are professional traders. Do individual 
investor orders receive high quality executions when routed to OTC 
market makers? For example, does competition among OTC market makers to 
attract order flow lead to significantly better prices for individual 
investor orders than they could obtain in the public markets? Do OTC 
market makers charge access fees comparable to those charged by public 
markets? Does the existence of payment for order flow arrangements 
between routing brokers and OTC market makers (and internalization 
arrangements when the routing broker and OTC market maker are 
affiliated) detract from the quality of executions for investor orders? 
If more individual investor orders were routed to public markets, would 
it promote quote competition in the public markets, lead to narrower 
spreads, and ultimately improve order execution quality for individual 
investors beyond current levels? Finally, are a significant number of 
individual investor orders executed in dark pools and, if so, what is 
the execution quality for these orders?
    Institutional Investors. An important objective of many dark pools 
is to offer institutional investors an efficient venue in which to 
trade in large size (often by splitting a large parent order into many 
child orders) with minimized market impact. To what extent do dark 
pools meet this objective of improving execution quality for the large 
orders of institutional investors? Does execution quality vary across 
different types of dark pools and, if so, which types? If so, does this 
difference depend on the characteristics of particular securities (such 
as market capitalization and security price)?
    As noted above in section IV.C., many dark pools execute orders 
with reference to the displayed prices in public markets. Does this 
reference pricing create opportunities for institutional investors to 
be treated unfairly by improper behavior (such as placing a small order 
to change the NBBO for a

[[Page 3613]]

very short period and quickly submitting orders to dark pools for 
execution at prices affected by the new NBBO)? \84\ If so, to what 
extent does gaming occur? Do all types of dark pools employ anti-gaming 
tools? How effective are such tools?

    \84\ The Commission has found that similar conduct is 
manipulative. See supra note 72.

    Finally, are institutional investors able to trade more efficiently 
using undisplayed liquidity at dark pools and broker-dealers than they 
are using the undisplayed liquidity at exchanges and ECNs? What are the 
advantages and disadvantages of each form of undisplayed liquidity? If 
the use of undisplayed liquidity at dark pools and broker-dealers were 
curtailed in any way, could institutional investors adjust by using 
undisplayed liquidity on exchanges and ECNs without incurring higher 
transaction costs?
2. Public Price Discovery
    Comment is requested on whether the trading volume of undisplayed 
liquidity has reached a sufficiently significant level that it has 
detracted from the quality of public price discovery and execution 
quality. For example, has the level of undisplayed liquidity led to 
increased spreads, reduced depth, or increased short-term volatility in 
the displayed trading centers? If so, has such harm to public price 
discovery led to a general worsening of execution quality for investors 
in undisplayed markets that execute trades with reference to prices in 
the displayed markets?
    It appears that a significant percentage of the orders of long-term 
investors are executed either in dark pools or at OTC market makers, 
while a large percentage of the trading volume in displayed trading 
centers is attributable to proprietary firms executing short-term 
trading strategies. Has there in fact been an increase in the 
proportion of long-term investor orders executed in undisplayed trading 
centers? If so, what is the reason for this tendency and is the 
practice beneficial or harmful to long-term investors and to market 
quality? With respect to undisplayed order types on exchanges and ECNs, 
do commenters believe that these order types raise similar concerns 
about public price discovery as undisplayed liquidity at dark pools and 
    If commenters do not believe the current level of undisplayed 
liquidity has detracted from the quality of public price discovery, is 
there any level at which they believe the Commission should be 
concerned? In this regard, it appears that the overall percentage of 
trading volume between undisplayed trading centers and displayed 
trading centers has remained fairly steady for many years between 70% 
and 80%.\85\ Does this overall percentage accurately reflect the effect 
of undisplayed liquidity on public price discovery or does it mask 
potentially important changes in the routing of underlying types of 
order flow? For example, the NYSE captures a smaller percentage of 
trading in NYSE-listed stocks, while the overall volume in NYSE stocks 
has increased dramatically.\86\ Should this change in market share be 
interpreted to mean that a greater percentage of long-term individual 
investor and long-term institutional investor order flow in NYSE-listed 
stocks has shifted to dark pools and OTC market makers, while the 
public markets are executing an expanding volume of trading that is 
primarily attributable to HFT strategies? If so, does this underlying 
shift in order flow affect the quality of public price discovery in 
NYSE-listed stocks and what are the reasons for this development? Do 
similar order flow patterns affect the quality of public price 
discovery in stocks listed on other exchanges as well?

    \85\ See supra note 21 and accompanying text (estimated 25.4% of 
share volume in NMS stocks executed in undisplayed trading centers 
in September 2009).
    \86\ See supra notes 8 and 10 and accompanying text.

    Trade-At Rule. If commenters believe that the quality of public 
price discovery has been harmed by undisplayed liquidity, are there 
regulatory tools that the Commission should consider to address the 
problem? Should the Commission consider a ``trade-at'' rule that would 
prohibit any trading center from executing a trade at the price of the 
NBBO unless the trading center was displaying that price at the time it 
received the incoming contra-side order? Under this type of rule, for 
example, a trading center that was not displaying the NBBO at the time 
it received an incoming marketable order could either: (1) Execute the 
order with significant price improvement (such as the minimum allowable 
quoting increment (generally one cent)); or (2) route ISOs to full 
displayed size of NBBO quotations and then execute the balance of the 
order at the NBBO price.
    The Commission requests comment on all aspects of a trade-at rule. 
Would it help promote pre-trade public price discovery by preventing 
the diversion of a significant volume of highly valuable marketable 
order flow away from the displayed trading centers and to undisplayed 
trading centers? If so, to what extent would the increased routing of 
this marketable order flow to displayed trading centers create 
significantly greater incentives for market participants to display 
quotations in greater size or with more aggressive prices?
    Given the order-routing and trading system technologies currently 
in place to prevent trade-throughs, would it be feasible for market 
participants to comply with a trade-at rule at reasonable cost? Should 
a trade-at rule apply to all types of trading centers (e.g., exchanges, 
ECNs, OTC market makers, and dark pools) or only to some of them? If 
so, which ones and why? In addition, if the Commission were to consider 
such a rule, how should it treat the issue of displayed markets that 
charge access fees? Should it, for example, condition the ``trade-at'' 
protection of a displayed quotation on there being no access fee or an 
access fee that is much smaller than the current 0.3 cent per share cap 
in Rule 610(c) of Regulation NMS?
    Depth-of-Book Protection. Rule 611 currently provides trade-through 
protection only to quotations that reflect the best, ``top-of-book,'' 
prices of a trading center.\87\ Should Rule 611 be expanded to provide 
trade-through protection to the displayed ``depth-of-book'' quotations 
of a trading center? Would depth-of-book protection significantly 
promote the greater display of trading interest? Is depth-of-book 
protection feasible under current trading conditions and could the 
securities industry implement depth-of-book protection at reasonable 

    \87\ See Regulation NMS Release, 70 FR at 37529-37530 
(discussion of decision not to adopt a ``Voluntary Depth 
Alternative'' that would have provided trade-through protection to 
depth-of-book quotations that a market voluntarily included in the 
consolidated quotation data).

    Low-Priced Stocks. There may be greater incentives for broker-
dealer internalization in low-priced stocks than in higher priced 
stocks. In low-priced stocks, the minimum one cent per share pricing 
increment of Rule 612 of Regulation NMS is much larger on a percentage 
basis than it is in higher-priced stocks. For example, a one cent 
spread in a $20 stock is 5 basis points, while a one cent spread in a 
$2 stock is 50 basis points--10 times as wide on a percentage basis. 
Does the larger percentage spread in low-price stocks lead to greater 
internalization by OTC market makers or more trading volume in dark 
pools? If so, why? Should the Commission consider reducing the minimum 
pricing increment in Rule 612 for lower priced stocks?

[[Page 3614]]

3. Fair Access and Regulation of ATSs
    A significant difference between the undisplayed liquidity offered 
by exchanges and the undisplayed liquidity offered by dark pools and 
broker-dealers is the extent of access they allow to such liquidity. As 
noted in section III.B.3. above, registered exchanges are required to 
offer broad access to broker-dealers. As ATSs that are exempt from 
exchange registration, dark pools are not required to provide fair 
access unless they reach a 5% trading volume threshold in a stock, 
which none currently do.\88\ Broker-dealers that internalize also are 
not subject to fair access requirements. As a result, access to the 
undisplayed liquidity of dark pools and broker-dealers is determined 
primarily by private negotiation.

    \88\ The Commission understands that ECNs, unlike most dark 
pools, generally offer wide access to their services, including 
undisplayed liquidity, even if not subject to the fair access 
requirement of Rule 301(b)(5) of Regulation ATS.

    The Commission requests comment on whether trading centers offering 
undisplayed liquidity are subject to appropriate regulatory 
requirements for the type of business they conduct. For example, should 
the trading volume threshold in Regulation ATS that triggers the fair 
access requirement be lowered from its current 5%? If so, what is the 
appropriate threshold?
    If an ATS exceeds the trading volume threshold, Regulation ATS 
requires that the ATS have access standards that do not unreasonably 
prohibit or limit any person in respect to access services, and 
prohibits the ATS from applying such standards in an unfair or 
discriminatory manner. Do commenters believe that all types of dark 
pools can comply with this fair access requirement, yet still achieve 
the objective of enabling institutional investors to trade in large 
size with minimized price impact? Can dark pool restrictions designed 
to prevent predatory trading behavior \89\ be drafted in an objective 
fashion that would comply with the Regulation ATS fair access 

    \89\ See, e.g., section IV.B.1.d. supra (discussion of order 
anticipation strategies that seek to ascertain the existence of 
large buyers and sellers).

    The majority of dark pool volume is executed in ATSs that are 
sponsored by multi-service broker-dealers.\90\ Can a broker-dealer 
sponsored dark pool apply objective fair access standards reasonably to 
prevent predatory trading, but without using such standards as a 
pretext to discriminate based on the competitive self interest of the 
sponsoring broker?

    \90\ Data compiled from Forms ATS submitted to Commission for 3d 
quarter 2009.

    Finally, do investors have sufficient information about dark pools 
to make informed decisions about whether in fact they should seek 
access to dark pools? Should dark pools be required to provide improved 
transparency on their trading services and the nature of their 
participants? If so, what disclosure should be required and in what 
manner should ATSs provide such disclosures?
    More broadly, are there any other aspects of ATS regulation that 
should be enhanced for dark pools or for all ATSs, including ECNs? For 
example, do ATSs contribute appropriately to the costs of consolidated 
market surveillance? Currently, FINRA is the SRO for ATSs, and ATSs 
must pay the applicable FINRA regulatory fees. Do these FINRA fees 
adequately reflect the significant volume currently executed by ATSs? 
Should ATSs be required to contribute more directly to the cost of 
market surveillance? Finally, are there any ways in which Regulation 
ATS should be modified or supplemented to appropriately reflect the 
significant role of ATSs in the current market structure?

D. General Request for Comments

    The Commission requests and encourages all interested persons to 
submit their views on any aspect of the current equity market 
structure. While this release was intended to present particular issues 
for comment, it was not intended in any way to limit the scope of 
comments or issues to be considered. In addition, the views of 
commenters are of greater assistance when they are accompanied by 
supporting data and analysis.

    Dated: January 14, 2010.

    By the Commission.
Elizabeth M. Murphy,
[FR Doc. 2010-1045 Filed 1-20-10; 8:45 am]