==========================================START OF PAGE 1====== SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34-37619A ; File No. S7-30-95] RIN 3235-AG66 Order Execution Obligations AGENCY: Securities and Exchange Commission ACTION: Final Rules SUMMARY: The Securities and Exchange Commission ("Commission") is adopting a new rule requiring the display of customer limit orders and amending a current rule governing publication of quotations to enhance the quality of published quotations for securities and to enhance competition and pricing efficiency in our markets. These rules have been designed to address growing concerns about the handling of customer orders for securities. Specifically, the Commission is adopting new Rule 11Ac1-4 ("Display Rule") under the Securities Exchange Act of 1934 ("Exchange Act") to require the display of customer limit orders priced better than a specialist's or over-the-counter ("OTC") market maker's quote or that add to the size associated with such quote. The Commission also is adopting amendments to Rule 11Ac1-1 ("Quote Rule") under the Exchange Act to require a market maker to publish quotations for any listed security when it is responsible for more than 1% of the aggregate trading volume for that security and to make publicly available any superior prices that a market maker privately quotes through certain electronic communications networks ("ECNs") ("ECN amendment"). Finally, the ==========================================START OF PAGE 2====== Commission is deferring action on proposed Rule 11Ac1-5 ("Price Improvement Rule"). Effective Date: [insert date 120 days from the date of publication in the Federal Register]. For specific phase-in dates for the Display Rule, see section III.A.3.d of this Release. FOR FURTHER INFORMATION CONTACT: Elizabeth Prout Lefler or Gail A. Marshall regarding amendments to the Quote Rule and David Oestreicher regarding the Display Rule at (202) 942-0158, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 5-1, Washington, D.C. 20549. ==========================================START OF PAGE 3====== SUPPLEMENTARY INFORMATION: I. Introduction and Summary On September 29, 1995, the Commission issued a release-[1]- proposing for comment new Rules 11Ac1-4 and 11Ac1-5 and amendments to Rule 11Ac1-1-[2]- under the Exchange Act.-[3]- As proposed, new Rule 11Ac1-4 would require the display of customer limit orders that improve certain OTC market makers' and specialists' quotes or add to the size associated with such quotes. The proposed amendments to the Quote Rule would require OTC market makers and specialists who place priced orders with ECNs to reflect those orders in their published quotes. The proposed Quote Rule amendments also would require OTC market makers and specialists that account for more than 1% of the volume in any listed security to publish their quotations for that security ("Mandatory Quote Rule"). The Price Improvement Rule would have required OTC market makers and specialists to provide their customer market orders an opportunity for price improvement; it also would have included a non-exclusive safe harbor to satisfy the price improvement obligation. The Commission received 152 comment letters (from 145 ---------FOOTNOTES---------- -[1]- Securities Exchange Act Release No. 36310 (September 29, 1995), 60 FR 52792 (October 10, 1995) ("Proposing Release"). -[2]- 17 CFR 240.11Ac1-1. -[3]- 15 U.S.C.  78a to 78ll (1988). ==========================================START OF PAGE 4====== commenters) in response to the Proposing Release.-[4]- Commenters generally supported the Display Rule and the Mandatory Quote Rule, with some commenters suggesting specific modifications or alternatives to the proposed rules. Commenters also supported the objectives of the ECN amendment, but many expressed concerns that diminishing the anonymity of such systems would threaten their viability. Most commenters believed the Price Improvement Rule would be costly to implement and would not be necessary if the other proposals were adopted. After considering the comments and relevant economic research, and based on the Commission's experience with the development of the national market system ("NMS") and its knowledge of current market practices, the Commission is adopting the Display Rule and the proposed amendments to the Quote Rule, with certain modifications. The Commission believes that these modifications are consistent with the proposals and responsive to many of the concerns voiced by the commenters. ---------FOOTNOTES---------- -[4]- The comment letters and a summary of comments have been placed in Public File No. S7-30-95, which is available for inspection in the Commission's Public Reference Room. The Commission received comments on the proposals from 77 individual investors, ten industry associations, seven exchanges and the National Association of Securities Dealers ("NASD"), eight academics, 41 market participants and the United States Department of Justice. In addition, the Commission met with representatives of broker- dealers, self-regulatory organizations ("SROs"), industry associations, and the U.S. Department of Justice to discuss the proposals. The Commission has conducted its own economic analysis of the likely economic effects of the various proposals. ==========================================START OF PAGE 5====== The Display Rule adopted today requires OTC market makers and specialists to display the price and full size of customer limit orders when these orders represent buying and selling interest that is at a better price than a specialist's or OTC market maker's public quote. OTC market makers and specialists also must increase the size of the quote for a particular security to reflect a limit order of greater than de minimis size when the limit order is priced equal to the specialist's or OTC market maker's disseminated quote and that quote is equal to the national best bid or offer. The Commission has modified the proposed Display Rule in some respects in response to comments. The proposal included an exception to permit a specialist or OTC market maker to deliver a limit order to an exchange or registered national securities association ("association") sponsored system that complies with the Display Rule. This exception has been expanded to permit delivery to ECNs that display and provide access to these orders. Additionally, with regard to implementation of the rule, the Commission has provided for a phase-in over a one year period for non-exchange-traded securities covered by the Display Rule. Today, the Commission also is adopting two significant amendments to the Quote Rule. These amendments are designed to ensure that more comprehensive quotation information is made available to the public. The first amendment requires a specialist or OTC market maker to make publicly available the price of any order it places in an ECN if the ECN price is better ==========================================START OF PAGE 6====== than the specialist's or OTC market maker's public quotation. The Commission has adopted this amendment as proposed, with an alternative ("ECN display alternative") that deems OTC market makers and specialists in compliance with the Quote Rule if prices these OTC market makers and specialists enter into an ECN are publicly disseminated and the ECN provides access to other broker-dealers to trade at those prices.-[5]- Thus, OTC market makers and specialists may comply directly with the ECN amendment by changing their public quote to reflect their ECN order, or by using an ECN that facilitates their compliance with the rule as described above. Implementation of the ECN display alternative requires the cooperation of the SROs in order to include the ECN prices in the public quotation system and to provide equivalent access to these quotations. The Commission expects the SROs to work expeditiously with ECNs that wish to avail themselves of this alternative to develop rules or understandings of general applicability. The Commission is prepared to act if necessary to ensure implementation of the ECN display alternative prior to the effective date of the Quote Rule. The second amendment to the Quote Rule expands the categories of securities covered by the Mandatory Quote Rule. As amended, the Quote Rule will require that OTC market makers and specialists publish quotes in any listed security if their volume ---------FOOTNOTES---------- -[5]- This alternative means of compliance with the ECN amendment is referred to hereinafter as the "ECN display alternative". ==========================================START OF PAGE 7====== in that security exceeds 1% of the aggregate volume during the most recent calendar quarter. Previously, these requirements applied only to certain listed securities.-[6]- The Commission is deferring final action on the Price Improvement Rule at this time. The Commission will consider the effect of the new Display Rule and the amendments to the Quote Rule adopted today before determining the appropriate course of action on that proposal. In a parallel action, the Commission today is proposing for comment an additional amendment to the Quote Rule. The proposed amendment would require OTC market makers and specialists that account for more than 1% of the volume in any Nasdaq security to publish their quotations for that security.-[7]- II. Basis and Purpose of the Display Rule and Quote Rule Amendments Twenty years ago, Congress directed the Commission -- having due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets -- to use the Commission's authority granted under the Exchange Act to facilitate the establishment of a national market system for ---------FOOTNOTES---------- -[6]- Additional amendments to the Quote Rule adopted today provide that certain Quote Rule provisions that previously applied to market makers that elected to quote a Nasdaq National Market security now also will apply to market makers electing to quote a Nasdaq SmallCap security. See section III.B.d.iii. -[7]- See Securities Exchange Act Release No. 37620 (August 28, 1996) ("Companion Release"). ==========================================START OF PAGE 8====== securities.-[8]- Congress further determined that the public interest, investor protection and the maintenance of fair and orderly markets required the NMS to feature: (i) economically efficient executions; (ii) fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets; (iii) public availability of quotation and transaction information; (iv) an opportunity to obtain best execution; and (v) an opportunity to obtain execution without dealer intervention to the extent consistent with economically efficient executions and the opportunity to obtain best execution.-[9]- The years since the 1975 Amendments have witnessed dramatic developments in the U.S. securities markets. Last sale reporting, which enables investors to determine the current market for a security, has been extended to OTC-traded securities. The Consolidated Quotation System ("CQS"), which allows investors to view in a single source quotes disseminated ---------FOOTNOTES---------- -[8]- Pub. L. No. 94-29, 89 Stat. 97 (1975) ("1975 Amendments"). -[9]- Exchange Act Section 11A(a)(1), 15 U.S.C.  78k- 1(a)(1). This Section also recites the Congressional findings that: the securities markets are an important national asset which must be preserved and strengthened; and new data processing and communications techniques create the opportunity for more efficient and effective market operations. ==========================================START OF PAGE 9====== from dispersed market centers, did not exist in 1975. The Intermarket Trading System ("ITS"), which permits investors' orders in certain exchange-listed securities to be routed to the market center displaying the best quotation, has greatly facilitated quote competition. Moreover, technological developments not envisioned twenty years ago have enabled market centers to handle volume levels many times greater than those that led to the "back office" crisis of the late 1960s and early 1970s. Taken together, these and other developments have made it possible for investors' orders to be executed much more rapidly and at far lower cost. The Commission recognized that U.S. equity markets had undergone significant changes since passage of the 1975 Amendments and were likely to undergo further changes of equal magnitude.-[10]- Accordingly, the Commission announced in July 1992 that its Division of Market Regulation ("Division") would undertake a study of the structure of the U.S. equity markets and of the regulatory environment in which those markets operate.-[11]- In January 1994, the Division published a study,-[12]- which reviewed, among other things, market ---------FOOTNOTES---------- -[10]- See Securities Exchange Act Release No. 30920 (July 14, 1992), 57 FR 32587 (July 22, 1992) ("Market 2000 Concept Release"). -[11]- Id. -[12]- Division of Market Regulation, Market 2000: An Examination of Current Equity Market Developments (January 1994) ("Market 2000 Study" or "Study"). ==========================================START OF PAGE 10====== practices and structures that could affect the ability of customers to obtain opportunities for better prices. The Market 2000 Study noted that U.S. equity markets had evolved since 1975 to provide a much wider array of trading venues to meet the diverse needs of investors and made a series of recommendations intended to facilitate the further development of a national market system. As expected, U.S. equity markets have continued to evolve since the Market 2000 Study was published. This evolution of the markets is reflected in part by comparing trading volumes and the venues in which orders are executed. In 1976, the New York Stock Exchange ("NYSE") average daily trading volume was approximately 21.2 million shares.-[13]- By 1995, average daily trading volume exceeded 346 million shares.-[14]- Third market trading, i.e., OTC trading of listed securities, in NYSE-listed issues accounted for 4.57% of consolidated volume in 1976.-[15]- By 1995, third market trading increased to 7.94% of consolidated volume.-[16]- In 1987, the NYSE handled almost 74% of trades of NYSE-listed issues reported on the consolidated tape; in 1995, it handled 70.22% of such trades.-[17]- ---------FOOTNOTES---------- -[13]- 1982 NYSE Fact Book. -[14]- 1995 NYSE Annual Report. -[15]- 1982 NYSE Fact Book. -[16]- 1995 NYSE Fact Book. -[17]- Regional exchanges, namely, the Boston Stock Exchange ("BSE"), the Philadelphia Stock Exchange (continued...) ==========================================START OF PAGE 11====== Comparable figures for The Nasdaq Stock Market ("Nasdaq") are even more dramatic. In 1975, Nasdaq annual volume was approximately 1.39 billion shares.-[18]- By 1995, Nasdaq annual volume increased to 101.2 billion shares,-[19]- which means that more shares traded hands on three average trading days in 1995 than in all of 1975. In 1993, volume in all proprietary trading systems combined represented 13% of the total volume in Nasdaq/National Market securities;-[20]- by January 1996, volume on Instinet alone represented approximately 15% of total Nasdaq volume and 20% of total volume for the 250 ---------FOOTNOTES---------- -[17]-(...continued) ("Phlx"), the Cincinnati Stock Exchange ("CSE"), the Chicago Stock Exchange ("CHX"), and the Pacific Stock Exchange ("PSE"), have captured a significant share of volume in NYSE-listed issues, particularly with respect to smaller investor orders. In 1995, the regional exchanges accounted for 9.96% of consolidated volume in NYSE-listed issues but accounted for 19.01% of trades of NYSE- listed issues reported on the consolidated tape. Id. They also accounted for approximately 35% of share volume in trades of 100 to 2,099 shares. Shapiro, U.S. Equity Markets: Recent Equity Developments, in GLOBAL EQUITY MARKETS: TECHNOLOGICAL, COMPETITIVE, AND REGULATORY CHALLENGES 21 (R. Schwartz ed. 1995). In January 1996, trades of 100-499 shares represented between 65-72% of all trades in NYSE-listed issues on regional exchanges; such trades represented only 37% of all trades on the NYSE. Ross, Shapiro and Smith, Price Improvement of SuperDOT Market Orders on the NYSE (NYSE Working Paper 96-01) (March 11, 1996 draft) (prepared for the NYSE Conference for the Search for Best Price) ("Ross, Shapiro and Smith"). -[18]- 1992 Nasdaq Fact Book. -[19]- 1995 NASD Annual Report. -[20]- Market 2000 Study at Appendix IV-2. ==========================================START OF PAGE 12====== Nasdaq stocks with the highest median dollar volume.-[21]- The Study addressed the development of certain practices, such as internalization,-[22]- payment for order flow-[23]- and the non-disclosure of certain customer trading interest to all market participants, that raise a variety of market structure and customer order handling concerns. For example, brokers today may quote one price publicly to retail customers, while showing a better price privately to other investors and dealers on an ECN. In addition, the quotes displayed to public investors may not accurately reflect the best price for a security because limit orders, which specify the price at which customers will buy or sell a security, are not ---------FOOTNOTES---------- -[21]- The Introduction of NAqcess into the Nasdaq Stock Market: Intent and Expectation, NASD Economic Research Staff, June 6, 1996 ("NASD Study"), Exhibit D to Securities Exchange Act Release No. 37302 (June 11, 1996), 61 FR 31574 (June 20, 1996) (Notice of Filing of Amendment No. 2 to Proposed Rule Change by National Association of Securities Dealers Relating to the NAqcess System and Accompanying Rules of Fair Practice)("NAqcess Release 2"). -[22]- Internalized orders are customer orders routed by a broker-dealer to an affiliated specialist or executed by that broker-dealer as a market maker. -[23]- The Commission now requires enhanced disclosure of payment for order flow practices on customer confirmations and account statements, as well as upon opening new accounts. Securities Exchange Act Release No. 34902 (October 27, 1994), 59 FR 55006 (November 2, 1994) (adopting rules requiring enhanced disclosure of payment for order flow practices on customer confirmations, and account statements, as well as upon opening new accounts) ("Payment for Order Flow Release"). See also Securities Exchange Act Release No. 35473 (March 10, 1995), 60 FR 14366 (March 17, 1995). ==========================================START OF PAGE 13====== uniformly required to be included in the quote. The Study recommended that the exchanges and the NASD consider taking action to respond appropriately to certain of these developments. Since that time, Nasdaq market makers holding customer limit orders have been prohibited from trading ahead of those orders,-[24]- and some market makers have begun to offer price improvement opportunities in OTC transactions to their retail customers.-[25]- In addition, the NYSE now requires almost all limit orders transmitted through SuperDOT to be displayed to the market.-[26]- Further, Commission rules require enhanced disclosure of payment for order flow practices on customer confirmations and account statements, as well as upon opening new accounts.-[27]- Notwithstanding the progress achieved in this period, the Commission believes that further regulatory initiatives are warranted at this time. These changes, as indicated in the Proposing Release, are intended to address current market practices that inhibit opportunities for order interaction and ---------FOOTNOTES---------- -[24]- Securities Exchange Act Release No. 34279 (June 29, 1994), 59 FR 34883 (July 7, 1994) ("Manning I"); Securities Exchange Act Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 1995) ("Manning II"). -[25]- See, e.g., Louis, Schwab Debuts New Trading System, San Francisco Chronicle, October 17, 1995, at D1. -[26]- Securities Exchange Act Release No. 36231 (September 14, 1995), 60 FR 48736 (September 20, 1995). -[27]- See Payment for Order Flow Release supra note 23. ==========================================START OF PAGE 14====== that are inconsistent with Congress's vision of the national market system. These changes also address certain problems in Nasdaq. The Commission recently reported that, among other things: (i) Nasdaq market makers widely followed a pricing convention concerning the increments they used to adjust their displayed quotes; (ii) adherence to the pricing convention was not the result of natural economic forces, often impacted the fairness and accuracy of public quotation information and interfered with the economically efficient execution of customer transactions; (iii) the pricing convention impaired the ability of investors to ascertain the best market for their trades, increased the costs of transactions, and resulted in unfair discrimination among classes of market participants; (iv) numerous market makers collaborated in ways that misled and disadvantaged their customers and other market participants and frequently failed to honor their price quotations; and (v) many market makers have not consistently reported their trades on time or appropriately designated them as late as required by NASD rules.-[28]- The Commission has taken specific regulatory and enforcement actions to address these problems.-[29]- The Display Rule and Quote Rule amendments adopted today should bring about other, ---------FOOTNOTES---------- -[28]- Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD, the Nasdaq Market, and Nasdaq Market Makers, Securities Exchange Act Release No. 37542 (August 8, 1996) ("21(a) Report"). -[29]- See id. ==========================================START OF PAGE 15====== significant changes in the operation of Nasdaq, by ensuring the disclosure of customer and market maker buying and selling interest that heretofore has been hidden from many market participants. At the same time, the new rules will benefit investors in the exchange markets by increasing transparency in those markets and improving opportunities for the best execution of customer orders. The Commission firmly believes that the actions it is taking today are consistent with the regulatory framework for a national market system established by Congress in the 1975 Amendments. Congress envisioned a national market system supported by accurate and reliable public quotation and transaction information, and fair competition among market centers. Congress also believed that linking all markets for qualified securities through communication and data processing facilities would foster efficiency, enhance competition, increase information available to market participants and contribute to the best execution of customer orders.-[30]- The Commission recognizes that investors will lose confidence in the fairness of the markets unless market structures and practices treat all investors fairly. The regulatory initiatives adopted today address current market practices that hinder competition among markets and affect the prices at which customer orders are executed. The Display Rule ---------FOOTNOTES---------- -[30]- See Exchange Act Section 11A(a)(1)(D), 15 U.S.C.  78k-1(a)(1)(D). ==========================================START OF PAGE 16====== and Quote Rule amendments enhance transparency and facilitate best execution of customer orders in a manner that preserves maximum flexibility for the markets to design and implement trading and communication systems that are consistent with the objectives of the national market system. These rules contribute to the achievement of the full potential of the national market system as envisioned by Congress. They represent one more step to facilitate the development of an efficient, competitive and transparent national market system in which all market participants can achieve best execution of their orders. III. Discussion A. Display of Customer Limit Orders 1. Introduction As discussed above, the 1975 Amendments contain an explicit statutory mandate for the establishment of a national market system. Congress considered mandating certain minimum components of the national market system, but instead created a statutory scheme granting the Commission broad authority to oversee the implementation, operation and regulation of the national market system.-[31]- At the same time, Congress charged the Commission with the responsibility to assure that the national market system develop and operate in accordance with specific ---------FOOTNOTES---------- -[31]- S. Rep. No. 75, 94th Cong., 1st Sess. 8-9 (1975) ("Senate Report"). ==========================================START OF PAGE 17====== goals and objectives.-[32]- The Commission believes that the adoption of a limit order display rule furthers these goals and objectives determined by Congress. Specifically, the display of customer limit orders advances the national market system goal of the public availability of quotation information, as well as fair competition, market efficiency, best execution and disintermediation. The enhanced transparency of such orders increases the likelihood that limit orders will be executed because contra-side market participants will have a more accurate picture of trading interest in a given security. Further, this increased visibility will enable market participants to interact directly with limit orders, rather than rely on the participation of a dealer for execution. Moreover, as noted in the Proposing Release, the display of limit orders that are priced better than current quotes addresses at least three regulatory concerns. First, displaying customer limit orders in the quotation can increase quote competition. If the quotes from a market or market maker represent only market maker buying and selling interest in a given security, the market or market maker faces less price competition than if customer ---------FOOTNOTES---------- -[32]- Id. at 9. Among other things, Congress found it in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure an opportunity for investors' orders, in both dealer and auction markets, to be executed without the participation of a dealer, to the extent that this was consistent with economically efficient executions of such orders in the best market. Exchange Act Section 11A(a)(1(c), 15 U.S.C.  78k-1(a)(1)(C). ==========================================START OF PAGE 18====== buying and selling interest is made public. As a result, the price discovery process may be constrained. Second, the display of limit orders can narrow quotation spreads. Third, because many markets and market makers offer automatic executions of small orders at the best displayed quotes, the display of limit orders that improve the best displayed quotes can result in improved executions for these orders. Limit orders currently are handled differently in the various auction and dealer markets. Generally, the rules of most exchanges require that a limit order be displayed in the quotation for a security when it improves the best bid or offer. NYSE specialists, for example, must reflect a customer limit order in their quotations at the limit price when requested to do so.-[33]- In addition, the NYSE's order handling procedures assume that all limit orders routed to a specialist through SuperDOT contain a display request.-[34]- Therefore, except in the unusual and infrequent circumstance where a specialist believes market conditions suggest the likelihood of imminent price improvement, a limit order received ---------FOOTNOTES---------- -[33]- See NYSE Rule 79A.10 (when a limit order is presented to the specialist by a floor broker, the floor broker must affirmatively request that the specialist display the limit order; failure to so request leaves the decision whether to display the limit order to the discretion of the specialist); see also NYSE Rule 60 (requiring specialists to promptly report, inter alia, the best bid and offer in the trading crowd in each reported security in which the specialist is registered). -[34]- NYSE Information Memo 93-12 (Mar. 30, 1993). ==========================================START OF PAGE 19====== by a specialist through SuperDOT should be reflected in the specialist's quote as soon as practicable following receipt of the order.-[35]- According to the NYSE, 93% of all SuperDOT limit orders that improve the best bid or offer displayed are reflected in the specialist's quote within two minutes of receipt, while 98% of such limit orders are reflected within five minutes of receipt.-[36]- A recent NYSE policy statement requires specialists to display the full size of all orders received through SuperDOT as well as orders received by specialists manually that are subsequently entered into the electronic book.-[37]- When a member requests that less than the full size of the order be shown, the specialist is obligated to show the size requested. Specialists must display as soon as practicable any order that, ---------FOOTNOTES---------- -[35]- Id. -[36]- Telephone Conference between Edward A. Kwalwasser, Executive Vice President, NYSE, and Holly H. Smith, Associate Director, Division of Market Regulation, SEC, January 9, 1995. Other exchanges also have rules regarding dissemination of bids and offers. However, no uniform standard has been adopted among the exchanges. Generally, the rules either cite, in whole or in part, language from the Quote Rule, or are drafted in such a manner as to allow for broad interpretation with respect to the display of limit orders. See, e.g., BSE Guide, Rules of the Board of Governors, Chapter II, Sec. 7, (CCH) 2020; PSE Guide, Rules of the Board of Governors, Rule 5.6(f), (CCH) 3979; American Stock Exchange Guide, General and Floor Rules, Rule 115, (CCH) 9265; CHX Guide, Article XX, Rule 7, (CCH) 1688; Phlx Guide, Rules 105 and 229 (CCH) 2105 and 2229; Cincinnati Stock Exchange Rules, Rule 11.9. -[37]- See supra note 26. ==========================================START OF PAGE 20====== in relation to current market conditions in a particular security, represents a material change in the supply or demand for that security. This requirement includes increasing the size of a quotation for orders at the same price as the current bid or offer. If the quotation already reflects significant supply or demand, and the specialist receives an order that is de minimis in relation to such supply or demand, the specialist may take a reasonable time (generally not more than two minutes) before updating the size of the quotation.-[38]- Currently in the OTC market, the quote for any security typically represents a dealer's own bid and offer. The rules of the NASD do not require market makers to display customer limit orders, whether or not they better the best bid or offer for the security.-[39]- Generally, customer limit orders in OTC securities either will be routed to a broker-dealer's market making desk or to another market maker for execution if the customer's firm does not make a market in the security. In the past, market makers typically did not execute limit orders until the best bid (for sell orders) or offer (for buy orders) ---------FOOTNOTES---------- -[38]- The NYSE provides the following example of when a specialist may take a reasonable time to update the size of the quotation: If the market in XYZ security is 20 (5,000) - 20 1/4 (50,000), and the specialist receives an order to sell 200 shares at 20 1/4, such order would be considered de minimis and the specialist would be permitted to wait a reasonable period of time (but not more than two minutes) before changing the size of the offer to 50,200. -[39]- See NASD Manual, Rule 4613. ==========================================START OF PAGE 21====== displayed on Nasdaq reached the limit price. This practice has changed, however, in recent years. In June 1994, the Commission approved a rule change filed by the NASD that prohibits broker- dealers from trading ahead of their customers' limit orders.-[40]- This rule was expanded in May 1995, to prohibit broker-dealers from trading ahead of customer limit orders they accept from other brokers.-[41]- The NASD also has filed a proposed rule change that would require, in certain circumstances, the display of customer limit orders for exchange- listed securities traded OTC.-[42]- The exchanges and the NASD use automated trading systems to route and, in some instances, execute orders up to a predetermined size. Some of these systems accept limit orders. ---------FOOTNOTES---------- -[40]- See Manning I, supra note 24. -[41]- See Manning II, supra note 24. -[42]- See Securities Exchange Act Release No. 35471 (March 10, 1995), 60 FR 14310 (March 16, 1995). The NASD proposal, applicable to exchange-listed securities traded OTC, generally would require a market maker either to execute immediately a limit order of less than the minimum quotation size priced better than the market maker's quotation, or display the order in its quotation for an amount equal to the minimum quotation size. Market makers would have to display a limit order greater than the minimum quotation size for that security but would not have to display the full size of the order. Any portion of the order not displayed, however, would have to be executed at a price at least as favorable as the displayed price if the displayed portion is executed in its entirety. At the NASD's request, the Commission has postponed final action on the NASD's proposal in order to permit the NASD to evaluate its proposal in light of the Commission's actions on the proposals it is adopting today. ==========================================START OF PAGE 22====== Each system, however, may differ in its handling of limit orders that are not executed immediately upon receipt. For example, the NYSE's SuperDOT system routes limit orders to the specialists' posts where they are handled in accordance with NYSE rules governing specialist representation of such orders. The American Stock Exchange's ("Amex") PER system routes limit orders in the same manner as SuperDOT and the orders are handled in accordance with Amex rules. The NASD's Small Order Execution System ("SOES") treats limit orders priced at the current inside market as market orders that are immediately executed.-[43]- All other limit orders reside in a limit order file that can be viewed only by market makers.-[44]- SOES does not provide an opportunity for limit orders to interact with incoming market orders. The Commission has published for comment an NASD proposal to replace SOES with "NAqcess," a system that would include a limit order file designed to display certain customer ---------FOOTNOTES---------- -[43]- Preferenced orders (i.e., orders routed to a specific market maker pursuant to a pre-existing agreement) are executed immediately at the inside quote. Unpreferenced orders are executed against market makers in a security in rotation. SOES, however, does not execute an unpreferenced order against a single market maker more than once every 15 seconds. -[44]- The current SOES rules have been extended, with certain changes that do not affect the handling of limit orders, through January 31, 1997. Securities Exchange Act Release No. 37502 (July 30, 1996), 61 FR 40869 (August 6, 1996). ==========================================START OF PAGE 23====== limit orders.-[45]- The disparate treatment of limit orders across markets was raised as an issue in the Market 2000 Study. The Commission received numerous comments concerning whether the optimal degree of pre-trade disclosure of limit orders was being achieved within the U.S. equity markets. Some commentators alleged that specialists and third market dealers sometimes fail to display limit orders priced better than the displayed quotation.-[46]- Questions also were raised about the lack ---------FOOTNOTES---------- -[45]- See Securities Exchange Act Release No. 36548 (December 1, 1995), 60 FR 60392 (December 8, 1995) ("NAqcess Release 1"); NAqcess Release 2, supra note 21. As proposed, NAqcess would act as an order delivery system with a limited public limit order file. Limit orders up to 9,900 shares would be permitted in NAqcess for the top 250 Nasdaq National Market securities, defined by median daily dollar volume, and for 1,000 shares for all other Nasdaq securities. Market makers would be allowed to query the entire limit order file. All other market participants would be limited to viewing the top of the NAqcess limit order file (i.e., the best priced buy and sell limit orders, and the size associated with those orders - the NAqcess inside market). This inside market would be factored into the calculation for the inside quote for each Nasdaq security. Although use of NAqcess would be voluntary, limit orders not entered in NAqcess would be provided with market-wide price protection under the proposal. -[46]- See generally Thomas H. McInish & Robert A. Wood, Hidden Limit Orders on the NYSE, 21 J. Portfolio Mgmt. 19 (No. 3, Spring 1995) ("McInish & Wood Study"). The authors asserted that NYSE specialists only display about 50% of limit orders that better existing quotes. In their opinion, this practice represents a serious policy issue because it places both public investors and regional exchanges at a disadvantage. They asserted that hiding limit orders impedes (continued...) ==========================================START OF PAGE 24====== of limit order exposure on Nasdaq. After considering these comments, the Division recommended in the Study that the securities exchanges consider whether to encourage the display of all limit orders in listed stocks priced better than the best intermarket quotes, unless the ultimate customer requests that the order not be displayed. The Market 2000 Study also recommended the display of limit orders in Nasdaq stocks when the orders are at prices better than the best Nasdaq quotes, unless the customer requests that the order not be displayed.-[47]- 2. Discussion ---------FOOTNOTES---------- -[46]-(...continued) strategic decisions on order placement; results in publicly submitted market orders receiving inferior prices; hampers the monitoring of order executions; reduces the probability of a limit order being executed; results in a delay in reporting limit order executions; interferes with the ability of the regional exchanges to execute public orders; and artificially improves NYSE performance relative to the regional exchanges using a common benchmark. The authors also claimed that NYSE Rule 60 is ambiguous in that the specialists may have some leeway in choosing what to disclose in their quotes. In its comment letter to the Market 2000 Study, however, the NYSE asserted that its publicly disseminated best bid or offer includes all firm trading interest announced on the floor as required by the exchange's rules. See Letter from William H. Donaldson, Chairman and Chief Executive Officer, NYSE, to Jonathan G. Katz, Secretary, SEC at 25-26 (November 24, 1992). In addition, the NYSE issued a policy statement that reiterates that specialists have an obligation to reflect in their quotes certain limit orders received manually or via SuperDOT that are not executed on receipt. See supra note 26. -[47]- Market 2000 Study, at IV-6. ==========================================START OF PAGE 25====== a. Basis For Adoption of the Rule After carefully considering all of the comments as well as economic research regarding the Display Rule, and based on the Commission's experience and knowledge of current market practices and conditions, the Commission believes that adoption of the Display Rule will promote transparency and enhance execution opportunities for customer orders, and encourage liquidity.-[48]- The Commission stresses, however, that ---------FOOTNOTES---------- -[48]- See, e.g., Letter from Thomas F. Ryan, Jr., President and Chief Operating Officer, Amex, to Jonathan G. Katz, Secretary, SEC, dated February 1, 1996 ("Amex Letter"); Letter from David E. Shaw, Ph.D., Chairman, D.E. Shaw & Co., to Jonathan G. Katz, Secretary, SEC, dated January 9, 1996 ("D.E. Shaw Letter") (rule will promote transparency); Letter from Paul A. Merolla, Vice President, Associate General Counsel, Goldman, Sachs & Co., to Jonathan G. Katz, Secretary, SEC, dated January 26, 1996 ("Goldman Sachs Letter") (rule would benefit marketplace); Letter from Craig S. Tyle, Vice President and Senior Counsel, Securities and Financial Regulation, Investment Company Institute, to Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 ("ICI Letter") (increased transparency of customer limit orders in all markets could produce benefits to the markets and investors); Letter from Donald L. Crooks, Managing Director, Lehman Brothers, Inc., to Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 ("Lehman Letter") (rule promotes transparency and results in improved opportunities for execution of customer orders); Letter from Bernard L. Madoff and Peter B. Madoff, Bernard L. Madoff Investment Securities, to Jonathan G. Katz, Secretary, SEC, dated January 12, 1996 ("Madoff Letter") (rule will help achieve true price discovery and fairness to investors); Letter from Andrew E. Feldman, Director and Associate General Counsel, Smith Barney Inc., to Jonathan G. Katz, Secretary, SEC, dated January 29, 1996 ("Smith Barney Letter") (rule will promote transparency and assist in achieving best execution of orders). (continued...) ==========================================START OF PAGE 26====== the rule is not meant to displace any SRO rules that provide additional order handling protections to customer limit orders. Instead, the Commission rule represents only a minimum display standard. The Commission believes that limit orders are a valuable component of price discovery. The uniform display of such orders will encourage tighter, deeper, and more efficient markets. Limit orders convey buying and selling interest at a given price. The display of limit orders can be expected to narrow the bid-ask spread when this buying and selling interest is priced better than publicly disclosed prices.-[49]- Both large and small orders stand to benefit from the Display Rule's effect on price discovery.-[50]- In fact, the importance of limit orders ---------FOOTNOTES---------- -[48]-(...continued) But see Letter from Charles R. Hood, Senior Vice President and General Counsel, Instinet, to Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 ("Instinet Letter") (exceptions to rule eliminate potential positive impact on transparency). -[49]- For example, limit order trading allows investors the opportunity to trade at prices superior to those represented by the prevailing inside bid and offer. See NASD Study, supra note 21. -[50]- According to SuperDOT trade data analyzed by the Commission's Office of Economic Analysis ("OEA"), customer limit orders account for 50% of all NYSE customer trades originating from orders routed through SuperDOT ("customer trades") of 100-500 shares; 66% of all customer trades of 600-1,000 shares; 71% of all customer trades of 1,100-3,000 shares; and 74% of all customer trades of 3,100- 9,900 shares. The Commission believes that these high percentages are based, at least in part, on the fact that limit orders routed through SuperDOT (continued...) ==========================================START OF PAGE 27====== in the trading process was documented in recent studies.-[51]- The author quantified the impact of exposing limit orders on quoted spreads and effective transaction costs. Using NYSE data, he determined that the quote spreads resulting from participation of the limit order book were approximately 4 to 6 cents smaller than the spreads not set by the limit order book. Further, trading costs on the NYSE were approximately 3-4 cents less per share on a "round trip" transaction when both the purchase and the sale were executed against the limit order book.-[52]- ---------FOOTNOTES---------- -[50]-(...continued) are required to be displayed in the specialist's quote. The Commission believes that these percentages help demonstrate the benefits associated with limit order display for both large and small order sizes. In addition, OEA data shows that NYSE customer limit orders routed through SuperDOT narrow the NYSE quote 22% of the time and match the quote 39% of the time for customer limit orders of 100-1,000 shares; narrow the quote 17% of the time and match the quote 43% of the time for customer limit orders of 1,100- 3,000 shares; and narrow the quote 14% of the time and match the quote 46% of the time for customer limit orders of 3,100-9,900. OEA data also shows that, when the NYSE bid-ask spread was 1/4 point or more, customer limit orders routed through SuperDOT narrow the NYSE spread between 41% and 50% of the time, depending on the size of the customer order. -[51]- See Jason T. Greene, The Impact of Limit Order Executions on Trading Costs in NYSE Stocks (An Empirical Examination), December 1995 ("Greene Study"); see also Jason T. Greene, Limit Order Executions and Trading Costs for NYSE Stocks, June 1996 ("Greene Study II"). -[52]- The Commission further believes that the display requirement will improve price transparency in (continued...) ==========================================START OF PAGE 28====== The uniform display of limit orders also will lead to increased quote-based competition. Market makers will not only be competing amongst themselves, but also against customer limit orders represented in the quote. The Commission believes that this result will reduce the possibility of certain trading behavior on Nasdaq that was recently the subject of a Commission ---------FOOTNOTES---------- -[52]-(...continued) securities with diverse trading characteristics. Based on SuperDOT trade data, the Commission's OEA has determined that for NYSE securities with an average daily trading value ("ADTV") of under $100,000, customer limit orders account for 57% of all NYSE customer trades originating from orders routed through SuperDOT ("customer trades") of 100-500 shares; 69% of all customer trades of 600- 1,000 shares; 76% of all customer trades of 1,100- 3,000 shares; and 83% of all customer trades of 3,100-9,900 shares. Limit orders also are frequently used for securities with higher ADTVs. For example, for NYSE securities with an ADTV of over $5,000,000, customer limit orders account for 48% of all NYSE customer trades of 100-500 shares; 68% of all customer trades of 600-1,000 shares; 72% of all customer trades of 1,100-3,000 shares; and 73% of all customer trades of 3,100-9,900 shares. Moreover, OEA data shows that for NYSE securities with an ADTV of under $100,000, customer limit orders routed through SuperDOT narrow the NYSE quote 30% of the time and match the quote 32% of the time. For less liquid securities, therefore, the display of customer limit orders narrows spreads, improves price discovery, and increases market depth. For NYSE securities with an ADTV of $5,000,000 or more, customer limit orders routed through SuperDOT narrow the NYSE quote 18% of the time and match the quote 41% of the time. The NASD has suggested that the greater the size of the displayed spread, the greater the use of limit orders. See NASD Study, supra note 21. ==========================================START OF PAGE 29====== investigation.-[53]- As reported in the 21(a) Report, Nasdaq market makers widely adhered to a "pricing convention," whereby Nasdaq market makers maintained artificially inflexible quotations and as a result often traded with the public at prices unduly favorable to such market makers.-[54]- In addition, the Commission determined that Nasdaq market makers adhered to a "size convention" that deterred Nasdaq market makers from narrowing their quotes to create a new inside market unless the market makers were willing to trade at least 2,000 to 5,000 shares at that price, rather than the minimum quotation size as determined by NASD rules.-[55]- This practice prevented ---------FOOTNOTES---------- -[53]- See 21(a) Report, supra note 28. The investigation identified a number of practices in the Nasdaq market that are similar to practices identified in the 1963 Special Study. See SEC, Report of Special Study of Securities Markets (1963). For example, the 1963 Special Study discussed cooperation and information sharing between traders, as well as other non-competitive practices. Id. at pt. 2, 576-577.; See also Competitive Impact Statement of the U.S. Department of Justice Antitrust Division, United States v. Alex. Brown & Sons, et. al., (S.D.N.Y. 1996). -[54]- As a result of this convention, most Nasdaq stocks were quoted only in increments of 1/4. Under the convention, stocks with a dealer spread of 3/4 or more would only be quoted in even-eighths (i.e., 1/4, 1/2, 3/4), thereby giving rise to a minimum inside spread of 1/4. Stocks with dealer spreads less than 3/4 would be quoted in both even and odd-eighths, thereby allowing a minimum inside spread of 1/8. The pricing convention significantly limited the flexibility and competitiveness of price quotations in the Nasdaq market. -[55]- See 21(a) Report, supra note 28. ==========================================START OF PAGE 30====== the dissemination of improved quotes when a trader sought to trade stock only at a size equal to the minimum quotation size. Thus, the true buying and selling interest in a given security was not reflected in the published quotes. In addition to the Commission's actions, and those of the Department of Justice in connection with its investigation of the Nasdaq market, the Commission believes the requirement to display customer limit orders in market maker quotes would inhibit market makers from engaging in the conduct described above. Moreover, the display of limit orders reduces the potential for certain other conduct described in the 21(a) Report, including market maker collaboration and coordination of trade and quote activities. Market makers will be less able to improperly coordinate such behavior due to the display of competing customer order flow and the resulting transparency of ultimate buying and selling interest. The Commission believes that the display requirement will both foster renewed quote-based competition among market makers and introduce new competition from customer limit orders. The Commission also believes that overall market liquidity should be enhanced due to the increased trading volume that is expected to result from the display of limit orders.-[56]- ---------FOOTNOTES---------- -[56]- See Greene Study and Greene Study II, supra note 51 (limit orders affect the quoted spread, provide liquidity to traders that demand immediacy of execution, and may contribute to reduced trading costs); NASD Study, supra note 21 (the liquidity supplied by limit orders reduces trading costs of (continued...) ==========================================START OF PAGE 31====== As noted previously, customer limit orders account for a significant percentage of total customer orders on the NYSE, where customer limit orders generally are required to be displayed when they represent a better price.-[57]- Moreover, previous Commission initiatives designed to enhance transparency have resulted in increased competition and liquidity for the markets.-[58]- Customers also will be better able to monitor the quality of their executions. Currently, the failure to display limit orders often results in inferior or missed executions for these orders. The Commission has received frequent complaints from customers whose limit orders have not been filled while other executions are reported at prices inferior to their limit order prices. Requiring the display of customer limit orders in specialist and market maker quotes, although not guaranteeing that such limit orders will be executed, will help ensure that other orders are not executed at inferior prices until better priced limit orders are executed. Similarly, customers entering market orders will be able to determine whether their orders are receiving the best ---------FOOTNOTES---------- -[56]-(...continued) market participants); OEA Data, supra notes 50 and 52 (limit orders narrow spreads, improve price discovery, and increase market depth). -[57]- See OEA Data, supra notes 50 and 52. -[58]- See Market 2000 Study at Study IV. See also discussion at section III.A.b.iii., infra; Simon & Colby The National Market System For Over-The- Counter Stocks ("Simon and Colby"), 55 Geo. Wash. L. Rev. 17 (1986). ==========================================START OF PAGE 32====== price available. Customers also will be in a better position to compare the execution quality provided by different broker- dealers.-[59]- The absence of a uniform limit order display requirement across all markets has contributed to the controversy among market participants regarding the availability of true price improvement opportunities. Many claim that "hidden" limit orders in exchange markets contribute to distorted price improvement figures for these markets.-[60]- This potential distortion ---------FOOTNOTES---------- -[59]- The Commission notes that if the Display Rule leads some market makers to charge commissions for handling limit orders, Commission rules require disclosure of such charges. See 17 CFR 240.10b- 10. -[60]- See James J. Angel, Who Gets Price Improvement on the NYSE?, Working Paper, December 1994. In studying the availability of price improvement on the NYSE, the author noted that over 18% of the market orders that were price improved were filled by SuperDOT limit orders. Based on this percentage, the author estimated the percentage of orders price improved by "hidden" limit orders and determined that if such limit orders were represented in the specialist's quote rather than "hidden," spreads would have been narrower and NYSE price improvement statistics would have declined. See also, McInish & Wood Study, supra note 46; Mitchell A. Petersen & David Fialkowski, Posted Versus Effective Spreads: Good Prices or Bad Quotes, 35 J. Fin. Econ. 269 (1994) (the fact that so many orders execute inside the posted spreads indicates that quotes do not represent the true supply and demand of a given security, and may be based, in part, on the failure to display public limit order interest in the quote). Cf. Ross, Shapiro and Smith, supra note 17 (although the authors did not examine limit orders in detail, and discounted the effect of "hidden" limit orders on their statistics, the authors found that limit orders provide 27% of the price (continued...) ==========================================START OF PAGE 33====== also hinders a customer's ability to monitor execution quality. Pursuant to the Display Rule, the vast majority of limit orders will be publicly disclosed, thus enabling a more accurate comparison of price improvement opportunities, and enabling customers and broker-dealers to make more informed order routing decisions.-[61]- Moreover, the Commission believes that the display of limit orders will benefit orders routed to automated execution systems. To the extent these systems execute orders at prices based on the best displayed quotation for a particular security,-[62]- customers whose orders are executed through these systems will receive the benefit of prices that more accurately reflect buying and selling interest in the market. In sum, the Commission believes the adoption of the Display Rule is an important step in furthering the goals expressed by Congress in the 1975 Amendments. The Display Rule will provide ---------FOOTNOTES---------- -[60]-(...continued) improvement afforded to SuperDOT market order volume). -[61]- See, e.g., Amex Letter (rule would help eliminate hidden limit orders); Letter from Frederick Moss, Chairman of the Board, CSE, to Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 ("CSE Letter") (elimination of hidden limit orders will eliminate illusion of superior price improvement); Letter from Harold S. Bradley, Vice President and Director of Trading, Investors Research Corporation, to Jonathan G. Katz, Secretary, SEC, dated January 13, 1996 ("Investors Research Letter") (hidden limit orders are not justified). -[62]- Compare discussion of best execution at section III.C.2. ==========================================START OF PAGE 34====== enhanced opportunities for public orders to interact with other public orders, consistent with congressional goals.-[63]- In addition, the display requirement will, among other things, narrow quotes, enhance market liquidity, and improve an investor's ability to monitor the quality of its executions.-[64]- This will create a better environment for execution of both limit and market orders without the participation of a dealer. The increased order interaction will result in quicker and more frequent executions of customer limit orders. The Display Rule, therefore, will increase the ---------FOOTNOTES---------- -[63]- See 15 U.S.C.  78k-1(a)(1)(C)(v). -[64]- The Commission notes that a few commenters are concerned about the potential effects of the Commission's proposals on institutional customers. See Goldman Sachs Letter; Letter from Howard J. Schwartz, Chairman and Chief Executive Officer, and James Hanrahan, Managing Director - Trading, Lynch, Jones & Ryan, Inc., to Jonathan G. Katz, Secretary, SEC, dated February 9, 1996 ("LJR Letter"); Letter from A.B. Krongard, Chairman, SIA Board of Directors, and Bernard L. Madoff and Robert Murphy, Co-Chairmen, Order Execution Committee, Securities Industry Association, to Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 ("SIA Letter"). The Commission believes that the Display Rule will benefit both retail and institutional customers, while preserving the access to the markets that institutional customers have today. For example, an institutional customer's block size limit order would not be subject to the rule unless such customer requests that the order be displayed. Moreover, any customer, whether individual or institutional, can request that its non-block size limit order not be displayed. The Commission also notes that increased quote competition and enhanced transparency should improve the prices at which institutions and market makers begin their negotiations for the execution of institutional orders. See also 21(a) Report, supra note 28. ==========================================START OF PAGE 35====== likelihood that limit orders will be executed, a result that the Commission believes is consistent with the duty of best execution. b. Response to Comments-[65]- The Commission proposed Rule 11Ac1-4 to establish minimum display requirements for customer limit orders that improve a specialist's or OTC market maker's best bid or offer for a particular security as well as the size of such orders. In addition, the rule requires the display of the size of certain limit orders priced at the national best bid or offer ("NBBO"). Although the rule generally would mandate the display of limit orders, market makers and specialists still would retain some flexibility in handling limit orders accepted for execution. Specifically, the rule allows an OTC market maker or specialist, immediately upon receipt of a limit order, to: (1) change its quote and the size associated with its quote to reflect the limit order; (2) execute the limit order; (3) deliver the limit order in an exchange- or association-sponsored system that complies with the requirements of the rule; or (4) send the limit order to another market maker or specialist who complies with the requirements of the rule. The rule would require a specialist or OTC market maker to display a customer limit order when the order was "held" by the specialist or OTC market maker. If the specialist or OTC market maker immediately sends the order ---------FOOTNOTES---------- -[65]- For further discussion of the views of commenters, see the Summary of Comments, supra note 4. ==========================================START OF PAGE 36====== to a system or to another specialist or OTC market maker that complies with the rule, the specialist or OTC market maker that routed the order would have satisfied its obligation to display the order. These alternatives are intended to allow market makers, specialists, and market centers an opportunity to continue to provide their valuable services while offering customers the best available execution opportunities. The Display Rule as adopted maintains these alternatives as proposed. Additionally, to better achieve its aims and to respond to comments, the Commission has made some modifications to the proposed rule. For example, the Commission has decided to permit a specialist or OTC market maker to deliver a limit order to certain ECNs as an alternative to representing the limit order in its quote. This change is an extension of the proposed exception that permits a specialist or OTC market maker to deliver a limit order to an exchange- or association-sponsored system that complies with the Display Rule. Moreover, with regard to implementation of the rule, the Commission is providing for a four-stage phase-in over a one year period for non- exchange-traded securities. Of the commenters who specifically addressed the proposed Display Rule, an overwhelming majority strongly support the inclusion of customer limit orders in the quote.-[66]- One ---------FOOTNOTES---------- -[66]- See, e.g., Amex Letter; Letter from Marshall E. Blume, Director, Howard Butcher Professor of Financial Management, The Wharton School of the University of Pennsylvania, to Jonathan G. Katz, (continued...) ==========================================START OF PAGE 37====== commenter notes that true price discovery and fairness for public investors can only be achieved when limit orders are reflected in the NBBO.-[67]- Other commenters, expressing strong support for the proposed rule, believe that market-wide limit order procedures will improve the markets by enhancing overall ---------FOOTNOTES---------- -[66]-(...continued) Secretary, SEC, dated January 11, 1996 ("Blume Letter"); Letter from George W. Mann, Jr., Senior Vice President and General Counsel, BSE, to Jonathan G. Katz, Secretary, SEC, dated January 26, 1996 ("BSE Letter"); Letter from Robert H. Forney, CHX, to Jonathan G. Katz, Secretary, SEC, dated January 23, 1996 ("CHX Letter"); D.E. Shaw Letter; Letter from Antitrust Division, U.S. Department of Justice, to SEC, dated January 26, 1996 ("DOJ Letter"); Letter from Preston Estep, Estep Trading Partners L.P., to Jonathan Katz, Secretary, SEC, dated December 21, 1995 ("Estep Letter"); Goldman Sachs Letter; ICI Letter; Lehman Letter; Madoff Letter; Letter from William A. Lupien, Chairman and Chief Executive Officer, Mitchum, Jones & Templeton, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 8, 1996 ("MJT Letter"); Letter from Joseph R. Hardiman, President, National Association of Securities Dealers, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 26, 1996 ("NASD Letter"); Letter from James E. Buck, Senior Vice President and Secretary, NYSE, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("NYSE Letter"); Letter from David S. Pottruck, President and Chief Operating Officer, The Charles Schwab Corporation, to Jonathan G. Katz, Secretary, SEC, dated May 7, 1996 ("Schwab Letter II"); SIA Letter; Letter from William R. Rothe, Chairman, and John L. Watson III, President, Security Traders Association, to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("STA Letter"); Letter from John F. Luikart, President and Chief Executive Officer, Sutro & Co., to Jonathan Katz, Secretary, SEC, dated January 16, 1996 ("Sutro Letter"). -[67]- Madoff Letter. ==========================================START OF PAGE 38====== market transparency-[68]- and eliminating the advantages derived by some markets from hidden limit orders.-[69]- The Department of Justice states that the proposed rule encourages quote competition, which is likely to reduce spreads,-[70]- and allows customer orders to interact with one another.-[71]- In this regard, several commenters recognize that the proposed rule would assist in achieving best execution of customer orders-[72]- by increasing the opportunities for execution of limit orders, and improving the prices for market orders.-[73]- Another commenter states that the proposed rule is consistent with investor expectations and will act to protect retail customer interests.-[74]- Other commenters oppose the proposal. Several commenters in this group have raised the following general concerns regarding the proposed rule. ---------FOOTNOTES---------- -[68]- See, e.g., Amex Letter; CHX Letter; CSE Letter; D.E. Shaw Letter; ICI Letter; Investors Research Letter; Lehman Letter; Smith Barney Letter. -[69]- See, e.g., Amex Letter (rule would help eliminate hidden limit orders); CSE Letter (elimination of hidden limit orders will eliminate illusion of superior price improvement); Investors Research Letter (hidden limit orders are not justified). -[70]- DOJ Letter. -[71]- Id; see also Amex Letter; Lehman Letter. -[72]- See, e.g., Lehman Letter; Smith Barney Letter. -[73]- Lehman Letter. -[74]- D.E. Shaw Letter. ==========================================START OF PAGE 39====== i. Distinction Between Markets Several commenters argue that the Display Rule does not take into account distinctions between auction and dealer markets. Some of these commenters, discussing the Proposing Release as a whole, argue that the Commission's proposals would "auctionize" the dealer market.-[75]- One commenter warns that, because auction and dealer markets are fundamentally different, a single set of rules for both auction and dealer markets would reduce quote quality and damage overall market integrity in dealer markets.-[76]- Although the SIA reports that the consensus view of its Ad Hoc Committee on Order Execution is to require a market maker to reflect customer limit orders in the quote, the SIA argues that the adoption of the proposed rule, without suggested modifications, could adversely affect the dealer market ---------FOOTNOTES---------- -[75]- See, e.g., Letter from R. Steven Wunsch, President, AZX, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("AZX Letter"); Goldman Sachs Letter; Letter from David Rich, Vice President, Jefferies & Company, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 25, 1996 ("Jefferies Letter"); Letter from Robert W. Murphy, President, RPM Specialist Corporation, to Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 ("RPM Letter"); Letter from Robert A. Schwartz, Professor of Finance and Economics, and Yamaichi Faculty Fellow, Leonard N. Stern School of Business, New York University, and Robert A. Wood, Distinguished Professor of Finance, Fogelman College of Business and Economics, University of Memphis, to Jonathan G. Katz, Secretary, SEC, dated January 23, 1996 ("Schwartz & Wood Letter"); SIA Letter. -[76]- RPM Letter. ==========================================START OF PAGE 40====== so as to weaken competition between dealer and auction markets.-[77]- The Commission believes that the application of the principles underlying the limit order display rule to the dealer market is neither a new nor radical concept. In 1975, Congress envisioned an NMS in which public limit orders in qualified securities would have a central role.-[78]- Congress anticipated that the NMS would make all specialists and market makers aware of public customer limit orders held anywhere in the system, and provide enhanced protection and priority for limit orders in stocks qualified for trading in a national market system.-[79]- The Commission has consistently recognized since 1975 that, in order to satisfy this Congressional vision, multiple-market display of limit orders was an important ---------FOOTNOTES---------- -[77]- SIA Letter. Cf. Letter from A.B. Krongard, Chairman, SIA Board of Directors, and Bernard L. Madoff, Chairman, Trading Committee, to Jonathan G. Katz, Secretary, SEC, dated August 1, 1996 ("SIA NAqcess Letter") (the SIA, in its letter to the Commission regarding the NASD's NAqcess proposal, states that the Commission's Order Execution Obligations proposal would narrow quotation spreads, improve transparency, and provide customers with best execution of their orders, consistent with the 1975 Amendments). -[78]- Senate Report, supra note 31. -[79]- Id. The Senate Report stressed the need to establish a mechanism by which specialists and market makers could be made aware of customer orders within the NMS. The Senate Report was "satisfied that [the legislation] grant[ed] the Commission complete and effective authority to implement a system for the satisfaction of public limit orders." Id. at 18. ==========================================START OF PAGE 41====== component for qualified securities.-[80]- More recently, the Market 2000 Study recommended that the SROs, including the NASD, consider requiring the display of customer limit orders,-[81]- and the NASD, in a proposed rule change filed with the Commission, proposed that CQS market makers display in their quotes certain customer limit orders for exchange-listed securities traded OTC.-[82]- The NASD also has proposed a mechanism for the display and protection of customer limit orders in Nasdaq securities.-[83]- Although some commenters claim that the Commission is attempting to "auctionize" the dealer market, the display requirement is based on transparency and agency concerns, including a broker-dealer's obligation to provide its customers with best execution.-[84]- The display of customer limit orders will act to narrow spreads, improve price discovery, and ---------FOOTNOTES---------- -[80]- See Securities Exchange Act Release No. 15671 (March 22, 1979), 44 FR 20360 (April 4, 1979) (Development of a National Market System Status Report). See also Securities Exchange Act Release No. 18738 (May 13, 1982), 47 FR 22376 (May 24, 1982) (proposing limit order display requirement for Rule 19c-3 securities). -[81]- Market 2000 Study, at IV-6. -[82]- See supra note 42. -[83]- See supra note 45. -[84]- See NASD Study, supra note 21 (enhancements to limit order handling, within the dealer market structure, will create significant benefits for investors). See also Manning II, supra note 24 (Commission's extension of limit order protection to Nasdaq does not suggest an intention to "auctionize" the dealer market). ==========================================START OF PAGE 42====== increase market depth. The enhanced transparency resulting from the Display Rule will increase the likelihood that customer limit orders will be executed, improve the execution prices of market orders, and strengthen an investor's ability to monitor the quality of executions.-[85]- These results further several Congressional goals. In keeping with Congressional intent, the Commission believes the treatment of limit orders should reflect the very real changes in market structure that have taken place since the enactment of the 1975 Amendments. These changes include the development of a robust, liquid OTC dealer market that attracts significant investor trading interest, that trades at many multiples of the volume extant in 1975, and that is characterized by the inclusion of thousands of securities that meet the NMS designation.-[86]- In addition, the Commission believes that application of the Display Rule should also benefit investors in those securities that do not yet meet the NMS ---------FOOTNOTES---------- -[85]- See Senate Report, supra note 31 at 16-18 (discussing desirability of incorporating certain auction market principles, such as limit order display and protection, for certain qualifying securities in dealer markets). -[86]- To date, approximately 4,000 Nasdaq securities have qualified for the NMS designation. In order to qualify as an NMS security, transaction reports are required to be reported on a real-time basis pursuant to an effective transaction reporting plan approved by the Commission. See 17 CFR 240.11Aa2-1 and 11Aa3-1. ==========================================START OF PAGE 43====== designation.-[87]- As noted earlier, the Commission believes that the increased use of limit orders in these securities will lead to a narrowing of spreads and ameliorate certain anti-competitive practices that have developed in the Nasdaq market.-[88]- The Commission has determined that certain practices on Nasdaq have contributed to artificially wide spreads for OTC securities.-[89]- The display of customer limit orders in all Nasdaq securities will promote accurate pricing and convey the true buying and selling interest in such securities. A few commenters believe that the Display Rule was proposed solely to address problems in the OTC market, and accordingly there is no need for a uniform rule applicable to exchange markets.-[90]- As noted previously, the Commission's intention is to create a minimum standard for the handling of limit orders across all markets, consistent with market transparency, competition, and best execution principles. ---------FOOTNOTES---------- -[87]- As discussed below, the Display Rule will apply only to "covered securities." At the present time, the Commission does not believe the rule should be extended to securities for which market makers are not required to quote continuous firm two-sided markets, such as OTC Bulletin Board securities. -[88]- See supra discussion at section III.A.2.a. -[89]- 21(a) Report, supra note 28. -[90]- See, e.g., BSE Letter; NYSE Letter; RPM Letter; Letter from David E. Humphreville, Executive Director, The Specialist Association, to Jonathan G. Katz, Secretary, SEC, dated February 2, 1996 ("Specialist Assoc. Letter"). ==========================================START OF PAGE 44====== Currently, the national securities exchanges do not handle limit orders uniformly, and in fact the non-display of retail-size limit orders is permitted under certain circumstances. The rule will ensure that investors benefit from the display of limit orders, no matter where an order is sent for execution.-[91]- A minimum standard also addresses concerns regarding the prevalence of hidden limit orders.-[92]- The Commission believes, therefore, that a market-wide limit order display requirement is most consistent with the duty of best execution and the expectations of investors. ii. Distinction between Quotes and Orders ---------FOOTNOTES---------- -[91]- See, e.g., Greene Study & Greene Study II, supra note 51. -[92]- See generally McInish & Wood Study, supra note 46 (hidden limit orders result in, among other things, artificial price improvement statistics and inferior order executions); Traders Accuse Specialists of Holding Back Limit Orders, Investment Dealers' Digest, 8, (February 14, 1994) (some traders have continued to accuse NYSE specialists of hiding limit orders even after the NYSE issued an Information Memo reminding specialists of their duties); Greene Study and Greene Study II, supra note 51 (one explanation for the significantly lower bid-ask spreads in the 1994-95 sample than in the 1990 sample, and the increase in the percentage of transactions at the quoted prices from the 1990 sample to the 1994-95 sample, may be that NYSE specialists were more diligent in reflecting the limit order book in their quotes as per Information Memo 93-12); Amex Letter (rule would help eliminate hidden limit orders); CSE Letter (elimination of hidden limit orders will eliminate illusion of superior price improvement); Investors Research Letter (hidden limit orders are not justified). ==========================================START OF PAGE 45====== Some commenters maintain that the rule blurs the distinction between quotations and orders.-[93]- One commenter states that limit orders represent only a finite trading interest while quotes represent the "actual" market for a security; thus, displaying limit orders would not reflect the "true" state of the market and impair the quality of quotation information.-[94]- The commenter suggests that a separate limit order file would be more appropriate in light of these distinctions.-[95]- In this vein, several commenters mention the NASD's proposed NAqcess system,-[96]- suggesting that the Commission postpone implementation of the Display Rule until the Commission has an opportunity to assess ---------FOOTNOTES---------- -[93]- See, e.g., Letter from Raymond L. Aronson, Senior Managing Director, Bear, Stearns & Co. Inc., to Jonathan G. Katz, Secretary, SEC, dated February 1, 1996 ("Bear Stearns Letter"); Instinet Letter; Letter from Carol L. Cunniff, Executive Vice President, Ruane, Cunniff & Co., Inc., to Jonathan G. Katz, Secretary, SEC, dated February 23, 1996 ("Ruane Letter"); Letter from Charles R. Schwab, Chairman and Chief Executive Officer, The Charles Schwab Corporation, to Jonathan G. Katz, Secretary, SEC, dated January 25, 1996 ("Schwab Letter"). But see Schwab II Letter (supporting the Display Rule). -[94]- Ruane Letter. -[95]- Id. See also Bear Stearns Letter (discussion of proposed central limit order file for The Nasdaq Stock Market so as to preserve distinction between dealer quotes and agency or proprietary orders). -[96]- See supra note 45. ==========================================START OF PAGE 46====== the effects of NAqcess.-[97]- A few commenters suggest the implementation of an industry-wide consolidated limit order book as an alternative or a logical outgrowth of the Display Rule.-[98]- The Commission believes that the display of limit orders is an essential component of accurate price discovery. A quote provides market participants with information regarding a market maker's or specialist's trading interest at a given price. A market maker or specialist could be willing to purchase or sell ---------FOOTNOTES---------- -[97]- See, e.g., Letter from A.B. Krongard, Chief Executive Officer, Alex. Brown & Sons, Inc., to Jonathan G. Katz, Secretary, SEC, dated February 29, 1996 ("Alex. Brown Letter"); Letter from Albert G. Lowenthal, Chairman of the Board, Fahnestock & Co., Inc., to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("Fahnestock Letter"); Jefferies Letter; Letter from Gerard S. Citera, Deputy General Counsel, First Vice President, PaineWebber Incorporated, to Jonathan G. Katz, Secretary, SEC, dated February 9, 1996 ("PaineWebber Letter"); Schwab Letter; STA Letter; Letter from Charles Snow, Counsel, Securities Traders Association of New York, to Jonathan G. Katz, Secretary, SEC, dated January 30, 1996 ("STANY Letter"); see also Letter from C. Robert Paul, III, Associate General Counsel, Dean Witter Reynolds, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 31, 1996 ("Dean Witter Letter"); Goldman Sachs Letter. -[98]- See, e.g., DOJ Letter; MJT Letter; Schwab Letter; Letter from Junius W. Peake, Monfort Distinguished Professor of Finance, University of Northern Colorado, to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("Peake Letter"); Letter from Jeffrey P. Ricker, CFA, to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("Ricker Letter"); Letter from Peter W. Jenkins, Chairman, and Holly A. Stark, Vice Chairman, Institutional Committee, Securities Traders Association, to Jonathan G. Katz, Secretary, SEC, dated January 19, 1996 ("STAIC Letter"). ==========================================START OF PAGE 47====== additional shares above its quoted size.-[99]- Entry of a customer limit order that improves the quote serves a similar purpose. A limit order accurately represents trading interest for a specific volume of a security at the limit price. There are few practical differences between customer limit orders and a market maker's quotation that is firm only for its quoted size. Nonetheless, the proposed rule was not intended to equate customer limit orders with market maker quotes. Instead, the proposed rule was designed to facilitate greater transparency of customer trading interest, with the expectation that orders would have an increased opportunity for best execution without the interaction of a dealer. In the Commission's opinion, these objectives are more difficult to achieve if customer trading interest is not routinely represented in publicly displayed quotes. The Commission notes that the Display Rule provides other means by which a market maker or specialist may comply with the requirements of the rule in the event a specialist or market maker elects not to display customer trading interest in its quote.-[100]- Further, the Commission does not agree with the suggestion ---------FOOTNOTES---------- -[99]- Under Commission rules, the market maker's quote is only required to be firm up to its published size. See 17 CFR 240.11Ac1-1(c)(2). -[100]- For example, a market maker or specialist may deliver a customer limit order immediately upon receipt to another market maker or specialist, or to an ECN or an exchange or association sponsored system pursuant to the rule. Section 240.11Ac1- 4(c)(5) & (6). ==========================================START OF PAGE 48====== that the Commission postpone the adoption of the Display Rule until the Commission has had an opportunity to evaluate the NASD's NAqcess proposal.-[101]- Although the NASD has argued that limit orders entered into NAqcess, as proposed, would result in greater display of OTC limit order prices, there is no assurance that market makers will enter such orders into NAqcess rather than hold the orders internally.-[102]- Therefore, the Commission believes that the Display Rule is necessary to ensure display of these orders in the OTC market.-[103]- If approved, NAqcess can assist in compliance with the Display Rule to the extent that the system incorporates customer limit orders in the consolidated quote stream, thereby allowing market makers to enter limit orders in NAqcess rather than displaying limit orders in their quotes.-[104]- As noted earlier, the Commission has identified important benefits associated with limit order display. Accordingly, the Commission believes that it is not necessary to observe the effects of NAqcess in order to ---------FOOTNOTES---------- -[101]- The Commission notes that the proposed NAqcess system is a significant and controversial proposal which has generated approximately 1,100 comment letters. The Commission is in the process of reviewing the comments and has yet to decide what action to take on the proposal. -[102]- See NAqcess Releases, supra note 45. As noted above, limit orders not entered in NAqcess would be provided with market-wide price protection. -[103]- In any event, NAqcess will not address at all the issues of disparate limit order handling practices or hidden limit orders in the exchange markets. -[104]- See Section 240.11Ac1-4(c)(5). ==========================================START OF PAGE 49====== determine the benefits of the limit order display requirement. iii. Liquidity Several commenters assert that application of the Display Rule to Nasdaq securities could reduce liquidity in the Nasdaq market.-[105]- These commenters believe that market maker profits may decline due to narrowed spreads or increased compliance costs, with the result that many firms will decide not to make the necessary capital commitment to continue their market making operations. The commenters conclude that as the number of market makers in a security declines, liquidity will be adversely affected, leading to wider spreads. Moreover, some commenters believe that the decrease in liquidity will impair the capital formation process, especially for securities that are not mature enough for auction trading.-[106]- At least one commenter states that the usefulness of limit orders could be diminished by the refusal of some market makers to accept such orders, or by the imposition of high commission ---------FOOTNOTES---------- -[105]- See, e.g., Alex. Brown Letter; Bear Stearns Letter; Dean Witter Letter; Letter from Robert F. Mercandino, Senior Vice President, Dillon, Read & Co., Inc., to Jonathan G. Katz, Secretary, SEC, dated March 15, 1996 ("Dillon Letter"); Jefferies Letter; Lehman Letter; Letter from Robert J. McCann, Managing Director, Co-Head, Global Equity Markets, Merrill Lynch, Pierce, Fenner & Smith Incorporated, to Jonathan G. Katz, Secretary, SEC, dated January 26, 1996 ("Merrill Letter"); NASD Letter; PaineWebber Letter; Letter from David P. Semak, Vice President Regulation, PSE, to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 ("PSE Letter"); SIA Letter. -[106]- See, e.g., NASD Letter; SIA Letter. ==========================================START OF PAGE 50====== costs charged to recoup lost profits on spreads.-[107]- Other commenters believe, however, that it will be difficult for market makers to increase their commissions for limit orders.-[108]- They believe commission charges would not compensate for lost trading profits or prevent the ebb of market liquidity.-[109]- Other commenters believe the proposed rule will not have a negative impact on market liquidity. One commenter explicitly states that the benefits of the proposed rule would outweigh any potential adverse effects on liquidity.-[110]- Another commenter says that the proposed rule would not result in any significant reduction in market making activity.-[111]- The CSE notes that it has not noticed any negative effects on market liquidity as a result of the implementation of its own limit order display rule.-[112]- Yet another commenter ---------FOOTNOTES---------- -[107]- Letter from David K. Whitcomb, Professor of Finance and Economics, Rutgers University Graduate School of Management, to Secretary, SEC, dated January 12, 1996 ("Whitcomb Letter"). -[108]- See, e.g., Letter from Irving M. Pollack, Alan B. Levenson, and Robert H. Rosenblum, Fulbright & Jaworski L.L.P., on behalf of Herzog, Heine and Geduld, Inc., to Jonathan Katz, Secretary, SEC, dated January 16, 1996 ("HHG Letter"); STA Letter. -[109]- Id. -[110]- Lehman Letter. -[111]- Letter from Daniel G. Weaver, Ph.D., Assistant Professor of Finance, Marquette University, to Jonathan G. Katz, Secretary, SEC, dated January 10, 1996 ("Weaver Letter"). -[112]- CSE Letter. ==========================================START OF PAGE 51====== states that although it currently does not trade OTC securities, it expects that many market participants, including the commenter, would begin trading such securities if the proposed rule was adopted, thereby increasing market liquidity.-[113]- The display of limit orders is designed, among other objectives, to publicize accurate market interest and increase quote competition.-[114]- The Commission understands that certain costs, including a diminution in market maker profits, are associated with this increased market transparency. For example, a market maker that holds a customer limit order has, in effect, a private "option" to execute the order as principal. The longer this "option" remains open, the more time the market maker has to determine whether it can profit from executing the order as principal.-[115]- This private market maker "option," however, is potentially detrimental to the execution opportunities for the limit order. The Display Rule will limit this "option" and expose the order to market-wide trading interest. Moreover, increased price competition from limit ---------FOOTNOTES---------- -[113]- The commenter noted further that it does not currently trade OTC securities because it cannot be sure that its order will be represented to the whole market. Estep Letter. -[114]- See Market 2000 Study, at Study IV. -[115]- The Commission recognizes that there is also a cost associated with holding that limit order, because a market maker is required to execute that limit order if it has engaged in a transaction for its own account that would have satisfied the limit order. See Manning I & II, supra note 24. ==========================================START OF PAGE 52====== orders may reduce market maker profits through the narrowing of spreads.-[116]- As a result, the Display Rule may force less efficient competitors to stop making markets in some of the securities they now quote. Although the rule could lead to a reevaluation by some market makers of the services they wish to provide, after considering the available evidence, and in light of its experience, the Commission does not believe that there will be a significant negative impact on the markets for covered securities. The Commission is not convinced that the loss of some market competitors in securities with many market makers would impair liquidity in these securities.-[117]- The Commission believes that customer orders are the ultimate source of liquidity to the markets, and that adoption of a rule that improves the handling of such orders will have the effect of enhancing market liquidity.-[118]- The Commission ---------FOOTNOTES---------- -[116]- See supra notes 53 - 55 and accompanying text (display of customer limit orders in market maker quotes will act to eliminate certain trading behavior on Nasdaq and foster quote competition). -[117]- See, e.g., STAIC Letter (limit orders are critical to market liquidity). -[118]- The Commission does not thereby denigrate the contribution OTC market makers provide in a dealer market. The Commission notes, however, that most market makers provide primarily intra-day liquidity to customers, and generally seek to end the trading day with a limited inventory position in order to minimize inventory risk. Customer limit orders represent buying or selling interest at specified prices for their stated duration, which may be longer than intra-day. Market makers (continued...) ==========================================START OF PAGE 53====== believes that a limit order display requirement will encourage new limit orders in securities to be entered, thus providing additional liquidity to the market from customers.-[119]- The potential of limit orders to narrow quotes also may encourage the entry of additional market orders.-[120]- The Commission believes that the additional liquidity due to narrower spreads and increased customer orders will outweigh any potential loss of liquidity provided by market makers. As noted above, some commenters expressed concern regarding the effect of the Display Rule on the availability of liquidity to small issuers.-[121]- In response to these comments, the Commission's OEA examined market maker participation in 4,839 ---------FOOTNOTES---------- -[118]-(...continued) holding customer limit orders rely in part on these limit orders in quoting their own prices to buy and sell securities. -[119]- See Greene Study & Greene Study II, supra note 51 (limit orders affect the quoted spread and provide liquidity); NASD Study, supra note 21 (limit orders, like market maker quotes, supply liquidity to the markets); OEA Data, supra notes 50 and 52. -[120]- See NASD Study, supra note 21 (those investors that demand immediate execution, e.g. those entering market orders, will pay less for executions due to the augmented liquidity supplied by limit orders); Greene Study and Greene Study II, supra note 51 (limit orders provide liquidity to traders that demand immediacy of execution and may contribute to reduced trading costs); OEA Data, supra notes 50 and 52 (display of limit orders narrows spreads, improves price discovery, and increases market depth for a variety of securities, including those NYSE securities that are thinly traded). -[121]- This concern also was raised in the context of the ECN Amendment to the Quote Rule. ==========================================START OF PAGE 54====== Nasdaq issuers over a one month period in 1996. The findings indicate that: (1) the median number of market makers in a security is not appreciably lower for initial public offering ("IPO") issuers or for securities with the smallest market capitalization; (2) broker-dealers that participated in IPO underwriting syndicates were active participants in aftermarket trading, but were not alone in providing significant market maker liquidity; and (3) in Nasdaq securities with the smallest market capitalization ($2 million or less), the single most active market maker in an issue typically participated in one-third or fewer trades. Thus, there is no convincing evidence that Nasdaq issuers, including IPO issuers, are dependent for liquidity on any one market maker. The pattern of market making activity indicates that significant liquidity is provided by market makers who are not the "most active" market makers in a security. Because there does not appear to be high concentration in market making, and because of the Commission's belief that customer order flow is a critical source of market liquidity, the Commission believes that the proposals adopted today will not unduly impact liquidity for small or new issuers. Furthermore, Commission experience has been that enhancements to transparency result in improved liquidity.-[122]- The Commission believes that these ---------FOOTNOTES---------- -[122]- In several instances in the past, commenters have claimed that other Commission initiatives to increase transparency would act to reduce liquidity; others have warned that such (continued...) ==========================================START OF PAGE 55====== improvements are attributable, at least in part, to the impact of transparency on market integrity and investor confidence. In addition, while market maker profits per trade may be reduced as spreads are narrowed, increased volume over time may result in stable profit levels.-[123]- ---------FOOTNOTES---------- -[122]-(...continued) initiatives would decrease the competitiveness of the U.S. markets in relation to foreign counterparts. These claims, however, have not been borne out. For example, many industry participants argued that the NASD's adoption of its "Manning" rules would severely impact market liquidity. See Market 2000 Study. However, there has been no evidence offered to the Commission of adverse liquidity consequences caused by these limit order protections, and the Commission is not aware of any significant diminution in liquidity. Further, as discussed in the Market 2000 Study, other transparency initiatives, such as the adoption of real-time transaction and quotation reporting, have resulted in increases in the competitiveness and liquidity of both listed and OTC equity markets despite market maker protestations to the contrary prior to adoption of these initiatives. See Id. at Study IV. See also Simon & Colby, supra note 58. Even the creation of Nasdaq itself was met with much opposition. The result of this major structural change was far from the predicted "death knell" of the OTC market. Rather, OTC market strength and liquidity have flourished since Nasdaq's inception. Based on the Commission's experience with other market structure initiatives, therefore, the Commission believes that improvements in order handling, market transparency, and efficiency will likely improve market liquidity. -[123]- Although the display requirement may decrease a market maker's per trade profit due to narrowed spreads, the Commission believes that this decrease will be made up for in part by expected increases in trading volume attributable to enhanced liquidity and pricing efficiency. See supra note 24. The Commission believes this potential impact on market maker profits is (continued...) ==========================================START OF PAGE 56====== It also may become feasible for market makers to charge customers commissions for handling limit orders, even if that is not the current practice today. As noted earlier, some commenters claim that the Display Rule will have a disparate impact on wholesale Nasdaq market makers in that such market makers would not be able to offset the increased costs associated with limit order display through charges or commissions.-[124]- The Commission believes, however, that the systems costs associated with the Display Rule should not be overly burdensome,-[125]- nor should systems costs or any reduced market maker profitability from declining spreads be more extensive for wholesale market makers than for integrated market makers. Although exchange specialists and integrated firms may find it easier than wholesale firms to charge commissions initially, the Commission notes that wholesale firms ---------FOOTNOTES---------- -[123]-(...continued) justified in light of the benefits that will accrue to investors and the markets as a whole. Moreover, even if market makers' profits from trading do decline, market makers may be able to obtain increased revenues from commissions or other fees charged directly to customers. Because these other revenue sources are more transparent to customers than are revenues from market maker trading with customers on a proprietary basis, increased reliance on these other revenue sources will enable customers to make more informed trading decisions. -[124]- See, e.g., HHG Letter. -[125]- See Memorandum from Stephen L. Williams, S.L. Williams Co. to Richard R. Lindsey, Director, Division of Market Regulation, SEC (July 29, 1996) ("Williams Study"). ==========================================START OF PAGE 57====== are not prohibited from attempting to compensate for handling limit orders, either through negotiated fee arrangements, or reducing any payment made for order flow for limit orders.-[126]- iv. Discretion Several commenters are concerned that the Display Rule would eliminate their discretion to determine the best way in which to ---------FOOTNOTES---------- -[126]- The level of these fees, of course, would be determined by competitive forces in the marketplace. Any fees passed on to non-broker- dealer customers would have to be disclosed in a clear fashion to the customer, and otherwise comply with applicable law. For example, NASD Rule 2440 states, in part, that if a member acts as agent for a customer in a transaction, the customer shall not be charged more than a fair commission or service charge, taking into consideration all relevant circumstances. See also NASD Regulatory & Compliance Alert Vol. 7, No. 4 (December 1993). At least one commenter argued that because spreads are ascertainable from public quotations and commissions are not, a rule that encourages charging commissions does not satisfy the goal of increased transparency. See Letter from Bruce C. Hackett, Managing Director, Salomon Brothers Inc., to Jonathan G. Katz, Secretary, SEC, dated January 25, 1996 ("Salomon Letter"). The Commission notes, however, that Rule 10b-10 under the Exchange Act requires customer confirmations to disclose commissions and, for listed and Nasdaq securities, the difference between the reported price and the price to the customer. Based on this disclosure, execution costs could actually become better known to customers if explicit fees are charged. Therefore, the Commission believes that the Display Rule will allow a customer to more easily monitor the execution quality of its limit orders, even if subject to fees for limit order executions. In addition, this situation should foster competition with respect to the amount, if any, firms will charge for the execution of a customer limit order. ==========================================START OF PAGE 58====== execute a customer's order. The commenters also claim that customers rely on the judgment of a market professional in choosing whether to display a limit order.-[127]- For example, the NYSE believes that its current procedures allow broker-dealers to achieve the best prices for their customers.-[128]- Other commenters suggest that if the rule were amended to require the display of representative size, a dealer would retain some discretion on how best to execute the order.-[129]- To preserve discretion, at least one commenter argues that the rule should apply only when the customer requests that its order be displayed.-[130]- The Commission believes that the rule appropriately establishes a presumption that limit orders should be displayed, unless such orders are of block size, the customer requests that its order not be displayed, or one of the exceptions to the rule ---------FOOTNOTES---------- -[127]- See, e.g., NYSE Letter; RPM Letter; Specialist Assoc. Letter. -[128]- See, e.g., NYSE Letter; Specialist Assoc. Letter. According to the NYSE, a customer can choose to benefit from the display of its order or to benefit from relying on the specialist's discretion, depending on whether the order is sent to the post via SuperDOT, or is manually submitted. The NYSE also notes that enabling a specialist to use discretion in the handling of limit orders is important in light of the fact that the NYSE defines a limit order as an order to buy or sell at a specified price, or at a better price, if obtainable after the order is represented in the trading crowd. See NYSE Rule 13. -[129]- See, e.g., Madoff Letter; NASD Letter; SIA Letter. -[130]- Jefferies Letter. ==========================================START OF PAGE 59====== applies. The exception allowing a customer to request that its limit order not be displayed gives the customer ultimate control in determining whether to trust the display of the limit order to the discretion of a market professional, or to display the order either in full, or in part, to other potential market interest.-[131]- v. Systems Burdens Based on their belief that compliance with the Display Rule would result in a large increase in quotation traffic, a number of commenters maintain that the rule would require major overhauls of the order handling systems used by brokers, market makers and markets. For example, one commenter believes that it would be impossible to comply with the rule without additional automated systems.-[132]- The commenter concludes that the costs associated with new systems and additional staff necessary to monitor a more volatile market would contribute to ---------FOOTNOTES---------- -[131]- See discussion of the exceptions to the Display Rule at section III.A.3.c., infra. See also Section 240.11Ac1-4(c)(2); Section 240.11Ac1- 4(c)(4) (permitting a customer with a block size limit order to request that the order be displayed pursuant to the Display Rule). The Commission does not mean to imply that a specialist or OTC market maker that is not displaying a limit order pursuant to the request of its customer may not change its quotation in that security based on the specialist's or market maker's own trading interest. -[132]- PaineWebber Letter. ==========================================START OF PAGE 60====== wider spreads and higher commissions.-[133]- In addition, one SRO claims that quotation traffic must be kept at manageable levels in order to allow entities to continue to manually process limit orders, thus eliminating the need for entities to bear the costs associated with automation of such orders.-[134]- Other commenters also note their concern over the potential operational costs associated with the rule.-[135]- The STA states that an in-depth review is needed to determine the costs for new equipment and technology necessary to comply with the rule.-[136]- A few commenters are concerned that the increased quotation traffic that may be associated with the rule could pose a threat to the integrity of the central quotation system.-[137]- ---------FOOTNOTES---------- -[133]- Id.; see also Bear Stearns Letter (noting that the display rule would increase the volatility of quotes and, as a result, market makers would have a difficult time keeping up with the rapid changes in bids, offers, and quote sizes). -[134]- PSE Letter. -[135]- See, e.g., Alex. Brown Letter; Bear Stearns Letter; Jefferies Letter. -[136]- STA Letter. -[137]- See, e.g., Letter from Thomas J. Jordan, Financial Information Forum, to Jonathan G. Katz, Secretary, SEC, dated January 12, 1996 ("FIF Letter"); PaineWebber Letter; PSE Letter. This concern was expressed with respect to the proposal that the Commission adopt both the Display Rule and Price Improvement Rule. The fact that the Commission has deferred action on the Price Improvement Rule, as discussed below, should substantially diminish any system capacity concerns. Moreover, the Commission's decision not to require display of de (continued...) ==========================================START OF PAGE 61====== One commenter suggests that the rule be suspended for the first 30 minutes of trading.-[138]- Another commenter argues that modifying the rule to require only the display of representative size could act to alleviate some of the traffic concerns.-[139]- The Commission recognizes that achieving greater transparency for limit orders depends upon the existence of systems that are capable of the smooth and efficient display of trading interest. The Commission believes that the Display Rule will not substantially increase the quotation burden for exchange markets, where systems currently exist for the display of quotes.-[140]- In the OTC market, the Display Rule will result in additional quotation entries for market makers that ---------FOOTNOTES---------- -[137]-(...continued) minimis orders also should minimize system capacity concerns. -[138]- FIF Letter. According to FIF, the heaviest traffic volume usually occurs within the first 30 minutes of trading. -[139]- PSE Letter. The PSE notes, however, that the rule, even if modified, still may result in an increase in staffing costs. Id. -[140]- For example, SuperDOT data indicates that 57% of all customer trades originating from orders routed through SuperDOT are limit orders. Of these limit orders, 20% narrowed the NYSE quote. See supra note 52. According to the NYSE, 93% of such orders are reflected in the NYSE quote within two minutes of receipt. See supra note 36 and accompanying text (teleconference). See also CSE Letter (costs associated with implementing such a system are minimal, especially in light of the benefits to the public); Paperwork Reduction Act discussion at section VII, infra. ==========================================START OF PAGE 62====== display customer limit orders in their quotes. The Commission believes, however, that current systems can handle the additional volume, or can be expanded at moderate cost to handle the additional volume.-[141]- Further, the Commission notes that the Display Rule contains an exception to the display requirement for limit orders of de minimis size priced at the NBBO when the market maker's or specialist's quote matches the NBBO.-[142]- The Display Rule also allows a specialist or OTC market maker several ways to comply with the rule by routing the order elsewhere without displaying the limit order in its own quote by transmitting a customer limit order to an exchange- or association-sponsored system or to a qualifying ECN. Additionally, a few commenters believe that the Commission ---------FOOTNOTES---------- -[141]- The Commission notes that many small to medium broker-dealers utilize shared trading systems that enable such broker-dealers to streamline their OTC market making and back office responsibilities. Subscribers to such systems benefit by sharing costs associated with the application of improved technologies, rather than creating and updating systems of their own. Therefore, it is assumed that any changes deemed necessary to these shared systems to facilitate efficient compliance with the Display Rule also would be shared by all subscribers. In addition, the Commission specifically evaluated the costs associated with implementation of the Display Rule. Based on this evaluation, the Commission concluded that most market makers will not be required to invest substantial amounts of money in systems development in order to comply with the Display Rule as adopted. See Williams Study, supra note 125. See also CSE Letter (costs of implementing a system for display of limit orders are minimal). -[142]- See, Section 240.11Ac1-4(b)(1)(ii). See also Section 240.11Ac1-4(b)(2)(ii). ==========================================START OF PAGE 63====== should give more consideration to the Display Rule's impact on automatic execution systems.-[143]- These commenters express concern that a market maker could be exposed to multiple transactions from its own customers in the firm's automatic execution system, which executes orders at the NBBO, even if the NBBO represents a customer limit order as opposed to the price at which a market maker is willing to trade. They claim this result is unfair, especially if the automatic system has a minimum share requirement that exceeds the customer limit order. The Commission acknowledges the concern of some commenters regarding the rule's interaction with automated execution systems. However, because customer limit orders reflect actual trading interest, it has been the Commission's intention to enhance customer order executions throughout the markets by requiring the display of these customer limit orders.-[144]- Where a limit order represents the best ---------FOOTNOTES---------- -[143]- See, e.g., Dillon Letter; HHG Letter; Merrill Letter; PaineWebber Letter; Schwab Letter. -[144]- The Commission recognizes that SROs may have rules regarding the minimum quotation sizes associated with a specialist's or market maker's quote. The Commission believes that SROs should consider amending such rules and modifying certain systems to allow a specialist or market maker to quote in sizes smaller than the minimum quotation size when such quote represents a customer limit order. With these changes, a specialist or market maker that displays a customer limit order in its quote pursuant to the Display Rule would not be responsible for executing as principal any addition