SECURITIES AND EXCHANGE COMMISSION

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

[Release No. 34-50870; File No. S7-10-04]

RIN 3235-AJ18

REGULATION NMS

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rules and amendments to joint industry plans.

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

DATES: Comments must be received on or before [insert date 30 days after date of publication in the Federal Register]. Given the advanced stage of this rulemaking initiative, the Commission anticipates taking further action as expeditiously as possible after the end of the comment period. It therefore strongly encourages the public to submit their comments within the prescribed comment period. Comments received after that point cannot be assured of full consideration by the Commission.

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

Electronic comments:

• Use the Commission’s Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
   
• Send an e-mail to rule-comments@sec.gov. Please include File Number S7-10-04 on the subject line; or
   
• Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper comments:

• Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609.

All submissions should refer to File Number S7-10-04. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments also are available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Trade-Through Rule: Heather Seidel, Attorney Fellow, at (202) 942-0788, Jennifer Colihan, Special Counsel, at (202) 942-0735, David Hsu, Special Counsel, at (202) 942-0731, or Raymond Lombardo, Attorney, at (202) 942-8080; Access Rule: Heather Seidel, Attorney Fellow, at (202) 942-0788, or David Liu, Attorney, at (202) 942-8085; Sub-Penny Rule: Michael Gaw, Senior Special Counsel, at (202) 942-0158, or Ronesha Butler, Special Counsel, at (202) 942-0791; Market Data Rules, Allocation Amendment, and Governance Amendment: Sapna C. Patel, Special Counsel, at (202) 942-0166, or David Hsu, Special Counsel, at (202) 942-0731; Regulation NMS: Yvonne Fraticelli, Special Counsel, at (202) 942-0197; all of whom are in the Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

1. Introduction
    
1. Need for Modernization of the NMS
    
2. Objectives for Future NMS
    
3. Overview of Reproposed Rules
    
1. Trade-Through Rule
    
2. Access Rule
    
3. Sub-Penny Rule
    
4. Market Data Rules and Plans
    
2. Trade-Through Rule
    
1. Response to Comments and Basis for Reproposed Rule
    
1. Need for Intermarket Trade-Through Rule
    
2. Limiting Protection to Automated and Accessible Quotations
    
3. Workable Implementation of Intermarket Trade-Through Protection
    
4. Elimination of Proposed Opt-Out Exception
    
5. Scope of Protected Quotations – Market BBO Alternative and Voluntary Depth Alternative
    
6. Benefits and Implementation Costs of Trade-Through Rule
    
2. Description of Reproposed Rule
    
1. Scope of Rule
    
2. Requirement of Reasonable Policies and Procedures
    
3. Exceptions
    
4. Duty of Best Execution
    
3. Access Rule
    
1. Response to Comments and Basis for Reproposed Rule
    
1. Access to Quotations
    
2. Limitation on Access Fees
    
3. Locking or Crossing Quotations
    
2. Description of Reproposed Rule
    
1. Access to Quotations
    
2. Limitation on Access Fees
    
3. Locking or Crossing Quotations
    
4. Regulation ATS Fair Access
    
4. Sub-Penny Rule
    
1. Background
    
2. Commission Proposal on Sub-Penny Quoting
    
3. Comments Received
    
1. Comments Addressing Overall Proposal
    
2. Response to Other Comments
    
4. Exemptive Authority
    
5. Market Data Rules and Plan Amendments
    
1. Response to Comments and Basis for Reproposed Rules
    
1. Alternative Data Dissemination Models
    
2. Level of Fees and Plan Governance
    
3. Revenue Allocation Formula
    
4. Distribution and Display of Data
    
2. Description of Reproposed Rules and Amendments
    
1. Allocation Amendment
    
2. Governance Amendment
    
3. Consolidation, Distribution, and Display of Data
    
6. Regulation NMS
    
7. General Request for Comment
    
8. Paperwork Reduction Act
    
9. Consideration of Costs and Benefits
    
10. Consideration of Burden on Competition, and Promotion of Efficiency, Competition and Capital Formation
     
11. Consideration of Impact on the Economy
     
12. Regulatory Flexibility Act
     
13. Statutory Authority
     
14. Text of Reproposed Amendments to the CTA Plan, the CQ Plan, and the Nasdaq UTP Plan
     
15. Text of Reproposed Rules

I. Introduction

The Commission is reproposing Regulation NMS, a series of initiatives designed to modernize and strengthen the national market system ("NMS") for equity securities.¹ These initiatives include:

(1) a new Trade-Through Rule, which would establish for all NMS stocks the fundamental principle of price priority for automated quotations that are immediately accessible;

(2) a new Access Rule, which would promote fair and non-discriminatory access to quotations displayed by NMS trading centers through a private linkage approach;

(3) a new Sub-Penny Rule, which would establish a uniform quoting increment of no less than one penny for quotations in NMS stocks equal to or greater than $1.00 per share to promote greater price transparency and consistency;

(4) amendments to the Market Data Rules and joint industry plans that would allocate plan revenues to self-regulatory organizations ("SROs") for their contributions to public price discovery and promote wider and more efficient distribution of market data; and

(5) a reorganization of existing Exchange Act rules governing the NMS to promote greater clarity and understanding of the rules.

The NMS encompasses the stocks of more than 5000 listed companies, which collectively represent more than $14 trillion in U.S. market capitalization. NMS stocks are traded simultaneously at a variety of different venues, including national securities exchanges, alternative trading systems ("ATSs"), and market-making securities dealers. Fair and efficient trading of NMS stocks is essential if the equity markets are to meet the long-term investment needs of the public and to reduce the cost of capital for listed companies. Section 11A of the Exchange Act charges the Commission with facilitating the establishment of an NMS that links multiple trading centers into a unified system that promotes the fairest and most efficient equity markets possible. The reproposed rules are intended to assure that the NMS remains up to date and continues to serve the interests of investors, listed companies, and the public.

A. Need for Modernization of the NMS

The reproposed rules would implement a major overhaul of the existing structure of the NMS, much of which was originally designed in the 1970s and 1980s. This overhaul is necessary to respond to sweeping changes that have reshaped the equity markets in recent years. First, communications and trading technologies have greatly expanded the available options for routing and executing orders in NMS stocks. Establishing connectivity among all types of securities industry participants has become both less costly and more flexible. Order-routing systems can be programmed to monitor prices at multiple trading centers, assess the most effective trading strategy to meet the needs of a particular customer, and instantaneously route orders to one or more trading centers to implement that strategy. Trading centers, in turn, are able to offer a near instantaneous response to incoming orders seeking to access automated quotations.

Another significant change has been the intensified competition among different types of markets that simultaneously trade many of the same NMS stocks, regardless of the particular market where the stocks are listed. These include (1) traditional exchanges with active trading floors, which even now are evolving to expand the range of choices that they offer investors for both automated and manual trading; (2) purely electronic markets, which offer both standard limit orders and conditional orders that are designed to facilitate complex trading strategies; (3) market-making securities dealers, which offer both automated execution of smaller orders and the commitment of capital to facilitate the execution of larger, institutional orders; (4) regional exchanges, many of which have adopted automated systems for executing smaller orders; and (5) automated matching systems that permit investors, particularly large institutions, to seek counter-parties to their trades with minimal publicity and price impact.

Finally, the initiation of trading in penny increments in 2001 transformed the equity markets. The number of quotation updates increased, and the quoted size at any particular price level dropped. The change clearly has benefited many investors, particularly retail investors that typically use smaller orders. Reducing the standard trading increment from 1/16ths to pennies allowed effective spreads to narrow for small orders.² As a result, the trading costs of small orders have dropped dramatically.³

For institutional investors that generally need to trade in large sizes, however, the results of decimal trading have been less clear cut. The primary component of trading costs for large orders is price impact – the change in stock price caused by the difficulty of executing large orders to buy (with rising prices) or to sell (with declining prices).⁴ The price impact for large orders, which generally will be many times the effective spread for small orders in the same stock, is largely determined by market depth and liquidity. The greater the depth and liquidity, the less the price impact of large orders. Given that millions of individuals invest in NMS stocks indirectly through these institutions, it is vitally important for the NMS to promote depth and liquidity for the trading of large orders.

To respond to all of these changes, the Commission has undertaken a deliberate and systematic review of market structure. We actively have sought out the views of the public and securities industry participants. Even prior to formulating proposals, our review included multiple public hearings and roundtables, an advisory committee, three concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives, and a constant dialogue with industry participants and investors. This process continued after the proposals were published for public comment.⁵ We held a public hearing on the proposals in April 2004 ("NMS Hearing").⁶ To give the public an opportunity to respond to important developments at the hearing, we published a supplemental request for comment and extended the comment period on the proposals.⁷ The public submitted more than 700 comment letters that encompassed a wide range of views. On one point, however, commenters agreed – the time has come to modernize the NMS.

The Commission believes that the insights of the commenters, as well as those of the NMS Hearing panelists, have contributed to significant improvements in the original proposals. Responding appropriately to these comments has caused the reproposed rules to differ in some respects from the rule text as originally proposed. As discussed extensively below, all of the changes address issues that were raised in the Proposing Release and Supplemental Release and that prompted substantial public comment. Rather than adopt rules at this point, however, the Commission is implementing a reproposal process to afford the public an additional opportunity to review and comment on the details of the rules. Given the advanced stage of rulemaking, it anticipates taking further action as expeditiously as possible after the end of the comment period. The Commission therefore strongly encourages the public to submit their comments within the comment period. Comments received after that point cannot be assured of full consideration by the Commission. In its evaluation of further rulemaking action, the Commission will consider, in addition to the comments received in response to this release, all comments received on the Proposing Release and Supplemental Release.

B. Objectives for Future NMS

The reproposed rules are designed to strengthen the NMS in three primary ways. First, they would update antiquated rules that no longer adequately serve the purposes for which they were adopted. Second, they would help level the competitive playing field by promoting equal regulation of different types of stocks and markets. Third, they would promote greater order interaction and displayed depth, of particular value for the large orders of institutional investors.

Taken together, the Commission believes the reproposed rules would significantly improve the fairness and efficiency of the NMS in the future. The NMS is premised on promoting fair competition among markets, while at the same time assuring that all of these markets are linked together, through facilities and rules, in a unified system that promotes interaction among the orders of buyers and sellers in a particular NMS stock. The NMS thereby incorporates two distinct types of competition – competition among individual markets and competition among individual orders – that together contribute to efficient markets. Vigorous competition among markets promotes more efficient and innovative trading services, while integrated competition among orders promotes more efficient pricing of individual stocks. Together, they produce markets that offer signal benefits for investors and listed companies.

The Commission has sought to avoid the extremes of (1) isolated markets that trade an NMS stock without regard to trading in other markets and thereby fragment the competition among buyers and sellers in that stock, and (2) a totally centralized system that loses the benefits of vigorous competition and innovation among individual markets. To achieve the appropriate degree of integration, the Commission primarily has relied on two tools. First, consolidated display of market data promotes transparency of the best prices for an NMS stock. Second, intermarket "rules of the road" establish a framework within which competition among individual markets can flourish on terms that ultimately benefit investors. The reproposed rules would continue this strategy. They are designed to strengthen and enhance the efficiency of linkages among the various competing markets, but without mandating any particular type of trading model. Investor choice and competition will determine the relative success or failure of the various competing markets.

Some have suggested that the Commission should move away from the fundamental NMS concept of promoting both competition among markets and competition among the buyers and sellers in a stock. They believe that, instead, markets should be allowed to trade in isolation from one another. This approach, of course, was in effect until 1975 when Congress directed the Commission to facilitate the establishment of an NMS. After fully considering the matter, Congress specifically found that linking the individual markets would "foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors' orders, and contribute to the best execution of such orders."⁸ The wisdom of this congressional finding has been proven by thirty years of practical experience. The NMS needs to be enhanced and modernized, not because it has failed investors, but because it has been so successful in promoting growth, efficiency, innovation, and competition that many of its old rules now are outdated. Since the NMS was created nearly thirty years ago, trading volume has exploded, competition among market centers has intensified, and investor trading costs have shrunk dramatically. The Commission preliminarily believes that the reproposed rules would contribute to further growth and efficiency in the NMS and thereby serve the interests of investors, listed companies, and the public in the future.

C. Overview of Reproposed Rules

1. Trade-Through Rule

The Trade-Through Rule (reproposed Rule 611 under Regulation NMS)⁹ would establish intermarket protection against trade-throughs for all NMS stocks. A trade-through occurs when one trading center executes an order at a price that is inferior to the price of a protected quotation, often representing an investor limit order, displayed by another trading center.¹⁰ Many commenters on the proposals, particularly large institutional investors, strongly supported the need for enhanced protection of limit orders against trade-throughs.¹¹ They emphasized that limit orders are the building blocks of public price discovery and efficient markets. They stated that a uniform rule for all NMS stocks, by enhancing protection of displayed prices, would encourage greater use of limit orders and contribute to increased market liquidity and depth. The Commission preliminarily agrees that strengthened protection of displayed limit orders would help reward market participants for displaying their trading interest and thereby promote fairer and more vigorous competition among orders seeking to supply liquidity. It therefore has decided to repropose Rule 611 to strengthen the protection of displayed and automatically accessible quotations in NMS stocks. As discussed below, today we are proposing two alternatives that would each further this goal, and we are seeking public comment on which alternative is likely best to advance the principle of limit order protection while preserving intermarket competition and avoiding practical implementation problems.

As with the original proposal, the reproposed Trade-Through Rule would take a substantially different approach than the trade-through provisions currently set forth in the Intermarket Trading System ("ITS") Plan,¹² which apply only to exchange-listed stocks. The ITS provisions are not promulgated by the Commission, but rather are rules of the markets participating in the ITS Plan. These rules were drafted decades ago and do not distinguish between manual and automated quotations. Moreover, they state that markets "should avoid" trade-throughs and require an after-the-fact complaint procedure pursuant to which, if a trade-through occurs, the aggrieved market may seek satisfaction from the market that traded through. Finally, the ITS provisions have significant gaps in their coverage, particularly for large, block transactions (10,000 shares or greater), that have seriously weakened their protection of limit orders.

In contrast, the reproposed Trade-Through Rule would only protect quotations that are immediately accessible through automatic execution. It thereby would address a serious weakness in the ITS provisions, which were drafted for a world of floor-based markets and fail to reflect the disparate speed of response between manual and automated quotations. By requiring order routers to wait for a response from a manual market, the ITS trade-through provisions can cause an order to miss both the best price of a manual quotation and slightly inferior prices at automated markets that would have been immediately accessible. The Trade-Through Rule would eliminate this potential inefficiency by protecting only automated quotations. It also would promote equal regulation and fair competition among markets by eliminating any potential advantage that the ITS trade-through provisions may have given manual markets over automated markets.

In addition, the reproposed Trade-Through Rule incorporates an approach to trade-throughs that is stricter and more comprehensive than the ITS provisions. First, it would require trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs, or, if relying on one of the rule's exceptions, that are reasonably designed to assure compliance with the exception. To assure effective compliance, such policies and procedures would need to incorporate objective standards that were coded into a trading center's automated systems. Moreover, a trading center would be required to regularly surveil to ascertain the effectiveness of its policies and procedures and to take prompt action to remedy deficiencies. Second, the Trade-Through Rule would eliminate very significant gaps in the coverage of the ITS provisions that have undermined the extent to which they protect limit orders and promote fair and orderly trading. In particular, the ITS provisions do not cover the large transactions of broker-dealers acting as block positioners in exchange-listed stocks. They also exclude trade-throughs of 100-share quotations, thereby allowing the limit orders of small investors to be bypassed. The Trade-Through Rule would close both of these gaps in coverage.

With respect to the scope of quotations to be protected, the Commission is proposing two alternatives, one of which would represent a more fundamental departure from the existing ITS provisions by potentially extending limit-order protection beyond the best limit orders on a market’s book. The definition of "protected bid" or "protected offer" in paragraph (b)(57) of reproposed Rule 600 controls the scope of quotations that would be protected by the Trade-Through Rule. The first alternative ("Market BBO Alternative") would protect only the best bids and offers ("BBOs") of the nine self-regulatory organizations ("SROs") and The Nasdaq Stock Market, Inc. ("Nasdaq") whose members currently trade NMS stocks. The scope of quotations covered by this alternative is comparable to the ITS provisions. The second alternative ("Voluntary Depth Alternative") also would protect the BBOs of the various SROs and Nasdaq, but would establish a mechanism for a market voluntarily to secure protection for its depth-of-book quotations at prices below its best bid or above its best offer. These alternatives are discussed in more detail in section II.A.5 below.

The rule text of the original proposal included a general "opt-out" exception that would have allowed market participants to disregard displayed quotations. Such an exception would have left a significant gap in protection of the best displayed prices and thereby severely reduced the proposal's potential benefits. The elimination of any protection for manual quotations is the principal reason that this broad exception is no longer necessary in the Trade-Through Rule as reproposed. In addition, the Rule adds a number of tailored exceptions that carve out those situations in which many investors may otherwise have felt they legitimately needed to opt-out of a displayed quotation. These exceptions are more consistent with the principle of protecting the best price than a general opt-out exception. The additional exceptions also would help assure that the Trade-Through Rule is workable for high-volume stocks. Examples of these exceptions include intermarket sweep orders, quotations displayed by markets that fail to meet the response requirements for automated quotations, and flickering quotations with multiple prices displayed in a single second.¹³

Some commenters questioned the need to extend a trade-through rule to Nasdaq stocks.¹⁴ These commenters generally emphasized the much improved efficiency of trading in Nasdaq stocks in recent years. They particularly were concerned that extension of intermarket price protection to Nasdaq stocks, at least in the absence of a general opt-out exception, would interfere with current trading methods.

The Commission preliminarily believes, however, that intermarket price protection would benefit investors and strengthen the NMS in all NMS stocks. It would contribute to the maintenance of fair and orderly markets and, thereby, promote investor confidence in the markets. As discussed below,¹⁵ trade-through rates currently are significant in both Nasdaq and exchange-listed stocks. For example, approximately 1 of every 40 trades in both Nasdaq and NYSE stocks represents a significant trade-through of a displayed quotation. For hundreds of active Nasdaq stocks, approximately 1 of every 11 shares traded is a significant trade-through. The routine execution of trades at prices inferior to those offered by displayed and accessible limit orders is inconsistent with basic notions of fairness and orderliness, particularly for investors, both large and small, who post limit orders and see those orders routinely traded through. These trade-throughs can undermine incentives to display limit orders. Moreover, many of the investors whose market orders are executed at inferior prices may not, in fact, be aware they received an inferior price from their broker and executing market. In sum, the Commission preliminarily believes that a uniform rule establishing price protection on an order-by-order basis is needed to protect the interests of investors, promote the display of limit orders, and thereby improve the efficiency of the NMS as a whole.

2. Access Rule

The Access Rule (reproposed Rule 610 under Regulation NMS) would set forth new standards governing access to quotations in NMS stocks. As emphasized by many commenters on the proposals,¹⁶ protecting the best displayed prices against trade-throughs would be futile if broker-dealers and trading centers were unable to access those prices fairly and efficiently. Accordingly, Rule 610 is designed to promote access to quotations in three ways. First, it would enable the use of private linkages offered by a variety of connectivity providers,¹⁷ rather than mandating a collective linkage facility such as ITS, to facilitate the necessary access to quotations. The lower cost and increased flexibility of connectivity in recent years has made private linkages a feasible alternative to hard linkages, absent barriers to access. Using private linkages, market participants may obtain indirect access to quotations displayed by a particular trading center through the members, subscribers, or customers of that trading center. To promote this type of indirect access, Rule 610 would prohibit a trading center from imposing unfairly discriminatory terms that would prevent or inhibit the access of any person through members, subscribers, or customers of such trading center.

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

The reproposed fee limitation substantially simplifies the proposed limitation on fees, which, in general, would have limited the fees of individual market participants to $0.001 per share, with an accumulated cap of $0.002 per share. Perhaps more than any other single issue, the proposed limitation on access fees splintered the commenters.¹⁸ Some supported the proposal as a worthwhile compromise on an extremely difficult issue. They believed that it would level the playing field in terms of who could charge fees, as well as give greater certainty to market participants that quoted prices will, essentially, be true prices. Others were strongly opposed to any limitation on fees, believing that competition alone would be sufficient to address high fees that distort quoted prices. Still others were equally adamant that all access fees of electronic communications networks ("ECNs") charged to non-subscribers should be prohibited entirely, although they did not see a problem with fees charged to a market's members or subscribers. Although consensus could not be achieved on any particular approach, commenters expressed a strong desire for resolution of a difficult issue that has caused discord within the securities industry for many years.

The Commission preliminarily believes that a single, uniform fee limitation of $0.003 per share would be the fairest and most appropriate resolution of the access fee issue. First, it would not seriously interfere with current business practices, as trading centers have very few fees on their books of more than $0.003 per share or earn substantial revenues from such fees.¹⁹ Second, the uniform fee limitation would promote equal regulation of different types of trading centers, where previously some had been permitted to charge fees and some had not. Finally and most importantly, the fee limitation of Rule 610 would be necessary to support the integrity of the price protection requirement established by the reproposed Trade-Through Rule. In the absence of a fee limitation, some "outlier" trading centers might take advantage of the requirement to protect displayed quotations by charging exorbitant fees to those required to access the outlier's quotations. Rule 610's fee limitation would preclude the initiation of this business practice, which would compromise the fairness and efficiency of the NMS.

Finally, reproposed Rule 610 would require SROs to establish and enforce rules that, among other things, prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross the automated quotations of other trading centers. Trading centers would be allowed, however, to display automated quotations that lock or cross the manual quotations of other trading centers. The reproposed rule thereby would reflect the disparity in speed of response between automated and manual quotations, while also promoting fair and orderly markets by establishing that the first automated quotation at a price, whether it be a bid or an offer, is entitled to an execution at that price instead of being locked or crossed by a quotation on the other side of the market.

3. Sub-Penny Rule

The Sub-Penny Rule (reproposed Rule 612 under Regulation NMS) would prohibit market participants from displaying, ranking, or accepting quotations in NMS stocks that are priced in an increment of less than $0.01, unless the price of the quotation is less than $1.00. If the price of the quotation is less than $1.00, the minimum increment would be $0.0001. A strong consensus of commenters supported the sub-penny proposal as a means to promote greater price transparency and consistency, as well as to protect displayed limit orders.²⁰ In particular, Rule 612 would address the practice of "stepping ahead" of displayed limit orders by trivial amounts. It therefore should further encourage the display of limit orders and improve the depth and liquidity of trading in NMS stocks.

4. Market Data Rules and Plans

The reproposed amendments to the Market Data Rules (reproposed Rules 601 and 603 under Regulation NMS) and joint industry plans ("Plans")²¹ are designed to promote the wide availability of market data and to allocate revenues to SROs that produce the most useful data for investors. They would strengthen the existing market data system, which provides investors in the U.S. equity markets with real-time access to the best quotations and most recent trades in the thousands of NMS stocks throughout the trading day. For each stock, quotations and trades are continuously collected from many different trading centers and then disseminated to the public in a consolidated stream of data. As a result, investors of all types have access to a reliable source of information for the best prices in NMS stocks. When Congress mandated the creation of the NMS in 1975, it noted that the systems for disseminating consolidated market data would "form the heart of the national market system."²² Accordingly, one of the Commission's most important responsibilities is to preserve the integrity and affordability of the consolidated data stream.

The reproposed amendments would promote this objective in several different respects. First, they would update the formulas for allocating revenues generated by market data fees to the various SRO participants in the Plans. The current Plan formulas are seriously flawed by an excessive focus on the number of trades, no matter how small the size, reported by an SRO. They thereby create an incentive for distortive behavior, such as wash sales and trade shredding,²³ and fail to reflect an SRO's contribution to the best displayed quotations in NMS stocks. The reproposed formula would correct these flaws. It also is much less complex than the proposal, primarily because, consistent with the approach of the Trade-Through Rule and Access Rule, the new formula would eliminate any reward for manual quotations. It therefore should promote an allocation of revenues to the various SROs that more closely reflects the usefulness to investors of each SRO's market information.

The reproposed amendments also are intended to improve the transparency and effective operation of the Plans by broadening participation in Plan governance. They would require the creation of advisory committees composed of non-SRO representatives. Such committees would give interested parties an opportunity to be heard on Plan business, prior to any decision by the Plan operating committees. Finally, the amendments would promote the wide availability of market data by authorizing markets to distribute their own data independently (while still providing their best quotations and trades for consolidated dissemination through the Plans) and streamlining outdated requirements for the display of market data to investors.

Many commenters on the market data proposals expressed frustration with the current operation of the Plans.²⁴ These commenters generally fell into two groups. One group, primarily made up of individual markets that receive market data fees, believed that the current model of consolidation should be discarded in favor of a new model, such as a "multiple consolidator" model under which each SRO would sell its own data separately. The other group, primarily made up of securities industry participants that pay market data fees, believed that the current level of fees is too high. This group asserted that, prior to modifying the allocation of market data revenues, the Commission should address the level of fees that generated those revenues. ²⁵

The Commission has considered these concerns at length in the recent past. As was noted in the Proposing Release,²⁶ a drawback of the current market data model, which requires all SROs to participate jointly in disseminating data through a single consolidator, is that it affords little opportunity for market forces to determine the overall level of fees or the allocation of those fees to the individual SROs. Prior to publishing the proposals, therefore, the Commission undertook an extended review of the various alternatives for disseminating market data to the public in an effort to identify a better model. These alternatives were discussed at length in the Proposing Release, but each has serious weaknesses. The Commission particularly is concerned that the integrity and reliability of the consolidated data stream must not be compromised by any changes to the market data structure.

For example, although allowing each SRO to sell its data separately to multiple consolidators may appear at first glance to subject the level of fees to competitive forces, this conclusion does not withstand closer scrutiny. If the benefits of a fully consolidated data stream are to be preserved, each consolidator would need to purchase the data of each SRO to assure that the consolidator's data stream in fact included the best quotations and most recent trade report in an NMS stock. Payment of every SRO's fees would effectively be mandatory, thereby affording little room for competitive forces to influence the level of fees.

The Commission also has considered the suggestion of many in the second group of commenters that market data fees should be cut back to encompass only the costs of the Plans to collect and disseminate market data. Under this approach, the individual SROs would no longer be allowed to fund any portion of their operational and regulatory functions through market data fees.²⁷ Yet, as discussed in the Commission's 1999 concept release on market data,²⁸ nearly the entire burden of collecting and producing market data is borne by the individual markets, not by the Plans. If, for example, an SRO's systems fail on a high-volume trading day and it can no longer provide its data to the Plans, investors will suffer the consequences of a flawed data stream, regardless of whether the Plan is able to continue operating.

If the Commission were to limit market data fees to cover only Plan costs, SRO funding would have been cut by $386 million in 2003.²⁹ Given the potential harm if vital SRO functions are not adequately funded, the Commission believes that the level of market data fees is most appropriately addressed in a context that looks at SRO funding as a whole. It therefore has requested comment on this issue in its recent concept release on SRO structure.³⁰ In addition, the recently proposed rules to improve SRO transparency would, if adopted, assist the public in assessing the level and use of market data fees by the various SROs.³¹

In sum, there is inherent tension between assuring price transparency for investors, which is a fundamental objective of the Exchange Act,³² and expanding the extent to which market forces determine market data fees and SRO revenues. Each alternative model for data dissemination has its particular strengths and weaknesses. The great strength of the current model, however, is that it benefits investors, particularly retail investors, by helping them to assess quoted prices at the time they place an order and to evaluate the best execution of their orders against such prices by obtaining data from a single source that is highly reliable and comprehensive. In the absence of full confidence that this benefit would be retained if a different model were adopted, the Commission has decided to repropose such immediate steps as are necessary to improve the operation of the current model.

II. Trade-Through Rule

The Commission is reproposing Rule 611 under Regulation NMS to establish protection against trade-throughs for all NMS stocks. Rule 611(a)(1) would require a trading center (which includes national securities exchanges, exchange specialists, ATSs, OTC market makers, and block positioners)³³ to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs of protected quotations and, if relying on an exception, that are reasonably designed to assure compliance with the terms of the exception. Rule 611(a)(2) would require a trading center to regularly surveil to ascertain the effectiveness of its policies and procedures and to take prompt action to remedy deficiencies in such policies and procedures. To qualify for protection, a quotation must be automated. Rule 600(b)(3) would define an automated quotation as one that, among other things, is displayed and immediately accessible through automatic execution. Rule 611 would not require market participants to route orders to access any manual quotations, which generally entail a much slower speed of response than automated quotations.

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

By strengthening price protection in the NMS for quotations that can be accessed fairly and efficiently, reproposed Rule 611 is designed to further the interests of both investors who submit displayed limit orders and investors who submit marketable orders.³⁴ Price protection encourages the display of limit orders by increasing the likelihood that they will receive an execution in a timely manner. Limit orders typically establish the best prices for an NMS stock. Greater use of limit orders would increase market depth and liquidity, thereby improving the quality of execution for the large market orders of institutional investors. Moreover, strong intermarket price protection would offer greater assurance, on an order-by-order basis, to investors who submit market orders that their orders in fact will be executed at the best prices, which can be difficult for investors, particularly retail investors, to monitor.³⁵ Finally, market orders would need to be routed only to quotations that are truly accessible.

A. Response to Comments and Basis for Reproposed Rule

Rule 611 as reproposed reflects a number of changes to the rule as proposed. As discussed below, the Commission made these changes in response to substantial public comment on the proposed rule and on the issues arising out of the NMS Hearing that were addressed in the Supplemental Release. The public submitted more than 700 comments addressing the trade-through proposal.³⁶ Although the comments covered a very wide range of matters, they particularly focused on the following issues:

(1) whether an intermarket trade-through rule is needed to promote fair and efficient equity markets, particularly for Nasdaq stocks which have not been subject to the current ITS trade-through provisions;

(2) whether only automated and immediately accessible quotations should be given trade-through protection and, if so, what is the best approach for defining such quotations;

(3) whether intermarket protection against trade-throughs can be implemented in a workable manner, particularly for high-volume stocks;

(4) whether the proposed exception allowing a general opt-out of protected quotations is necessary or appropriate, particularly if manual quotations are excluded from trade-through protection;

(5) whether the scope of quotations entitled to trade-through protection should extend beyond the best bids and offers of the various markets; and

(6) whether the benefits of an intermarket trade-through rule would justify its cost of implementation.

In the following sections, the Commission responds to comments on the trade-through proposal and discusses the basis for its reproposal of Rule 611.

1. Need for Intermarket Trade-Through Rule

Commenters were divided on the central issue of whether intermarket protection of displayed quotations is needed to promote the fairest and most efficient markets for investors.³⁷ Many commenters strongly supported the adoption of a uniform rule for all NMS stocks as necessary to protect the best displayed prices and encourage the public display of limit orders.³⁸ They stressed that limit orders are the cornerstone of efficient, liquid markets and should be afforded as much protection as possible. They noted, for example, that limit orders typically establish the "market" for a stock. In the absence of limit orders setting the current market price, there would be no benchmark for the submission and execution of marketable orders. Focusing solely on best execution of marketable orders (and the interests of orders that take displayed liquidity), therefore, would miss a critical part of the equation for promoting the most efficient markets (i.e., the best execution of orders that supply displayed liquidity and thereby provide public price discovery). Commenters supporting the need for an intermarket trade-through rule also believed that a trade-through rule would increase investor confidence by helping to eliminate the impression of unfairness when an investor's order executes at a price that is worse than the best displayed quotation, or when a trade occurs at a price that is inferior to the investor's displayed order.³⁹

Other commenters, in contrast, opposed any intermarket trade-through rule.⁴⁰ These commenters did not believe that such a rule is necessary to promote the protection of limit orders, the best execution of market orders, or efficient markets in general. They asserted that, given public availability of each market's quotations and ready access by all market participants to such quotations, competition among markets, a broker’s existing duty of best execution, and economic self-interest would be sufficient to protect limit orders and produce the most fair and efficient markets. They therefore believed that any trade-through rule would be unnecessary and costly. These commenters also were concerned that any trade-through rule could interfere with the ability of competitive forces to produce efficient markets, particularly for Nasdaq stocks.

Commenters opposed to any trade-through rule also generally cited a lack of empirical evidence justifying the need for intermarket protection against trade-throughs. They noted, for example, that trading in Nasdaq stocks has never been subject to an intermarket trade-through rule, while trading in exchange-listed stocks, particularly NYSE stocks, has been subject to the ITS trade-through provisions. Given the difference in regulatory requirements between Nasdaq and NYSE stocks, many commenters relied on two factual contentions to show that a trade-through rule is not needed: (1) trading in Nasdaq stocks currently is more efficient than trading in NYSE stocks;⁴¹ and (2) fewer trade-throughs occur in Nasdaq stocks than NYSE stocks.⁴² Based on these factual contentions, opposing commenters concluded that a trade-through rule is not necessary to promote efficiency or to protect the best displayed prices.

A few commenters submitted empirical data to support the claim that trading in Nasdaq stocks is more efficient than trading in NYSE stocks.⁴³ Specifically, they submitted tables asserting that effective spreads in Nasdaq stocks in the S&P 500 are significantly narrower than effective spreads in NYSE stocks in the S&P 500.⁴⁴ To help assess and respond to the views of commenters on market efficiency, the Commission staff analyzed Rule 11Ac1-5 reports and other trading data to evaluate the markets for Nasdaq and NYSE stocks.⁴⁵ The staff studies indicate that the execution quality statistics submitted by commenters are flawed. The claimed large and systematic disparities between Nasdaq and NYSE effective spreads disappear when an analysis of execution quality more appropriately controls for differences in stocks, order types, and order sizes.⁴⁶ The staff studies reveal that both the market for Nasdaq stocks and the market for NYSE stocks have significant strengths. But, as discussed below, both markets also have weaknesses that could be reduced by strengthened protection against trade-throughs.

First, the effective spread analyses submitted by commenters do not, in a number of respects, reflect appropriately the comparative trading costs in Nasdaq and NYSE stocks.⁴⁷ They were presented in terms of "cents-per-share" and therefore failed to control for the varying level of stock prices between Nasdaq stocks and NYSE stocks in the S&P 500. Lower priced stocks naturally will tend to have lower spreads in terms of cents-per-share than higher priced stocks, even when such cents-per-share spreads constitute a larger percentage of stock price and therefore represent trading costs for investors that consume a larger percentage of their investment. By using cents-per-share statistics, commenters did not adjust for the fact that the average prices of Nasdaq stocks are significantly lower than the average prices of NYSE stocks. For example, the average price of Nasdaq stocks in the S&P 500 in January 2004 was $34.14, while the average price of NYSE stocks was $41.32.⁴⁸

The effective spread analyses submitted by commenters also were weakened by their failure to address the much lower fill rates of orders in Nasdaq stocks than orders in NYSE stocks. The commenters submitted "blended" statistics that encompassed both market orders and marketable limit orders. The effective spread statistics for these order types are not comparable, however, because market orders do not have a limit price that precludes their execution at prices inferior to the prevailing market price at time of order receipt. In contrast, the limit price of marketable limit orders often precludes an execution, particularly when there is a lack of liquidity and depth at the prevailing market price. For example, the fill rates for marketable limit orders in Nasdaq stocks generally are less than 75%, and often fall below 50% for larger order sizes.⁴⁹

Accordingly, investors must accept trade-offs when deciding whether to submit market orders or marketable limit orders (particularly when the limit price equals or is very close to the current market price). Use of a limit price generally assures a narrower spread by precluding an execution an inferior price. By precluding an execution, however, the limit price may cause the investor to "miss the market" if prices move away (for example, if prices rise when an investor is attempting to buy). Effective spreads for marketable limit orders therefore represent trading costs that are conditional on execution, while effective spreads for market orders much more completely reflect the entire trading cost for a particular order. Market orders represent only approximately 14% of the blended flow of market and marketable limit orders in Nasdaq stocks (reflecting the fact that ECNs now dominate Nasdaq order flow and limit orders represent the vast majority of ECN order flow).⁵⁰ In contrast, market orders represent approximately 36% of the blended order flow in NYSE stocks.⁵¹ Accordingly, the effective spread statistics for marketable limit orders, and particularly for orders in Nasdaq stocks, must be considered in conjunction with the fill rate for such orders – a narrow spread is good, but the benefits are greatly limited if investors are unable to obtain an execution at that spread. The analyses presented by the commenters, however, did not address the respective fill rates for Nasdaq stocks and NYSE stocks or reflect the inherent differences in measuring the trading costs of market orders and marketable limit orders.

The analyses prepared by Commission staff are designed to provide appropriate evaluations of comments on the efficiency of trading in Nasdaq and NYSE stocks. In particular, they are more finely tuned to evaluate trading for different types of stocks with varying trading volume, different types of orders, and different sizes of orders. These analyses indicate that the markets for Nasdaq and NYSE stocks each have weaknesses that an intermarket price protection rule could help address. For example, the effective spread statistics for large, electronically-received market orders in NYSE stocks show significant "slippage" – the amount by which orders are executed at prices inferior to the national best bid or offer ("NBBO") at the time of order receipt.⁵² Slippage often results in effective spreads for large orders that are many times wider than the effective spreads for small orders in the same NYSE stocks. By protecting automated quotations, the reproposed Trade-Through Rule should enhance the depth and liquidity available for large, electronic orders in NYSE stocks.

For Nasdaq stocks, the Rule 11Ac1-5 statistics reveal very low fill rates for larger sizes of marketable limit orders (e.g., 2000 shares or more), which generally fall below 50% for most Nasdaq stocks. Contrary to the assertion of some commenters,⁵³ certainty of execution clearly is not a strength of the current market for Nasdaq stocks. Certainty of a fast response is a strength, but much of the time the response to large orders will be a "no fill" at any given trading center. The reproposed Trade-Through Rule is designed to enhance depth and liquidity and thereby improve the execution quality of large orders in Nasdaq stocks.⁵⁴

Effective spread statistics do not, of course, reflect all types of trading costs. They focus on the execution price of individual orders in comparison with the best quoted prices at the time orders are received. As a result, they do not capture trading costs that are associated with the short-term movement of quoted prices, or volatility. To further assist the Commission in evaluating the views of commenters, Commission staff also has analyzed short-term volatility for trading in Nasdaq and NYSE stocks.⁵⁵ This analysis particularly focuses on transitory volatility – short-term fluctuations away from the fundamental or "true" value of a stock. Transitory volatility should be distinguished from fundamental volatility – price fluctuations associated with factors independent of market structure, such as earnings changes and other economic determinants of stock prices. The staff analysis found that transitory volatility is significantly higher for Nasdaq stocks than for NYSE stocks.⁵⁶ Excessive transitory volatility indicates a shortage of liquidity. Such volatility may provide benefits in the form of profitable trading opportunities for short-term traders or market makers, but these benefits come at the expense of other investors, who would be buying at artificially high or selling at artificially low prices. Retail investors, in particular, tend to be relatively uninformed concerning short-term price movements and are apt to bear the brunt of the trading costs associated with excessive transitory volatility. The reproposed Trade-Through Rule, by promoting greater depth and liquidity, is designed to help reduce excessive transitory volatility in Nasdaq stocks.

The second principal factual contention of commenters opposed to a trade-through rule is premised on the claim that there are fewer trade-throughs in Nasdaq stocks, which are not covered by any trade-through rule, than in NYSE stocks, which are covered by the ITS trade-through provisions.⁵⁷ One commenter asserted that, outside the exchange-listed markets, competition alone had been sufficient to create a "no-trade through zone."⁵⁸ To respond to these claims, the Commissions staff examined public quotation and trade data to analyze the incidence of trade-throughs for Nasdaq and NYSE stocks.⁵⁹ It found that the overall trade-through rates for Nasdaq stocks and NYSE stocks were, respectively, 7.9% and 7.2% of the total volume of traded shares.⁶⁰ When considered as a percentage of number of trades, the overall trade-throughs rate for both Nasdaq and NYSE stocks was 2.5%. In addition, the staff analysis found that the amount of the trade-throughs was significant – 2.3 cents per share on average for Nasdaq stocks and 2.2 cents per share for NYSE stocks.⁶¹

The staff analysis also revealed that a large volume of block transactions (10,000 shares or greater) trade through displayed quotations. Block transactions represent approximately 50% of total trade-through volume for both Nasdaq and NYSE stocks.⁶² Importantly, many block transactions currently are not subject to the ITS trade-through provisions that apply to exchange-listed stocks. Broker-dealers that act solely as block positioners are not covered by the ITS trade-through provisions if they print their trades in the over-the-counter ("OTC") market. In addition to not covering the trades of block positioners, the ITS trade-through provisions include an exception for 100-share quotations. They therefore often may fail to protect the small orders of retail investors. When block trade-throughs and trade-throughs of 100-share quotations are eliminated, the overall trade-through rate for NYSE stocks is reduced from 7.2% to approximately 2.3% of total share volume.⁶³ The two gaps in ITS coverage therefore account for most of the trade-through volume in NYSE stocks. The reproposed Trade-Through Rule, by closing these gaps in protection against trade-throughs, would establish much stronger price protection than the ITS provisions.

In sum, relevant data supports the need for an intermarket rule to strengthen price protection and improve the quality of trading in both Nasdaq and exchange-listed stocks. The arguments of some commenters that competitive forces alone are sufficient to achieve these objectives fail to take into account two structural problems – principal/agent conflicts of interest and “free-riding” on displayed prices.

Agency conflicts occur when brokers may have incentives to act otherwise than in the best interest of their customers. Customers, particularly retail investors, may have difficulty monitoring whether their individual orders miss the best displayed prices at the time they are executed.⁶⁴ Given the large number of trades that fail to obtain the best displayed prices (e.g., approximately 1 in 40 trades for both Nasdaq and NYSE stocks, or approximately 98,000 trades per day in Nasdaq stocks),⁶⁵ the Commission is concerned that many of the investors that ultimately received the inferior price on these trades may not be aware that their orders did not, in fact, obtain the best price. The reproposed Trade-Through Rule would backstop a broker's duty of best execution by prohibiting the practice of executing orders at inferior prices, absent an applicable exception.

Just as importantly, even when market participants act in their own economic self-interest, or brokers act in the best interests of their customers, they may deliberately choose, for various reasons, to bypass (i.e., not protect) limit orders with the best displayed prices. For example, an institution may be willing to accept a dealer's execution of a particular block order at a price outside the NBBO, thereby transferring the risk of any further price impact to the dealer. Market participants that execute orders at inferior prices without protecting displayed limit orders are effectively “free-riding” on the price discovery provided by those limit orders. Displayed limit orders benefit all market participants by establishing the best prices, but, when bypassed, do not themselves receive a benefit, in the form of an execution, for providing this public good. This economic externality, in turn, creates a disincentive for investors to display limit orders, particularly limit orders of any substantial size.

As demonstrated by the current rate of trade-throughs of the best quotations in Nasdaq and NYSE stocks, these structural problems often can lead to executions at prices that are inferior to displayed quotations, meaning that limit orders are being bypassed. The frequent bypassing of limit orders can cause fewer limit orders to be placed. The Commission therefore preliminarily believes that the reproposed Trade-Through Rule is needed to encourage greater use of limit orders. The more limit orders available at better prices and greater size, the more liquidity available to fill incoming marketable orders. Increased liquidity, in turn, could lead market participants to interact more often with displayed orders, which would lead to greater use of limit orders, and thus begin the cycle again. The end result should be an NMS that more fully meets the needs of a broad spectrum of investors, particularly the long-term investors, as opposed to short-term traders, that benefit most from improved market depth and liquidity.

2. Limiting Protection to Automated and Accessible Quotations

The trade-through proposal sought to strengthen protection against trade-throughs, while also addressing problems posed by the inherent differences in quotations displayed by automated markets, which are immediately accessible, and quotations displayed by manual markets, which are not. The proposal included an exception that would have allowed automated markets to trade through manual markets, but only up to certain amounts that varied depending upon the price of the security. Under the proposal, a market would be classified as "manual" if it did not provide for an immediate automated response to all incoming orders attempting to access its displayed quotations.⁶⁶

At the NMS Hearing, a significant portion of the discussion of the trade-through proposal addressed issues relating to quotations of automated and manual markets. Representatives of two floor-based exchanges announced their intent to establish "hybrid" trading facilities that would offer automatic execution of orders seeking to interact with their displayed quotations, while at the same time maintaining a traditional floor.⁶⁷ These representatives acknowledged the difficulties posed in developing an efficient hybrid market, but emphasized that they were committed to developing such facilities and that such facilities were likely to become operational prior to any implementation of Regulation NMS.

Other panelists at the NMS Hearing strongly believed that manual quotations should not receive any protection against trade-throughs and that the proposed trade-through amounts should be eliminated. ⁶⁸ They noted, however, that existing order routing technologies are capable of identifying, on a quote-by-quote basis, indications from a market that a particular quotation is not immediately and automatically accessible (i.e., is a manual quotation). Using this functionality, a trade-through rule could classify individual quotations as automated or manual, rather than classifying an entire market as manual solely because it displayed manual quotations on occasion.

To give the public a full opportunity to comment on these issues, the Supplemental Release described the developments at the NMS Hearing and requested comment on whether a trade-through rule should protect only automated quotations and whether the rule should adopt a "quote-by-quote" approach to identifying protected quotations.⁶⁹ The Supplemental Release also requested comment on the requirements for an automated quotation, including whether the rule should impose a maximum response time, such as one second, on the total time for a market to respond to an order in an automated manner. Comment also was requested on mechanisms for enforcing compliance with the automated quotation requirements.

Nearly all commenters believed that only automated quotations should receive protection against trade-throughs and that therefore the proposed limitation on trade-through amounts for manual markets should be eliminated.⁷⁰ The Commission agrees. The reproposed Trade-Through Rule would protect only those quotations that are immediately and automatically accessible. Providing protection to manual quotations, even limited to trade-throughs beyond a certain amount, potentially would lead to undue delays in the routing of investor orders, thereby outweighing the benefits of price protection. If the Trade-Through Rule were adopted, investors would have the choice of whether to access a manual quotation and wait for a response or to access an automated quotation with an inferior price and obtain an immediate response. Moreover, those who route limit orders would be able to control whether their orders are protected by evaluating the extent to which various trading centers display automated versus manual quotations.

Commenters expressed differing views, however, on the appropriate standards for automated quotations and on the standards that should govern "hybrid" markets – those that display both automated and manual quotations. These issues are discussed below.

a. Standards for Automated Quotations

Nearly all commenters addressing the issue believed that only quotations that are truly firm and fully accessible should qualify as "automated."⁷¹ To achieve this goal, they suggested that, at a minimum, the market displaying an automated quotation should be required to provide a functionality for an incoming order to receive an immediate and automated (i.e., without human intervention) execution up to the full displayed size of the quotation. In addition, they believed the market should provide an immediate and automated response to the sender of the order indicating whether the order had been executed (in full or in part) and an immediate and automated updating of the quotation. A number of commenters advocated a specific time standard for distinguishing between manual and automated quotations, ranging from one second down to 250 milliseconds.⁷² Other commenters did not believe the definition of automated quotation should include a specific time standard, generally because setting a specific standard might discourage innovation and become a “ceiling” on market performance.⁷³

The Commission has included in the reproposal a definition of automated quotation that incorporates the three elements suggested by commenters: (1) acting on an incoming order, (2) responding to the sender of the order, and (3) updating the quotation. In particular, reproposed Rule 600(b)(3) would require that the trading center displaying an automated quotation must provide an "immediate-or-cancel" ("IOC") functionality for an incoming order to execute immediately and automatically against the quotation up to its full size, and for any unexecuted portion of such incoming order to be cancelled immediately and automatically without being routed elsewhere. The trading center also must immediately and automatically respond to the sender of an IOC order. To qualify as "automatic," no human discretion exercised after the time an order is received would be permissible in determining any action taken with respect to an order. Trading centers would be required to offer this IOC functionality only to customers that request immediate action and response by submitting an IOC order. Customers therefore would have the choice of whether to require an immediate response from the trading center, or to allow the market to take further action on the order (such as by routing the order elsewhere, seeking additional liquidity for the order, or displaying the order). Finally, trading centers would be required to immediately and automatically update their automated quotations to reflect any change to their material terms (such as a change in price, size, or "automated" status).

The definition of automated quotation does not set forth a specific time standard for responding to an incoming order. The Commission agrees with commenters that the standard should simply be "immediate" – i.e., a trading center's systems should provide the fastest response possible without any programmed delay. Nevertheless, the Commission also is concerned that trading centers with well-functioning systems should not be unnecessarily slowed down waiting for responses from a trading center that is experiencing a systems problem. Consequently, rather than fixing a specific time standard that may become obsolete as systems improve over time, Rule 611(b)(1) would address the problem of slow trading centers by providing an exception for quotations displayed by trading centers that are experiencing, among other things, a material delay in responding to incoming orders. Given current industry conditions, the Commission believes that repeatedly failing to respond within one second after receipt of an order would constitute a material delay.⁷⁴ Accordingly, a trading center would act reasonably in the current trading environment if it bypassed the quotations of another trading center that had repeatedly failed to respond to orders within a one-second time frame (after adjusting for any potential delays in transmission not attributable to the other trading center).⁷⁵ This "self-help" remedy, discussed further in sections II.A.3 and II.B.3 below, would give trading centers needed flexibility to deal with a trading center that is experiencing systems problems, rather than forcing smoothly-functioning trading centers to slow down for a problem market.

b. Standards for Automated Trading Centers

The trade-through proposal would have classified a market as manual if it did not provide automated access to all orders seeking access to its displayed quotations. Many commenters responded positively to the concept of allowing hybrid markets to display both automated and manual quotations that was raised at the NMS Hearing and discussed in the Supplemental Release. Most national securities exchanges believed that focusing on whether individual quotations are automated or manual would permit hybrid markets to function, thereby expanding the range of trading choices for investors.⁷⁶ For example, Amex stated that hybrid markets would offer investors the choice to utilize auction markets when advantageous for them to do so, while at the same time offering automatic execution to those investors desiring speed and certainty of a fast response.⁷⁷ A majority of other commenters also believed that the application of any trade-through rule should depend on whether a particular quotation is automated.⁷⁸ They believed that such a rule would achieve the benefits of encouraging limit orders and improving market depth and liquidity, while avoiding indirectly mandating a particular market structure.

Although generally supportive of the concept of hybrid markets, several commenters expressed concern about how the "quote-by-quote" approach to protected quotations would operate in practice.⁷⁹ The ICI noted that "[w]e are concerned that if it is left completely up to an individual market’s discretion when a quote is 'automated' or manual, that market could base its decision on what is in the best interests of that market and its members, as opposed to the best interests of investors and other market participants."⁸⁰ These commenters suggested that the Commission should provide clear guidelines as to when and how a market could switch its quotations from automated to manual, and vice versa, so as to prevent abuse by the market.

After considering the views of commenters, the Commission has decided to include in the reproposal an approach that would offer flexibility for a hybrid market to display both automated and manual quotations, but only when such a market meets basic standards that promote fair and efficient access by the public to the market's automated quotations. This approach is designed to allow markets to offer a variety of trading choices to investors, but without requiring other markets and market participants to route orders to a hybrid market with quotations that are not truly accessible. Reproposed Rule 600(b)(4) therefore sets forth requirements for a trading center to qualify as an "automated trading center." Unless a trading center met these requirements, none of its quotations could qualify as automated, and therefore protected, quotations.

To qualify as an automated trading center, the trading center must have implemented such systems and rules as are necessary to render it capable of displaying quotations that meet the action, response, and updating requirements set forth in the definition of an automated quotation. Further, the trading center must identify all quotations other than automated quotations as manual quotations, and must immediately identify its quotations as manual quotations whenever it has reason to believe that it is not capable of displaying automated quotations. These requirements are designed to enable other trading centers readily to determine whether a particular quotation displayed by a hybrid trading center is protected by the reproposed Trade-Through Rule. Finally, an automated trading center must adopt reasonable standards limiting when its quotations change from automated quotations to manual quotations, and vice versa, to specifically defined circumstances that promote fair and efficient access to its automated quotations and are consistent with the maintenance of fair and orderly markets.

These requirements are designed to promote efficient interaction between a hybrid market and other trading centers. The requirement that automated quotations cannot be switched on and off except in specifically defined circumstances is particularly intended to assure that hybrid markets do not give their members, or anyone else, overbroad discretion to control the automated or manual status of the trading center's quotations, which potentially could disadvantage less favorably situated market participants. Changes from automated to manual quotations, and vice versa, must to subject to specific, enforceable limitations as to the timing of switches. For a trading center to qualify as entitled to display any protected quotations, the public in general must have fair and efficient access to a trading center's quotations.

3. Workable Implementation of Intermarket Trade-Through Protection

Several commenters expressed concern that the proposed trade-through rule could not be implemented in a workable manner, particularly for high-volume stocks.⁸¹ Morgan Stanley, for example, asserted that an inefficient trading center might have inferior systems that would delay routed orders and potentially diminish their quality of execution.⁸² Instinet emphasized that protecting a market's quotations "confers enormous power on a market. . . Such power can and will be abused either directly (e.g., by quoting slower than executing orders) or indirectly (e.g., not investing in more than minimum system capacity or redundancy)."⁸³ Hudson River Trading noted that markets sometimes experience temporary systems problems and questioned how a trade-through rule would handle these scenarios.⁸⁴ Nasdaq observed that quotations in many Nasdaq stocks are updated more than two times per second. It said that these frequent changes could lead to many false indications of trade-throughs and that eliminating these "false positives" would greatly reduce the percentage of transactions subject to a trade-through rule.⁸⁵ Finally, many commenters noted that market participants need the ability to sweep multiple price levels simultaneously at different trading centers. They emphasized that a trade-through rule should accommodate this trading strategy by freeing each trading center to execute orders immediately without waiting for other trading centers to update their better priced quotations.⁸⁶

The Commission fully agrees with these commenters that intermarket protection against trade-throughs must be workable and implemented in a way that promotes fair and orderly markets. It therefore has formulated the reproposed Trade-Through Rule to achieve this objective in a variety of ways. First and most importantly, only automated trading centers, as defined in Rule 600(b)(4), that are capable of providing immediate responses to incoming orders would be eligible to have their quotations protected. Moreover, an automated trading center is required to identify its quotations as manual (and therefore not protected) whenever it has reason to believe that it is not capable of providing immediate responses to orders. Thus, a trading center that experiences a systems problem, whether because of a flood of orders or otherwise, must immediately identify its quotations as manual.

If the reproposed Trade-Through Rule were adopted, the Commission would monitor and enforce the foregoing requirements for automated trading centers and automated quotations. Nevertheless, it concurs with commenters' concerns that well-functioning trading centers should not be dependent on the willingness and capacity of other markets to meet, and the Commission's ability to enforce, these automation requirements. The Trade-Through Rule therefore provides a "self-help" remedy that would allow trading centers to bypass the quotations of a trading center that fails to meet the immediate response requirement. Rule 611(b)(1) sets forth an exception that applies to quotations displayed by trading centers that are experiencing a failure, material delay, or malfunction of its systems or equipment. To implement this exception consistent with the requirements of Rule 611(a), trading centers would have to adopt policies and procedures reasonably designed to avoid dealing with problem trading centers. Such policies and procedures would need to set forth specific and objective parameters for initiating and monitoring compliance with the self-help remedy. Given current industry capabilities, the Commission believes that trading centers should be entitled to bypass another trading center's quotations if it repeatedly fails to respond within one second to incoming orders attempting to access its protected quotations. Accordingly, trading centers would have the necessary flexibility to respond to problems at another trading center as they occur during the trading day. The Commission, of course, also would monitor a trading center's compliance with the policies and procedures required by Rule 611(a) to affirm that the trading center bypasses quotations only when, in fact, another trading center is experiencing a material delay.

In many active NMS stocks, the price of a trading center's best displayed quotations often can change multiple times in a single second ("flickering quotations"). These rapid changes can create the impression that a quotation was traded-through, when in fact the trade was effected nearly simultaneously with display of the quotation.⁸⁷ To address the problem of flickering quotations, reproposed Rule 611(b)(8) sets forth an exception that allows trading centers a one-second "window" prior to a transaction for trading centers to evaluate the quotations at another trading center. Trading centers would be entitled to trade at any price equal to or better than the least aggressive best bid or best offer, as applicable, displayed by the other trading center during that one-second window.⁸⁸ For example, if the best bid price displayed by another trading center has flickered between $10.00 and $10.01 during the one-second window, the trading center that received the order could execute a trade at $10.00 without violating Rule 611. By addressing the flickering quotation problem in this way, reproposed Rule 611(b)(8) would give trading centers added flexibility to deal with the practical difficulties of protecting quotations displayed by other trading centers.

The Commission believes that excepting flickering prices from trade-through protection would ease the implementation of the reproposed Trade-Through Rule without significantly reducing its benefits.⁸⁹ In this regard, it appears that many of the potential implementation difficulties with respect to high-volume stocks are related to the general problem of dealing with sub-second time increments. The Commission generally does not believe that the benefits would justify the costs imposed on trading centers of attempting to implement an intermarket price priority rule at the level of sub-second time increments. Accordingly, Rule 611 has been formulated to relieve trading centers of this burden.⁹⁰

Paragraphs (b)(5) and (b)(6) of reproposed Rule 611 set forth exceptions for intermarket sweep orders. The exceptions respond to the need of market participants to access multiple price levels simultaneously at different trading centers. An intermarket sweep order is defined in Rule 600(b)(30) as a limit order that meets the following requirements: (1) the limit order is identified as an intermarket sweep order when routed to a trading center, and (2) simultaneously with the routing of the limit order, one or more additional limit orders are routed to execute against all better-priced protected quotations displayed by other trading centers up to their displayed size. These additional orders also must be marked as intermarket sweep orders to inform the receiving trading center that they can be immediately executed without regard to protected quotations in other markets. Paragraph (b)(5) would allow a trading center to execute immediately any order identified as an intermarket sweep order, without regard for better-priced protected quotations displayed at one or more other trading centers. The exception is fully consistent with the principle of protecting the best displayed prices because it is premised on the condition that the trading center or broker-dealer responsible for routing the order will have attempted to access all better-priced protected quotations up to their displayed size.⁹¹ Consequently, there is no reason why the trading center that receives an intermarket sweep order while displaying an inferior-priced quotation should be required to delay an execution of the order.

Paragraph (b)(6) would authorize a trading center itself to route intermarket sweep orders and thereby enable immediate execution of a transaction at a price inferior to a protected quotation at another trading center. For example, paragraph (b)(6) could be used by a dealer that wished immediately to execute a block transaction at a price three cents down from the NBBO, as long as the dealer simultaneously routed orders to access all better-priced protected quotations. By facilitating intermarket sweep orders of all kinds, Rule 611 as reproposed would allow a much wider range of beneficial trading strategies than the rule as proposed. In addition, the intermarket sweep exception would help prevent an "indefinite loop" scenario in which waves of orders otherwise might be required to chase the same quotations from trading center to trading center, one price level at a time.⁹²

4. Elimination of Proposed Opt-Out Exception

The rule text of the trade-through proposal included a broad exception for persons to opt-out of the best displayed prices if they provided informed consent. The Proposing Release indicated that the exception was particularly intended to allow investors to bypass manual markets, to execute block transactions without moving the market price, and to help discipline markets that provided slow executions or inadequate access to their quotations.⁹³ The Commission also noted, however, that an opt-out exception would be inconsistent with the principle of price protection and, if used frequently, could undermine investor confidence that their orders will receive the best available price. It therefore requested comment on an automated execution alternative to the opt-out exception, under which all markets would be required to provide an automated response to electronic orders. At the subsequent NMS Hearing, some panelists questioned whether, assuming only truly accessible and automated quotations were protected, there was a valid reason for opting-out of such a quotation.⁹⁴ To address this issue, the Commission requested comment in the Supplemental Release on whether the proposed opt-out exception would be necessary if manual quotations were excluded from trade-through protection.

Many commenters opposed a general opt-out exception.⁹⁵ They believed that it would be inconsistent with the principle of price protection and undermine the very benefits the trade-through rule is designed to provide. American Century, for example, asserted that the Commission should focus on the limit order investors who have "opted-in" to the NMS, rather than on those that wish to opt-out.⁹⁶ Vanguard noted that an opt-out exception might serve a short-term desire to obtain an immediate execution, but "without recognizing the second order effect of potentially significantly reducing liquidity in the long term."⁹⁷ Similarly, the ICI stated that "while our members may be best served on a particular trade by 'opting-out' from executing against the best price placed in another market, we believe that in the long term, all investors will benefit by having a market structure where all limit orders are protected and investors are provided with an incentive to place those orders in the markets."⁹⁸ All of the foregoing views were conditioned on an assumption that only accessible, automated quotations would be protected by a trade-through rule.

Many other commenters, in contrast, supported the proposed opt-out exception.⁹⁹ Aside from concerns that a trade-through rule would be unworkable without an opt-out exception, which were discussed in the preceding section, the primary concerns of these commenters were that, without an opt-out exception, a trade-through rule would (1) dampen competition among markets, particularly with respect to factors other than price; and (2) restrict the freedom of choice for market participants to route marketable orders to trading centers that are most appropriate for their particular trading objectives and to achieve best execution. As discussed next, the Commission has formulated the reproposed Trade-Through Rule to respond to these concerns, while still preserving the benefits of intermarket price protection.

a. Preserving Competition Among Markets

Many commenters believed that an opt-out exception was necessary to promote competition among trading centers, particularly competition based on factors other than price, such as speed of response. For example, 179 commenters submitted letters stating that, in the absence of an opt-out exception, "Reg. NMS will freeze market development and, over the long term, could hurt investors."¹⁰⁰ Morgan Stanley asserted that allowing market participants to opt-out "would reward markets that provide faster and surer executions, and conversely, would penalize those markets that are materially slower or are displaying smaller quote sizes by ignoring those quotes."¹⁰¹ Instinet believed that, without an opt-out exception, a trade-through rule "would virtually eliminate intermarket competition by forcing operational and technological uniformity on each marketplace, negating price competition, system performance, or any other differentiating feature that a market may develop."¹⁰²

The Commission recognizes the vital importance of preserving vigorous competition among markets, but believes that commenters have overstated the risk that such competition would be dampened by adoption of a trade-through rule without a general opt-out exception. Even if reproposed Rule 611 were adopted, markets likely would have strong incentives to continue to compete and innovate to attract both marketable orders and limit orders. Market participants and intermediaries responsible for routing marketable orders, consistent with their desire to achieve the best price and their duty of best execution, would continue to rank trading centers according to the total range of services provided by those markets. Such services include cost, speed of response, sweep functionality, and a wide variety of complex order types. The most competitive trading center would be the first choice for routing marketable orders, thereby enhancing the likelihood of execution for limit orders routed to that trading center. Because likelihood of execution is of such great importance to limit orders, routers of limit orders would be attracted to this preferred trading center. More limit orders would enhance the depth and liquidity offered by the preferred trading center, thereby increasing its attractiveness for marketable orders, and beginning the cycle all over again.¹⁰³

Conversely, trading centers that offer poor services, such as a slower speed of response, likely would rank near the bottom in order-routing preference of most market participants and intermediaries. Whenever the least-preferred trading center was merely posting the same price as other trading centers, orders would be routed to other trading centers. As a result, limit orders displayed on the least preferred trading center would be least likely to be executed in general. Moreover, such limit orders would be the least likely to be executed when prices move in favor of the limit orders, and the most likely to be executed only when prices are moving against the limit order, adding the cost of "adverse selection" to the cost of a low likelihood of execution. In sum, the lowest ranked trading center in order-routing preference, with or without intermarket price protection, would suffer the consequences of offering a poor range of services to the routers of marketable orders.¹⁰⁴ The Commission therefore preliminarily does not believe that the absence of an opt-out exception would freeze market development or eliminate competition among markets.

b. Promoting the Interests of Both Marketable Orders and Limit Orders

Many commenters that supported an opt-out exception believed that an ability to opt-out of the best displayed prices was necessary to promote full freedom of choice in the routing of marketable orders, and particularly to allow factors other than quoted prices to be considered. For example, 179 commenters submitted a letter stating that "[i]nvestors are driven by price, but prices that are inaccessible either because of lagging execution time within a market or insufficient liquidity at the best price point impact the overall costs associated with trading securities in today's markets. The Trade Through rule may harm investors by restricting their ability to achieve best execution, and investors deserve the opportunity to make choices."¹⁰⁵ Similarly, Fidelity asserted that "as a fiduciary to the mutual funds under our management, we should be free to reach our own informed judgment regarding the market center where our funds' trades are to be executed, particularly when a delay may open the way for exchange floor members and others to exploit an informational advantage that arises not from their greater investment or trading acumen but merely from their privileged presence on the physical trading floor."¹⁰⁶

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

Limit orders, however, make the first move – when submitted, they must be displayed rather than executed, and therefore offer a "free option" for other market participants to trade a stock by submitting marketable orders and taking the liquidity supplied by limit orders. Consequently, the fate of limit orders is dependent on the choices made by those who route marketable orders. Much of the time, the interests of marketable orders in obtaining the best available price are aligned with those of limit orders that are displaying the best available price. But, as shown by the significant trade-through rates discussed in section II.A.1 above (even for automated quotations in Nasdaq stocks), the interests of marketable orders and limit orders are not always aligned.

One important example where the interests of limit orders and marketable orders often diverge are large, block trades. Several commenters noted that they often are willing to bypass the best quoted prices if they can obtain an immediate execution of large orders at a fixed price that is several cents away from the best prices.¹⁰⁷ Yet these block trades often will be priced based on the displayed quotations in a stock. They thereby demonstrate the "free-riding" economic externality that, as discussed in section II.A.1 above, is at the heart of the need for intermarket price protection. To achieve the full benefits of intermarket price protection, all investors must be governed by a uniform rule that encompasses their individual trades. For any particular trade, an investor may believe that the best course of action is to bypass displayed quotations in favor of executing larger size immediately. The Commission believes, however, that the long-term strength of the NMS as a whole is best promoted by fostering greater depth and liquidity, and it follows from this that the Commission should examine the extent to which it can encourage the limit orders that provide this depth and liquidity to the market at the best prices. Allowing individual market participants to pick and choose when to respect displayed quotations could undercut the fundamental reason for displaying the liquidity in the first place.

Consequently, the Commission has decided to eliminate the proposed opt-out exception from the reproposal because it could severely detract from the benefits of intermarket order protection. Instead, reproposed Rule 611 has been modified to address the concerns of those who otherwise may have felt they needed to opt-out of protected quotations. In particular, it would incorporate an approach that seeks to serve the interests of both marketable orders and limit orders by appropriately balancing these interests in the contexts where they may diverge. In this way, the reproposed Trade-Through Rule is intended to promote the overall efficiency of the NMS for all investors.

First and most importantly, reproposed Rule 611 would protect only immediately accessible quotations that are available through automatic execution. It would never require investors submitting marketable orders to access "maybe" quotations that, after arrival of the order, are subject to human intervention and thereby create the potential for other market participants to determine whether to honor the quotation. Moreover, as discussed in section II.A.2 above, reproposed Rule 611 includes a variety of provisions designed to assure that marketable orders must be routed only to well-functioning trading centers displaying executable quotations.

Second, reproposed Rule 611 has been formulated to promote the interests of investors seeking immediate execution of specific order types that reduce their total trading costs, particularly for larger orders, by, among other things, minimizing price impact costs. Paragraph (b)(7), for example, sets forth an exception that would allow the execution of volume-weighted average price ("VWAP") orders, as well as other types of orders that are not priced with reference to the quoted price of a stock at the time of execution and for which the material terms were not reasonably available at the time the commitment to execute the order was made. This exception would serve the interests of marketable orders and is consistent with the principle of protecting the best displayed quotations.

Although reproposed Rule 611 does not provide a general exception for block orders, it seeks to address the legitimate interest of investors in obtaining an immediate execution in large size (and thereby minimizing price impact). The intermarket sweep order exception would allow broker-dealers to continue to facilitate the execution of block orders. The entire size of a large order can be executed immediately at any price, so long as the broker-dealer routes orders seeking to execute against the full displayed size of better-priced protected quotations. The size of the order therefore need not be parceled out over time in smaller orders that might tip the market about pending orders. By both allowing immediate execution of the large order and protecting better-priced quotations, reproposed Rule 611 is designed to appropriately balance the interests for investors on both sides of the market.

The Commission recognizes, however, that the existence of a intermarket price protection, without an opt-out exception, may interfere to some extent with the extremely short-term trading strategies of some market participants. Some of these strategies can be affected by a delay in order-routing or execution of as little as 3/10ths of one second. Given the current NMS structure with multiple competing markets, any protection of displayed quotations in one market could affect the implementation of short-term trading strategies in another market. This conflict between protecting the best displayed prices and facilitating short-term trading strategies raises a fundamental policy question – should the overall efficiency of the NMS defer to the needs of professional traders, many of whom rarely intend to hold a position overnight? Or should the NMS serve the needs of longer-term investors, both large and small, that will benefit substantially from intermarket price protection?

The Commission believes that two of the most important public policy functions of the secondary equity markets are to minimize trading costs for long-term investors and to reduce the cost of capital for listed companies. These functions are inherently connected, because the cost of capital of listed companies depends on the trading costs of those who are willing to accept the investment risk of holding corporate stock for an extended period. To the extent that the interests of professional traders and market intermediaries in a broad opt-out exception conflict with those of investors, the interests of investors are entitled to take precedence. In this way, the NMS will fulfill its Exchange Act objectives to promote fair and efficient equity markets for investors and to serve the public interest.

5. Scope of Protected Quotations: Market BBO Alternative and Voluntary Depth Alternative

The trade-through proposal would have protected all quotations disseminated by a Plan processor in the consolidated quote stream. Currently, the scope of these quotations depends on the regulatory status of an SRO. Under Exchange Act Rule 11Ac1-1 ("Quote Rule") (proposed to be redesignated as Rule 602), exchange SROs are required to provide only their best bids and offers ("BBOs") in a stock. In contrast, a national securities association, which currently encompasses Nasdaq's trading facilities and the NASD's ADF, must provide BBOs of its individual members. Consequently, the proposal would have protected only a single BBO of an exchange and not any additional quotations in its depth of book ("DOB"). For Nasdaq facilities and the ADF, however, the proposal would have protected member BBOs at multiple price levels. The Proposing Release requested comment on whether only a single BBO for Nasdaq and the ADF should be protected.¹⁰⁸

Commenters expressed concern that the proposed rule text would protect the BBOs of individual market makers and ATSs in Nasdaq's facilities and the ADF, but only a single BBO of exchange SROs.¹⁰⁹ The Specialist Association, for example, believed that it would be unfair to offer greater protection to the quotations of members of an association SRO than to those of an exchange SRO.¹¹⁰ Morgan Stanley stated that to "equalize the protections available to all market participants, we believe the Commission should treat SuperMontage as a single market for purposes of the trade-through rule, instead of treating each individual Nasdaq market maker as a separate quoting market participant."¹¹¹

The Commission agrees that reproposed Rule 611 should not mandate a regulatory disparity between the quotations displayed through exchange SROs and those displayed through Nasdaq facilities and the ADF. Potentially, Nasdaq and the ADF could attract a significant number of limit orders if they were able to offer order protection that was not available at exchange SROs. This result would not be consistent with the Exchange Act goals of fair competition among markets and the equal regulation of markets.¹¹² Each of the proposed alternatives for the definition of "protected bid" and "protected offer" in reproposed Rule 600(b)(57) (the Market BBO Alternative and the Voluntary Depth Alternative) therefore encompasses the BBOs of an exchange, Nasdaq, and the ADF. In this way, exchange markets would be treated comparably with Nasdaq and the ADF under either alternative.

The Proposing Release also addressed the issue of extending trade-through protection to DOB quotations, but questioned whether protecting all DOB quotations would be feasible at this time.¹¹³ Comment specifically was requested, however, on whether protection should be extended beyond the BBOs of SROs if individual markets voluntarily provided DOB quotations through the facilities of an effective national market system plan.¹¹⁴ At the subsequent NMS Hearing, a panelist specifically endorsed the policy and feasibility of extending trade-through protection to DOB quotations, as long as such quotations were automated and accessible: "Automatically executable quotes, whether they are on the top of the book or up and down the book, should be protected by the trade-through rule, and manual quotes should not be. This is a simple and technically easy idea to implement."¹¹⁵

Most of the subset of comment letters that specifically addressed the DOB issue supported the approach of extending trade-through protection to all limit orders displayed in the NMS, not merely the BBOs of the various markets.¹¹⁶ The Consumer Federation of America, for example, stated that "such an approach would result in better price transparency and help to address complaints that decimal pricing has reduced price transparency because of the relatively thin volume of trading interest displayed in the best bid and offer."¹¹⁷ The ICI recognized that protecting all displayed limit orders might not be feasible at this time, but urged the Commission to examine the issue further.¹¹⁸

The Commission recognizes, however, that other commenters may have chosen not to address the alternative of protecting voluntary DOB quotations because it was not included in the proposed rule text. In this reproposal, therefore, the Commission has decided to propose rule text for two alternatives: (1) the Market BBO Alternative that would protect only the BBOs of the exchange SROs, Nasdaq, and the ADF, or (2) the Voluntary Depth Alternative that, in addition to protecting BBOs, would protect the DOB quotations that markets voluntarily disseminate in the consolidated quotations stream. The alternatives are incorporated in two alternative definitions of "protected bid" and "protected offer" in Rule 600(b)(57). Comment is requested on which of the two alternatives would most further the Exchange Act objectives for the NMS in a practical and workable manner. The following discussion is intended to highlight issues that commenters may wish to address when evaluating the two alternatives.

Comment is requested on whether extending trade-through protection to DOB quotations would significantly increase the benefits of the reproposed Trade-Through Rule. Would protecting quotations at multiple price levels further encourage the display of limit orders and thereby significantly enhance depth and liquidity in the NMS? Since decimalization, quoted spreads have narrowed substantially. Market participants often may not be willing to quote in significant size at the inside prices, but might be willing to do so at a price that is a penny or more away from the inside prices. Granting trade-through protection to such quotations potentially would reward this beneficial quoting activity.

In assessing the potential benefits of DOB protection, commenters should consider the effect of the reserve (or undisplayed) size function that many trading centers offer investors. For example, Market A may be displaying a best offer of 1000 shares at $10.00, and DOB offers of 2000 shares at $10.01 and 2000 shares at $10.02. With a reserve size function, however, Market A may have an additional 1000 shares offered at $10.00 and an additional 2000 shares offered at $10.01, neither of which is displayed. Assuming the displayed offers of $10.00, $10.01, and $10.02 were protected quotations under the Voluntary Depth Alternative, Market B could execute a trade at $10.03 only by simultaneously routing an order to execute against the accumulated displayed size of the protected quotations at Market A. Market B therefore would be required to route a buy order, identified as an intermarket sweep order, to Market A with a limit price of $10.02 for a total of 5000 shares (the accumulated amount of the displayed size of protected quotations with a price of $10.02 or better at Market A). Under the priority rules currently in effect at electronic markets, undisplayed size has priority over displayed size at a inferior price. Accordingly, Market A would execute the 5000 share buy order as follows: 2000 shares at $10.00 (1000 displayed plus 1000 reserve) and 3000 shares at $10.01 (2000 displayed plus 1000 reserve). While Market B would have complied with the Rule, the displayed $10.02 offer at Market A would still go unfilled when Market B traded at $10.03. Comment is requested on the extent to which this outcome would detract from the benefits of the Voluntary Depth Alternative.

The Commission also requests comment on whether the Voluntary Depth Alternative could be implemented in a practical and cost-effective manner. To comply, trading centers would need to monitor a significantly larger number of protected quotations displayed by other markets and route orders to execute against such quotations.¹¹⁹ The Voluntary Depth Alternative, however, would not increase the number of orders that a trading center would be required to route to other trading centers if only BBOs were protected. Instead, the size of the routed orders would need to be increased to reflect the accumulated depth displayed by other trading centers in their protected DOB quotations.

In addition, protection of DOB quotations would not be feasible unless (1) market participants have a source of information that clearly identifies the quotations to be protected, (2) such quotation information is made available on fair and reasonable terms, and (3) market participants have fair and efficient access to the protected quotations at reasonable cost (i.e., without paying exorbitant access fees). Moreover, the applicable regulatory authorities must be able to monitor and enforce compliance with a rule that protected DOB quotations. At a minimum, this would require an objective and uniform source to identify the quotations that are protected at any particular time. Comment is requested on whether the Voluntary Depth Alternative would meet these vitally important requirements.

The Voluntary Depth Alternative would set up a process through which individual markets could choose to secure protection for their DOB quotations by disseminating them in the consolidated quotation stream. To implement this approach, the SRO participants in the market data Plans would need to establish a mechanism for individual markets to disseminate their quotations through the Plan processor and have them designated as protected quotations. The participants in the Nasdaq UTP Plan already have agreed on such a mechanism.¹²⁰ It provides that the future processor for the Plan should have the ability to collect, consolidate, and disseminate quotations at multiple price levels beyond the BBO from any participant that voluntarily chooses to submit such quotations. The participant would be expected to bear the costs of processing its additional information. If the Voluntary Depth Alternative were adopted and any individual market were willing to disseminate its DOB quotations through the Plan processors, the participants in each of the Plans would be expected to agree on a fair and equitable means to disseminate such quotations.

As noted in section II.A.3 above, any intermarket protection against trade-throughs must be workable and implemented in a way that promotes fair and orderly markets. To the extent commenters are concerned about practical problems with implementing the Trade-Through Rule, would the basis for these concerns be magnified by the Voluntary Depth Proposal? Specifically, comment is requested on all issues relating to the feasibility and desirability of disseminating DOB quotations through Plan processors.¹²¹ For example, would the voluntary dissemination of protected DOB quotations through the Plan processors create a single point of failure that could threaten the stability of trading in NMS stocks?

In addition, it would be inappropriate to extend trade-through protection to any quotation unless it was publicly available and accessible on fair and reasonable terms. For example, the limitation on access fees set forth in reproposed Rule 610(c) would apply to any protected quotation, whether a BBO or DOB quotation. Moreover, any fee charged for DOB information disseminated pursuant to a market data Plan would have to be filed with the Commission for approval. The fee could be approved only if it was fair and reasonable and appropriately justified by Plan participants. The Commission requests comment on how best to evaluate the fairness and reasonableness of fees for DOB quotations if the Voluntary Depth Alternative were adopted.

Finally, the Commission requests comment on the effect that adoption of the Voluntary Depth Alternative would have on competition among markets. One commenter, for example, suggested that protection of DOB quotations might cause increased fragmentation of liquidity across different markets because limit orders, no matter where displayed, would have price protection.¹²² Another commenter, in contrast, asserted that protecting only BBOs would lead to greater fragmentation because limit orders would be routed to any market where they would set or equal the BBO and thereby obtain trade-through protection.¹²³ Comment is requested on the fragmentation issue, as well as in general on whether protecting DOB quotations would inappropriately limit the terms of market competition so as to harm investors and the efficiency of the NMS. For example, would adoption of the Voluntary Depth Alternative inappropriately reduce the scope of competition among markets to the payment of liquidity rebates for executed limit orders? Comment also is requested on whether adoption of the Voluntary Depth Alternative would generate forces that would lead to a monopolization of trading in a single trading facility.

6. Benefits and Implementation Costs of Trade-Through Rule

Commenters were concerned about the cost of implementing the original trade-through proposal. Some argued that, in general, implementing the proposed rule would be too expensive and would outweigh any perceived benefits of the rule.¹²⁴ Commenters also were concerned about the cost of specific requirements in the proposed rule, particularly the procedural requirements associated with the proposed opt-out exception (e.g., obtaining informed consent from customers and disclosing the NBBO to customers).¹²⁵

In assessing the implementation costs of the reproposed Trade-Through Rule, it is important to recognize that much, if not all, of the connectivity among trading centers necessary to implement intermarket price protection has already been put in place. Trading centers for exchange-listed securities already are connected through the ITS. The Commission understands that, at least as an interim solution, ITS facilities and rules could be modified relatively easily and at low cost to enable an automatic execution functionality. With respect to Nasdaq stocks, connectivity among trading centers already is established through private linkages. Routing out to other trading centers when necessary to obtain the best prices for Nasdaq stocks is an integral part of the business plan of many trading centers, even when not affirmatively required by best execution responsibilities. Moreover, a variety of private vendors currently offer connectivity to NMS trading centers for both exchange-listed and Nasdaq stocks.

Some of the commenters based their concerns about implementation costs on the estimated costs included in the Proposing Release for purposes of the Paperwork Reduction Act of 1995 ("PRA").¹²⁶ The Commission has revised its estimate of the PRA costs associated with the proposed rule to reflect the streamlined requirements of Rule 611 as reproposed, and to reflect a further refinement of the estimated number of trading centers subject to the rule.¹²⁷ In particular, Rule 611 as reproposed does not contain the proposed opt-out exception. Costs associated with this proposed exception represented a large portion of the overall estimated costs described in the Proposing Release, and are no longer applicable.^<