Regulation NMS

Federal RegisterJun 29, 2005

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SECURITIES AND EXCHANGE COMMISSION

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

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

RIN 3235-AJ18

Regulation NMS

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rules and amendments to joint industry plans.

SUMMARY:

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

DATES:

Effective Date:

August 29, 2005.

Compliance Dates:

For specific phase-in dates for compliance with the final rules and amendments, see section VII of this release.

FOR FURTHER INFORMATION CONTACT:

Order Protection Rule:

Heather Seidel, Senior Special Counsel, at (202) 551-5608, Marc F. McKayle, Special Counsel, at (202) 551-5633, David Hsu, Special Counsel, at (202) 551-5664, or Raymond Lombardo, Attorney, at (202) 551-5615;

Access Rule:

Heather Seidel, Senior Special Counsel, at (202) 551-5608, or David Liu, Attorney, at (202) 551-5645;

Sub-Penny Rule:

Michael Gaw, Senior Special Counsel, at (202) 551-5602;

Market Data Rules, Allocation Amendment, and Governance Amendment:

David Hsu, Special Counsel, at (202) 551-5664;

Regulation NMS:

Yvonne Fraticelli, Special Counsel, at (202) 551-5654; all of whom are in the Division of Market Regulation, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-6628.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Summary of Rulemaking Process and Record

B. NMS Principles and Objectives

1. Competition Among Markets and Competition Among Orders

2. Serving the Interests of Long-Term Investors and Listed Companies

C. Overview of Adopted Rules

1. Order Protection Rule

2. Access Rule

3. Sub-Penny Rule

4. Market Data Rules and Plans

II. Order Protection Rule

A. Response to Comments and Basis for Adopted Rule

1. Need for Intermarket Order Protection Rule

2. Limiting Protection to Automated and Accessible Quotations

3. Workable Implementation of Intermarket Trade-Through Protection

4. Elimination of Proposed Opt-Out Exception

5. Scope of Protected Quotations

6. Benefits and Implementation Costs of the Order Protection Rule

B. Description of Adopted Rule

1. Scope of Rule

2. Requirement of Reasonable Policies and Procedures

3. Exceptions

4. Duty of Best Execution

III. Access Rule

A. Response to Comments and Basis for Adopted Rule

1. Means of Access to Quotations

2. Limitation on Access Fees

3. Locking or Crossing Quotations

B. Description of Adopted Rule

1. Access to Quotations

2. Limitation on Access Fees

3. Locking or Crossing Quotations

4. Regulation ATS Fair Access

IV. Sub-Penny Rule

A. Background

B. Commission Proposal and Reproposal on Sub-Penny Quoting

C. Comments Received

1. Restriction Based on Price of the Quotation Not Price of the Stock

2. Quotations Below $1.00

3. Revisiting the Penny Increment

4. Sub-Penny Trading

5. Acceptance of Sub-Penny Quotations

6. Application to Options Markets

7. One-to-One Negotiating Systems

8. Implementation of Rule 612

V. Market Data Rules and Plan Amendments

A. Response to Comments and Basis for Adopted Rules

1. Alternative Data Dissemination Models

2. Level of Fees and Plan Governance

3. Revenue Allocation Formula

4. Distribution and Display of Data

B. Description of Adopted Rules and Amendments

1. Allocation Amendment

2. Governance Amendment

3. Consolidation, Distribution, and Display of Data

VI. Regulation NMS

A. Description of Regulation NMS

B. Rule 600—NMS Security Designation and Definitions

1. NMS Security Designation—Transaction Reporting Requirements for Equities and Listed Options

2. NMS Security and NMS Stock

3. Changes to Existing Definitions in the NMS Rules

4. Definitions in the Regulation NMS Rules Adopted Today

C. Changes to Other Rules

VII. Effective Date and Phased-In Compliance Dates

VIII. Paperwork Reduction Act

IX. Consideration of Costs and Benefits

X. Consideration of Burden on Competition, and Promotion of Efficiency, Competition and Capital Formation

XI. Regulatory Flexibility Act

XII. Response to Dissent

XIII. Statutory Authority

XIV. Text of Adopted Amendments to the CTA Plan, the CQ Plan, and the Nasdaq UTP Plan

XV. Text of Adopted Rules

I. Introduction

The Commission is adopting Regulation NMS, a series of initiatives designed to modernize and strengthen the national market system (“NMS”) for equity securities.

These initiatives include:

The Commission originally proposed Regulation NMS in February 2004. Securities Exchange Act Release No. 49325 (Feb. 26, 2004), 69 FR 11126 (Mar. 9, 2004) (“Proposing Release”). It issued a supplemental request for comment in May 2004. Securities Exchange Act Release No. 49749 (May 20, 2004), 69 FR 30142 (May 26, 2004)

(“Supplemental Release”). On December 16, 2004, the Commission reproposed Regulation NMS in its entirety for public comment. Securities Exchange Act Release No. 50870 (Dec. 16, 2004), 69 FR 77424 (Dec. 27, 2004) (“Reproposing Release”).

(1) A new Order Protection Rule,

which reinforces the fundamental principle of obtaining the best price for investors when such price is represented by automated quotations that are immediately accessible;

Although the Reproposing Release referred to Rule 611 as the “Trade-Through Rule,” the reproposed Rule itself was named “Order Protection Rule.” The term “Trade-Through Rule” was used in the Reproposing Release to avoid confusion, given that the term had been widely used in public debate. The term “Order Protection Rule,” however, better captures the nature of the adopted Rule. For example, the term helps distinguish the existing trade-through provisions for exchange-listed stocks, which do not really protect orders. Limit order users want a fast, efficient execution of their orders, not a slow, costly “satisfaction” process that is provided by the existing trade-through provisions.

See infra

, note 30 and accompanying text.

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

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

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

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

The Commission is adopting Regulation NMS in furtherance of its statutory responsibilities. In 1975, Congress directed the Commission, through enactment of Section 11A of the Exchange Act, to facilitate the establishment of a national market system to link together the multiple individual markets that trade securities. Congress intended the Commission to take advantage of opportunities created by new data processing and communications technologies to preserve and strengthen the securities markets. By incorporating such technologies, the NMS is designed to achieve the objectives of efficient, competitive, fair, and orderly markets that are in the public interest and protect investors. For three decades, the Commission has adhered to these guiding objectives in its regulation of the NMS, which are essential to meeting the investment needs of the public and reducing the cost of capital for listed companies. Over this period, the Commission has continued to revise and refine its NMS rules in light of changing market conditions.

Today, the NMS encompasses the stocks of more than 5000 listed companies, which collectively represent more than $14 trillion in U.S. market capitalization. Consistent with Congressional intent, these stocks are traded simultaneously at a variety of different venues that participate in the NMS, including national securities exchanges, alternative trading systems (“ATSs”), and market-making securities dealers. The Commission believes that the NMS approach adopted by Congress is a primary reason that the U.S. equity markets are widely recognized as being the fairest, most efficient, and most competitive in the world. The rules that the Commission is now adopting represent an important and needed step forward in its continuing implementation of Congress's objectives for the NMS. By modernizing and strengthening the nation's regulatory structure, the rules are designed to assure that the equity markets will continue to serve the interests of investors, listed companies, and the public for years to come.

In recent years, the equity markets have experienced sweeping changes, ranging from new technologies to new types of markets to the initiation of trading in penny increments. The pressing need for NMS modernization to reflect these changes is inescapable. Thus, for the last five years, the Commission has undertaken a broad and systematic review to determine how best to keep the NMS up-to-date. This review has required the Commission to grapple with many difficult and contentious issues that have lingered unresolved for many years. We have devoted a great deal of effort to studying these issues, listening to the views of the public, and have carefully considered the comments contained in the record to craft rule proposals that would achieve the statutory objectives for the NMS.

Given the wide range of perspectives on market structure issues, it is perhaps inevitable that there would be differences of opinion on the Commission's policy choices. The time has arrived, however, when decisions must be made and contentious issues must be resolved so that the markets can move forward with certainty concerning their future regulatory environment and appropriately respond to fundamental economic and competitive forces. The Commission always seeks to achieve consensus, but trying to achieve consensus should not impede the achievement of the statutory objectives for the NMS and should not damage the competitiveness of the U.S. equity markets, both at home and internationally. We believe that further delay is not warranted and therefore have adopted final rules needed to modernize and strengthen the NMS. The following discussion briefly summarizes the deliberate and open rulemaking process that the Commission has undertaken and the extensive record that supports the adoption of Regulation NMS, including the many empirical studies undertaken by the Commission staff.

A. Summary of Rulemaking Process and Record

The Commission has engaged in a thorough, deliberate, and open rulemaking process that has provided at every point an opportunity for public participation and debate. We have actively sought out the views of the public and securities industry participants. Even prior to formulating proposals, our review included multiple public hearings and roundtables, an advisory committee, three concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives, and a constant dialogue with industry participants and investors. This process continued after the proposals were published for public comment.

We held a public hearing on the proposals in April 2004 (“NMS Hearing”) that included more than 30 panelists representing investors, individual markets, and market participants from a variety of different sectors of the securities industry.

Because we believed that there were a number of important developments at the public hearing, we published a supplemental request for comment and extended the comment period on the proposals in May 2004 to give the public a full opportunity to respond to these developments.

We then carefully considered the more than 700 comment letters submitted by the public, which encompassed a wide range of views.

Proposing Release, 69 FR at 11126.

A list of all panelists and full transcript of the NMS Hearing (“Hearing Tr.”), as well as an archived video and audio webcast, are available on the Commission's Internet Web site (http://www.sec.gov).

Supplemental Release, 69 FR at 30142.

The insights of the commenters, as well as those of the NMS Hearing panelists, contributed to significant refinements of the original proposals. In addition, the Commission staff prepared

several studies of relevant trading data to help evaluate and respond to the views of commenters. Consequently, rather than immediately adopting rules, the Commission reproposed Regulation NMS in its entirety in December 2004 to afford the public an additional opportunity to review and comment on the details of the rules and on the staff studies. The Commission then received, and carefully considered, more than 1500 additional comments on the reproposal.

The Reproposing Release stated that the Commission would continue to consider all comments received on the Proposing Release and Supplemental Release, in addition to those on the Reproposing Release, in evaluating further rulemaking action. 69 FR at 77426. Accordingly, this release discusses comments received in response to all three previous releases. Comments on the Proposing Release and Supplemental Release are referred to as “[name of commenter] Letter.” Comments on the Reproposing Release are referred to as “[name of commenter] Reproposal Letter.”

This extensive rulemaking process has generated an equally extensive record, which is discussed at length throughout this release as it relates to each of the four substantive rulemaking initiatives. Indeed, substantial parts of the release are devoted to responding to the many public comments (particularly those opposing the proposals) and to discussing the estimated costs and benefits of the rules. This rulemaking raised difficult policy issues on which commenters submitted differing views. To move forward, the Commission necessarily has had to make policy decisions that not everyone will agree with.

The fact that each of the adopted rules provoked conflicting views from commenters should not, however, obscure the very substantial evidence in the record strongly supporting each of the four substantive rulemaking initiatives in Regulation NMS. Clearly, the Order Protection Rule was most controversial and attracted the most public comment and attention, yet the breadth of support in the record for the Rule is compelling. Indeed, support for an intermarket price protection rule begins with the adoption by Congress in 1975 of the national market system itself. Both the House and Senate committees responsible for drafting Section 11A specifically considered and endorsed the Commission's authority to adopt a price protection rule as a means to achieve the statutory objectives for the NMS.

See infra

, notes 920-922 and accompanying text.

Consistent with the drafters' views, a broad spectrum of commenters supported adoption of the Order Protection Rule for all NMS stocks, including investors, listed companies, individual markets, market participants, and academics.

Many individual and institutional investors particularly supported the Commission's view that significant problems exist that require the Commission to modernize its regulations. They also suggested the need for strengthened intermarket price protection to further their interests, as did major groups representing investors, such as the Investment Company Institute (whose mutual fund members manage assets of $7.8 trillion that account for more than 95% of all U.S. mutual fund assets), the Committee on Investment of Employee Benefit Assets (which represents 110 of the nation's largest corporate retirement funds managing $1.1 trillion on behalf of 15 million plan participants and beneficiaries), the National Association of Investors Corporation (whose membership consists of investment clubs and individual investors with aggregate personal investments of approximately $116 billion), and the Consumer Federation of America.

See infra

, notes 56-59, 939-941, 957-960, and accompanying text.

Moreover, the commenters' views on the need for an intermarket price protection rule were supported by the various empirical studies of trading data performed by Commission staff. These studies found, among other things, that an estimated 1 out of 40 trades for both NYSE and Nasdaq stocks are executed at prices inferior to the best displayed quotations, or approximately 98,000 trades per day in Nasdaq stocks alone.

While the Commission believes that the total number of trade-throughs should not be the sole consideration in making its policy choices, the staff studies and analyses demonstrate that trade-through rates are significant and indicate the need for strengthened order protection for all NMS stocks.

See infra

, notes 66-69, 104, and accompanying text.

Why did a broad spectrum of commenters, many of which have extensive experience and expertise regarding the inner workings of the equity markets, support the Order Protection Rule and its emphasis on the principle of best price? They based their support on two fundamental rationales, with which the Commission fully agrees. First, strengthened assurance that orders will be filled at the best prices will give investors, particularly retail investors, greater confidence that they will be treated fairly when they participate in the equity markets. Maintaining investor confidence is an essential element of well-functioning equity markets. Second, protection of the best displayed and accessible prices will promote deep and stable markets that minimize investor transaction costs. More than 84 million individual Americans participate, directly or indirectly, in the U.S. equity markets.

The transaction costs associated with the prices at which their orders are executed represent a continual drain on their long-term savings. Although these costs are difficult to calculate precisely, they are very real and very substantial, with estimates ranging from $30 billion to more than $100 billion per year.

Minimizing these investor costs to the greatest extent possible is the hallmark of efficient markets, which is a primary objective of the NMS. The Order Protection Rule is needed to help achieve this objective, thereby improving the long-term financial well-being of millions of investors and reducing the cost of capital for listed companies.

See infra

, notes 25-26 and accompanying text.

See infra

, note 990.

In sum, the rules adopted today are the culmination of a long and comprehensive rulemaking process. Reaching appropriate policy decisions in an area as complex as market structure requires an understanding of the relevant facts and of the often subtle ways in which the markets work, as well as the balancing of policy objectives that sometimes may not point in precisely the same direction. Based on the extensive record that we have developed over the course of the rulemaking process, the Commission firmly believes that Regulation NMS will protect investors, promote fair competition, and enhance market efficiency, and therefore fulfills its Exchange Act responsibility to facilitate the development of the NMS.

B. NMS Principles and Objectives

1. Competition Among Markets and Competition Among Orders

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

integrated competition among orders promotes more efficient pricing of individual stocks for all types of orders, large and small. Together, they produce markets that offer the greatest benefits for investors and listed companies.

Accordingly, the Commission's primary challenge in facilitating the establishment of an NMS has been to maintain an appropriate

balance

between these two vital forms of competition. It particularly has sought to avoid the extremes of: (1) Isolated markets that trade an NMS stock without regard to trading in other markets and thereby fragment the competition among buyers and sellers in that stock; and (2) a totally centralized system that loses the benefits of vigorous competition and innovation among individual markets. Achieving this objective and striking the proper balance clearly can be a difficult task. Since Congress mandated the establishment of an NMS in 1975, the Commission frequently has resisted suggestions that it adopt an approach focusing on a single form of competition that, while perhaps easier to administer, would forfeit the distinct, but equally vital, benefits associated with both competition among markets and competition among orders.

With respect to competition among markets, for example, the record of the last thirty years should give pause to those who believe that any market structure regulation is inherently inconsistent with vigorous market competition. Other countries with significant equity trading typically have a single, overwhelmingly dominant public market.

The U.S., in contrast, is fortunate to have equity markets that are characterized by extremely vigorous competition among a variety of different types of markets. These include: (1) Traditional exchanges with active trading floors, which even now are evolving to expand the range of choices that they offer investors for both automated and manual trading; (2) purely electronic markets, which offer both standard limit orders and conditional orders that are designed to facilitate complex trading strategies; (3) market-making securities dealers, which offer both automated execution of smaller orders and the commitment of capital to facilitate the execution of larger, institutional orders; (4) regional exchanges, many of which have adopted automated systems for executing smaller orders; and (5) automated matching systems that permit investors, particularly large institutions, to seek counter-parties to their trades anonymously and with minimal price impact.

These markets include the London Stock Exchange in the United Kingdom, the Tokyo Stock Exchange in Japan, Euronext in France, and the Deutsche Bourse in Germany.

In sum, while NMS regulation may channel specific types of market competition (

e.g.

, by mandating the display to investors of consolidated prices and including the prices displayed internally by significant electronic markets), it has been remarkably successful in promoting market competition in its broader forms that are most important to investors and listed companies.

The difficulty, however, is that competition among multiple markets trading the same stocks can detract from the most vigorous competition among orders in an individual stock, thereby impeding efficient price discovery for orders of all sizes. The importance of competition among orders has long been recognized. Indeed, when Congress mandated the establishment of an NMS, it well stated this basic principle: “Investors must be assured that they are participants in a system which maximizes the opportunities for the most willing seller to meet the most willing buyer.”

To the extent that competition among orders is lessened, the quality of price discovery for all sizes of orders can be compromised. Impaired price discovery could cause market prices to deviate from fundamental values, reduce market depth and liquidity,

and create excessive short-term volatility that is harmful to long-term investors and listed companies. More broadly, when market prices do not reflect fundamental values, resources will be misallocated within the economy and economic efficiency—as well as market efficiency—will be impaired.

H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975). The quotation from the text of the House Report concludes a cogent description of the importance of maintaining the proper balance between competition among markets and competition among orders that is worth quoting in full:

Critics of this development [multiple trading of stocks] suggest that the markets are becoming dangerously fragmented. Others contend that the dilution of large market dominance is the result of healthy competitive forces which have done much to add to the liquidity and depth of the securities markets to the benefit of the investing public. The Committee shares the opinion that our markets will be strengthened by the infusion of marketmaker competition in listed securities with the concomitant increase in capital availability and diminution of risk which results from increased competition among specialists and marketmakers. Nonetheless, market fragmentation becomes of increasing concern in the absence of mechanisms designed to assure that public investors are able to obtain the best price for securities regardless of the type or physical location of the market upon which his transaction may be executed. Investors must be assured that they are participants in a system which maximizes the opportunities for the most willing seller to meet the most willing buyer.

Id.

The Proposing Release and Reproposing Release frequently emphasized the importance of promoting greater depth and liquidity. Some commenters appeared to equate depth and liquidity with other factors, such as trading volume and frequency of quotation updates.

See, e.g.

, Letter from Edward J. Nicoll, Chief Executive Officer, Instinet Group Incorporated, to Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 (“Instinet Reproposal Letter”) at 9; Letter from Marc E. Lackritz, President, Securities Industry Association, to Jonathan G. Katz, Secretary, Commission, dated Feb. 1, 2005 (“SIA Reproposal Letter”) at 12. The Commission, however, uses the terms specifically to refer to the ability of investors to trade in large size at low cost and in general to a market's capacity to absorb order imbalances with minimized price impact. Depth is measured in terms of the volume of stock that can be readily traded at a particular price point. Liquidity is measured by the price movement experienced by investors when attempting to trade in large size.

See infra

, section II.A.6 (estimate of transaction costs for equity mutual funds). Although depth and liquidity are correlated with trading volume, they are not synonymous. For example, one stock might have less trading volume than another stock, but still have greater depth available at and close to the best quoted prices and lower transaction costs for large institutional investors.

2. Serving the Interests of Long-Term Investors and Listed Companies

In its extended review of market structure issues and in assessing how best to achieve an appropriate balance between competition among markets and competition among orders, the Commission has been guided by a firm belief that one of the most important goals of the equity markets is to minimize the transaction costs of long-term investors and thereby to reduce the cost of capital for listed companies. These functions are inherently related because the cost of capital of listed companies is influenced by the transaction costs of those who are willing to accept the risk of holding corporate equity for an extended period.

Investors are more willing to own a stock if it can be readily traded in the secondary market with low transaction costs. The greater the willingness of investors to own a stock, the higher its price will be, thereby reducing the issuer's cost of capital.

The Reproposing Release touched on this issue in the specific context of assessing the effect of the Order Protection Rule on the interests of professional traders in conducting extremely short-term trading strategies that can depend on millisecond differences in order response time from markets. Noting that any protection against trade-throughs could interfere to some extent with such short-term trading strategies, the release framed the Commission's policy choice as follows: “Should the overall efficiency of the NMS defer to the needs of professional

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 Reproposing Release emphasized that the NMS must meet the needs of longer-term investors, noting that any other outcome would be contrary to the Exchange Act and its objectives of promoting fair and efficient markets that serve the public interest.

Reproposing Release, 69 FR at 77440.

Id.

In response, some commenters disputed this focus on the interests of long-term investors in formulating Regulation NMS, one even questioning the Commission's statutory authority to do so.

Other commenters appeared to share this view, as evidenced by their downplaying, or failing entirely to address, indications of a need for improvements in market quality that are important to long-term investors, such as minimizing short-term price volatility.

Letter from Phylis M. Esposito, Executive Vice President, Chief Strategy Officer, Ameritrade, Inc., to Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 (“Ameritrade Reproposal Letter”) at 9 (among other issues, questioning Commission's statutory authority); Letter from James A. Duncan, Chairman, and John C. Giesea, President and CEO, Security Traders Association, to Jonathan G. Katz, Secretary, Commission, dated Jan. 19, 2005 (“STA Reproposal Letter”) at 6; Letter from William A. Vance, Stephen Kay, and Kimberly Unger, The Security Traders Association of New York, Inc., dated Jan. 24, 2005 (“STANY Reproposal Letter”) at 8 n. 18.

See, e.g.

, Instinet Reproposal Letter at 7-8 (“We further believe there is no basis for the Commission's assertion that the reproposed trade-through rule would increase fill rates or reduce transitory volatility on the Nasdaq market (or, for that matter, whether these are in fact ‘weaknesses' that need to be addressed.”). Short-term price volatility for Nasdaq stocks is discussed further in section II.A.1.b below.

Most of the time, the interests of short-term traders and long-term investors will not conflict. Short-term traders clearly provide valuable liquidity to the market. But when the interests of long-term investors and short-term traders diverge, few issues are more fundamentally important in formulating public policy for the U.S. equity markets than the choice between these interests. While achieving the right balance of competition among markets and competition among orders will always be a difficult task, there will be no possibility of accomplishing it if in the case of a conflict the Commission cannot choose whether the U.S. equity markets should meet the needs of long-term investors or short-term traders.

The objective of minimizing short-term price volatility offers an important example where the interests of long-term investors can diverge from those of short-term traders. Deep and liquid markets that minimize volatility are of most benefit to long-term investors. Such markets help reduce transaction costs by furthering the ability of investors to establish and unwind positions in a stock at prices that are as close to previously prevailing prices as possible. Indeed, the 1975 Senate Report on the NMS emphasized that one of the “paramount” objectives for the NMS is “the maintenance of stable and orderly markets with maximum capacity for absorbing trading imbalances without undue price movements.”

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

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

Efficient markets with maximum liquidity and depth minimize such price movements and thereby afford long-term investors an opportunity to achieve their trading objectives with the lowest possible transaction costs.

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

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

The concept of ownership for a significant time period is inherent in the meaning of word “invest.” A dictionary definition of “investor,” for example, is “one that seeks to commit funds for long-term profit with a minimum of risk.”

Webster's Third New International Dictionary of the English Language

1190 (Unabridged 1993).

Short-term traders and market intermediaries unquestionably provide needed liquidity to the equity markets and are essential to the welfare of investors. Consequently, much, if not most, of the time the interests of long-term investors and short-term traders in market quality issues such as speed and operational efficiency will coincide. Indeed, implementation of Regulation NMS likely will lead to a significant expansion of automated trading in exchange-listed stocks that both benefits all investors and opens up greater potential for electronic trading in such stocks than currently exists. But when the interests of long-term investors and short-term traders conflict in this context, the Commission believes that its clear responsibility is to uphold the interests of long-term investors.

Indeed, the core concern for the welfare of long-term investors who depend on equity investments to meet their financial goals was first expressed in the foundation documents of the Exchange Act itself. In language that remains remarkably relevant today, the 1934 congressional reports noted how the national public interest of the equity markets had grown as more and more Americans had begun to place their savings in equity investments, both directly and indirectly through investment intermediaries.

Given this development, the reports emphasized that “stock exchanges which handle the distribution and trading of a very substantial part of the entire national wealth * * * cannot operate under the same traditions and practices as pre-war stock exchanges which handled substantially only the transactions of professional investors and speculators.”

H.R. Rep. No. 1383, 73rd Cong., 2d Sess. 3-4 (1934) (“It is estimated that more than 10,000,000 individual men and women in the United States are the direct possessors of stocks and bonds; that over one-fifth of all the corporate stock outstanding in the country is held by individuals with net incomes of less than $5,000 a year. Over 15,000,000 individuals held insurance policies, the value of which is dependent on the security holdings of insurance companies. Over 13,000,000 men and women have savings accounts in mutual savings banks and at least 25,000,000 have deposits in national and State banks and trust companies—which are in turn large holders of corporate stocks and bonds.”).

Id.

at 4. The Congressional emphasis on the interests of long-term investors versus short-term traders also was expressed in the 1934 Report on

Stock Exchange Practices prepared by investigators for the Senate Committee on Banking and Currency:

“Transactions in securities on organized exchanges and over-the-counter markets are affected with the national public interest. * * * In former years transactions in securities were carried on by a relatively small portion of the American people. During the last decade, however, due largely to the development of the means of communication * * * the entire Nation has become acutely sensitive to the activities on the securities exchanges. While only a fraction of the multitude who now own securities can be regarded as actively trading on the exchanges, the operations of these few profoundly affect the holdings of all.”

S. Rep. No. 73-1455, 73rd Cong., 2d Sess. 5 (1934).

In the years since 1934, the priority placed by Congress on the interests of long-term investors has grown more and more significant. Today, more than 84 million individuals representing more than one-half of American households own equity securities.

More than 70 million of these individuals participate indirectly in the equity markets through ownership of mutual fund shares. Most of them hold their investments, at least in part, in retirement plans. Indeed, nearly all view their equity investments as savings for the long-term, and their median length of ownership of equity mutual funds, both inside and outside retirement plans, is 10 years.

Investment Company Institute and Securities Industry Association,

Equity Ownership in America

17 (2002).

Id.

at 85, 89, 92, 96.

In assessing the current state of the NMS and formulating its rule proposals, the Commission has focused on the interests of these millions of Americans who depend on the performance of their equity investments for such vital needs as retirement security and their children's college education. Their investment returns are reduced by transaction costs of all types, including the explicit costs of commissions and mutual fund fees. But the largely hidden costs associated with the prices at which trades are executed often can dwarf the explicit costs of trading. For example, the implicit transaction costs associated with the price impact of trades and liquidity search costs of mutual funds and other institutional investors is estimated at more than $30 billion per year.

Such hidden costs eat away at the long-term returns of millions of individual mutual fund shareholders and pension plan participants. One of the primary objectives of the NMS is to help reduce such costs by improving market liquidity and depth. The best way to promote market depth and liquidity is to encourage vigorous competition among orders. As a result, the Commission cannot merely focus on one type of competition—competition among markets to provide trading services—at the expense of competition among orders. The interests of U.S. long-term investors and listed companies require that the NMS continue to promote both types of competition.

See infra

, section II.A.6.

C. Overview of Adopted Rules

1. Order Protection Rule

The Order Protection Rule (Rule 611 under Regulation NMS) establishes intermarket protection against trade-throughs for all NMS stocks. A trade-through occurs when one trading center executes an order at a price that is inferior to the price of a protected quotation, often representing an investor limit order, displayed by another trading center.

Many commenters on the proposals, particularly large institutional investors, strongly supported the need for enhanced protection of limit orders against trade-throughs.

They emphasized that limit orders are the building blocks of public price discovery and efficient markets. They stated that a uniform rule for all NMS stocks, by enhancing protection of displayed prices, would encourage greater use of limit orders and contribute to increased market liquidity and depth. The Commission agrees that strengthened protection of displayed limit orders would help reward market participants for displaying their trading interest and thereby promote fairer and more vigorous competition among orders seeking to supply liquidity. Moreover, strong intermarket price protection offers greater assurance, on an order-by-order basis, that investors who submit market orders will receive the best readily available prices for their trades. The Commission therefore has adopted the Order Protection Rule to strengthen the protection of displayed and automatically accessible quotations in NMS stocks.

The nature and scope of quotations that will be protected under the Order Protection Rule are discussed in detail in sections II.A.2 and II.B.1 below.

See infra

, note 56 (overview of commenters supporting trade-through proposal).

The Order Protection Rule takes a substantially different approach than the trade-through provisions currently set forth in the Intermarket Trading System (“ITS”) Plan,

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

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

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

In addition, the Order Protection Rule incorporates an approach to trade-throughs that is stricter and more comprehensive than the ITS provisions. First, it requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs, or, if relying on one of the rule's exceptions, that are reasonably designed to assure compliance with the exception. To assure effective compliance, such policies and procedures will need to incorporate objective standards that are coded into a trading center's automated systems.

Moreover, a trading center is required to regularly surveil to ascertain the effectiveness of its policies and procedures and to take prompt action to remedy deficiencies. Second, the Order Protection Rule eliminates very significant gaps in the coverage of the ITS provisions that have undermined the extent to which they protect limit orders and promote fair and orderly trading. In particular, the ITS provisions do not cover the transactions of broker-dealers acting as off-exchange block positioners in exchange-listed stocks. They also exclude trade-throughs of 100-share quotations, thereby allowing some limit orders of small investors to be bypassed. The Order Protection Rule closes both of these gaps in coverage.

The definition of “protected bid” or “protected offer” in paragraph (b)(57) of adopted Rule 600 controls the scope of quotations that are protected by the Order Protection Rule. The Commission is adopting the reproposed “Market BBO Alternative” that protects only the best bids and offers (“BBOs”) of the nine self-regulatory organizations (“SROs”) and The Nasdaq Stock Market, Inc. (“Nasdaq”) whose members currently trade NMS stocks. As discussed further in section II.A.5 below, the Commission has decided not to adopt the reproposed “Voluntary Depth Alternative.” In particular, it believes that the Market BBO Alternative: (1) Strikes an appropriate balance between competition among markets and competition among orders; and (2) will be less difficult and costly to implement than the Voluntary Depth Alternative.

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

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

Some commenters questioned the need to extend the Order Protection Rule to Nasdaq stocks.

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.

See infra,

notes 61-62 and accompanying text.

The Commission believes, however, that intermarket price protection will benefit investors and strengthen the NMS in both exchange-listed and Nasdaq stocks. It will contribute to the maintenance of fair and orderly markets and, thereby, promote investor confidence in the markets. As discussed below,

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

See infra

, section II.A.1.a.ii.

2. Access Rule

The Access Rule (Rule 610 under Regulation NMS) sets forth new standards governing access to quotations in NMS stocks. As emphasized by many commenters on the proposals,

protecting the best displayed prices against trade-throughs would be futile if broker-dealers and trading centers were unable to access those prices fairly and efficiently. Accordingly, Rule 610 is designed to promote access to quotations in three ways. First, it enables the use of private linkages offered by a variety of connectivity providers,

rather than mandating a collective linkage facility such as ITS, to facilitate the necessary access to quotations. The lower cost and increased flexibility of connectivity in recent years has made private linkages a feasible alternative to hard linkages, absent barriers to access. Using private linkages, market participants may obtain indirect access to quotations displayed by a particular trading center through the members, subscribers, or customers of that trading center. To promote this type of indirect access, Rule 610 prohibits a trading center from imposing unfairly discriminatory terms that would prevent or inhibit the access of any person through members, subscribers, or customers of such trading center.

See infra

, section III.A.1.

Private linkages are discussed further in section III.A.1 below.

Second, Rule 610 generally limits the fees that any trading center can charge (or allow to be charged) for accessing its protected quotations to no more than $0.003 per share.

The purpose of the fee limitation is to ensure the fairness and accuracy of displayed quotations by establishing an outer limit on the cost of accessing such quotations. For example, if the price of a protected offer to sell an NMS stock is displayed at $10.00, the total cost to access the offer and buy the stock will be $10.00, plus a fee of no more than $0.003. The adopted rule thereby assures order routers that displayed prices are, within a limited range, true prices.

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

See infra

, section III.A.2.

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

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 comments on access fees are addressed in section III.A.2 below.

The Commission believes that a single, uniform fee limitation of $0.003 per share is the fairest and most appropriate resolution of the access fee issue. First, it will not seriously interfere with current business practices, as trading centers have very few fees on their books of more than $0.003 per share or earn substantial revenues from such fees.

Second, the uniform fee limitation promotes equal regulation of different types of trading centers, where previously some had been permitted to charge fees and some had not. Finally and most importantly, the fee limitation of Rule 610 is necessary to support the integrity of the price protection requirement established by the adopted Order Protection Rule. In the absence of a fee limitation, some “outlier” trading centers might take advantage of the requirement to protect displayed quotations by charging exorbitant fees to those required to access the outlier's quotations. Rule 610's fee limitation precludes the initiation of this business practice, which would compromise the fairness and efficiency of the NMS.

See infra

, section III.A.2.

Finally, Rule 610 requires SROs to establish, maintain, and enforce written rules that, among other things, prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross the protected quotations of other trading centers. Trading centers will be allowed, however, to display automated quotations that lock or cross the

manual

quotations of other trading centers. The Access Rule thereby reflects the disparity in speed of response between automated and manual quotations, while also promoting fair and orderly markets by establishing that the first protected quotation at a price, whether it be a bid or an offer, is entitled to an execution at that price instead of being locked or crossed by a quotation on the other side of the market.

3. Sub-Penny Rule

The Sub-Penny Rule (adopted Rule 612 under Regulation NMS) prohibits market participants from displaying, ranking, or accepting quotations in NMS stocks that are priced in an increment of less than $0.01, unless the price of the quotation is less than $1.00. If the price of the quotation is less than $1.00, the minimum increment is $0.0001. A strong consensus of commenters supported the sub-penny proposal as a means to promote greater price transparency and consistency, as well as to protect displayed limit orders.

In particular, Rule 612 addresses the practice of “stepping ahead” of displayed limit orders by trivial amounts. It therefore should further encourage the display of limit orders and improve the depth and liquidity of trading in NMS stocks.

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

4. Market Data Rules and Plans

The adopted amendments to the Market Data Rules (adopted Rules 601 and 603 under Regulation NMS) and joint industry plans (“Plans”)

are designed to promote the wide availability of market data and to allocate revenues to SROs that produce the most useful data for investors. They will strengthen the existing market data system, which provides investors in the U.S. equity markets with real-time access to the best quotations and most recent trades in the thousands of NMS stocks throughout the trading day. For each stock, quotations and trades are continuously collected from many different trading centers and then disseminated to the public in a consolidated stream of data. As a result, investors of all types have access to a reliable source of information for the best prices in NMS stocks. When Congress mandated the creation of the NMS in 1975, it noted that the systems for disseminating consolidated market data would “form the heart of the national market system.”

Accordingly, one of the Commission's most important responsibilities is to preserve the integrity and affordability of the consolidated data stream.

The three joint-industry plans are (1) the CTA Plan, which is operated by the Consolidated Tape Association and disseminates transaction information for exchange-listed securities, (2) the CQ Plan, which disseminates consolidated quotation information for exchange-listed securities, and (3) the Nasdaq UTP Plan, which disseminates consolidated transaction and quotation information for Nasdaq-listed securities. The CTA Plan and CQ Plan are available at

www.nysedata.com.

The Nasdaq UTP Plan is available at

www.utpdata.com.

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

The adopted amendments promote this objective in several different respects. First, they update the formulas for allocating revenues generated by market data fees to the various SRO participants in the Plans. The current Plan formulas are seriously flawed by an excessive focus on the number of trades, no matter how small the size, reported by an SRO. They thereby create an incentive for distortive behavior, such as wash sales and trade shredding,

and fail to reflect an SRO's contribution to the best displayed quotations in NMS stocks. The adopted formula corrects these flaws. It also is much less complex than the original proposal, primarily because, consistent with the approach of the Order Protection Rule and Access Rule, the new formula eliminates any allocation of revenues for manual quotations. It therefore will promote an allocation of revenues to the various SROs that more closely reflects the usefulness to investors of each SRO's market information.

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

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

Many commenters on the market data proposals expressed frustration with the current operation of the Plans.

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.

Comments on the market data proposals are discussed in section V.A below.

Some commenters mistakenly believed that the level of market data fees had been left unreviewed for many years. In fact, the Commission comprehensively reviewed market data fees in 1999, which led to a 75% reduction in fees paid by retail investors for market data.

See infra

, note 574.

The Commission has considered these concerns at length in the recent past. As was noted in the Proposing Release,

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.

Proposing Release, 69 FR at 11177.

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

The Commission also has considered the suggestion of many in the second group of commenters that market data fees should be cut back to encompass only the costs of the

Plans

to collect and disseminate market data. Under this approach, the individual SROs would no longer be allowed to fund any portion of their operational and regulatory functions through market data fees.

Yet, as discussed in the Commission's 1999 concept release on market data,

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.

The U.S. equity markets are not alone in their reliance on market information revenues as a significant source of funding. All of the other major world equity markets currently derive large amounts of revenues from selling market information.

See infra

, note 587 and accompanying text.

Securities Exchange Act Release No. 42208 (Dec. 9, 1999), 64 FR 70613 (Dec. 17, 1999) (“Market Information Release”).

If the Commission were to limit market data fees to cover only Plan costs, SRO funding would have been cut by $393.7 million in 2004.

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.

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.

See infra

, text accompanying note 564 (table setting forth revenue allocations for 2004).

Securities Exchange Act Release No. 50700 (Nov. 18, 2004), 69 FR 71256 (Dec. 8, 2004) (“SRO Structure Release”).

Securities Exchange Act Release No. 50699 (Nov. 18, 2004), 69 FR 71126 (Dec. 8, 2004) (“SRO Transparency Release”).

In sum, there is inherent tension between assuring consolidated price transparency for investors, which is a fundamental objective of the Exchange Act,

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

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

II. Order Protection Rule

The Commission is adopting Rule 611 under Regulation NMS to establish protection against trade-throughs for all NMS stocks. Rule 611(a)(1) requires a trading center (which includes national securities exchanges, exchange specialists, ATSs, OTC market makers, and block positioners)

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

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

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

quotations that are truly automated and accessible.

By strengthening price protection in the NMS for quotations that can be accessed fairly and efficiently, Rule 611 is designed to promote market efficiency and further the interests of both investors who submit displayed limit orders and investors who submit marketable orders.

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

For ease of reference in this release, the term “limit order” generally will refer to a non-marketable order and the term “marketable order” will refer to both market orders and marketable limit orders. A non-marketable limit order has a limit price that prevents its immediate execution at current market prices. Because these orders cannot be executed immediately, they generally are publicly displayed to attract contra side interest at the price. In contrast, a “marketable limit order” has a limit price that potentially allows its immediate execution at current market prices. As discussed further below, marketable limit orders often cannot be filled at current market prices because of insufficient liquidity and depth at the market price.

See infra

, text accompanying notes 121-123, 134-136.

A. Response to Comments and Basis for Adopted Rule

Rule 611 as adopted reflects a number of changes to the rule as originally proposed. As discussed below, the Commission has made these changes in response to substantial public comment on the proposed rule and on the issues arising out of the NMS Hearing that were addressed in the Supplemental Release. In addition, the adopted rule includes a new exception for certain “stopped orders” in response to the suggestions of commenters on the reproposal. The public submitted more than 2200 comments addressing the trade-through proposal and reproposal.

Although the comments covered a very wide range of matters, they particularly focused on the following issues:

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

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

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

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

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

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

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

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

1. Need for Intermarket Order Protection Rule

Commenters were divided on the central issue of whether intermarket protection of displayed quotations is needed to promote the fairest and most efficient markets for investors.

Many commenters strongly supported the adoption of a uniform rule for all NMS stocks to promote best execution of market orders, to protect the best displayed prices, and to encourage the public display of limit orders.

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 the most transparent form of price discovery). Commenters supporting the need for an intermarket trade-through rule also believed that it would increase investor confidence by helping to eliminate the impression of unfairness when an investor's order executes at a price that is worse than the best displayed quotation, or when a trade occurs at a price that is inferior to the investor's displayed order.

Nearly all commenters, both those supporting and opposing the need for an intermarket trade-through rule, agreed that the current ITS trade-through provisions are seriously outdated and in need of reform. They particularly focused on the problems created by affording equal protection against trade-throughs to both automated and manual quotations.

See supra

, section II.A.2. Adopted Rule 611 responds to these problems by protecting only automated quotations.

Approximately 1689 commenters on the proposal and reproposal favored a uniform trade-through rule without an opt-out exception. These commenters included: (1) several mutual fund companies and the Investment Company Institute; (2) the Consumer Federation of America and the National Association of Individual Investors Corporation; (3) the floor-based exchanges and their members; (4) approximately 107 listed companies; (5) a variety of securities industry participants; and (6) approximately 42 members of Congress. Of the commenters supporting the reproposal, approximately 452 utilized “Letter Type G” (noting the existence of two alternative proposals and urging “support for the Regulation NMS proposal without the CLOB” alternative), 70 utilized “Letter Type H” (“we support the ‘top of the book' proposal that has been discussed for the past year as part of the Regulation NMS discussion”), 204 utilized “Letter Type I” (“I believe a better approach would be the SEC's proposed alternative to the CLOB, to protect the best price in each market center”), 548 utilized “Letter Type J” (“Of the two alternatives laid out in the rule as re-proposed on December 15, 2004, protecting the best bid and offer in each market center preserves both types of competition in a way that benefits all securities industry participants.”), 28 utilized “Letter Type K” (“One alternative is that of protecting the “best bid and offer” in each market center. This concept enhances competition, allows for price negotiation, encourages innovation, and treats all market participants fairly and equally.”), and 109 utilized “Letter Type L” (noting the existence of two alternative proposals and urging support for “the Regulation NMS proposal without the CLOB” alternative). Each of the letter types is posted on the Commission's Internet Web site

(http://www.sec.gov/rules/proposed.shtml

). Those commenters that only expressed opposition to the Voluntary Depth Alternative were not included in the foregoing summary. In addition, many commenters supported an opt-out exception to a trade-through rule, but varied in the extent to which they made clear whether they supported a trade-through rule in general. These commenters are not included in the foregoing summary, but are included in note 232 below addressing supporters of an opt-out exception.

See, e.g.

, Letter from John J. Wheeler, Vice President, Director of U.S. Equity Trading, American Century Investment Management Inc., to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 (“American Century Letter”) at 2; Letter from Matt D. Lyons, Capital Research and Management Company, to Jonathan G. Katz, Secretary, Commission, dated June 28, 2004 (“Capital Research Letter”) at 2; Letter from Ari Burstein, Associate Counsel, Investment Company

Institute, to Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 (“ICI Reproposal Letter”) at 2; Letter from Henry H. Hopkins, Vice President and Chief Legal Counsel, and Andrew M. Brooks, Vice President and Head of Equity Trading, T. Rowe Price Associates, Inc., to Jonathan G. Katz, Commission, dated Jan. 27, 2005 (“T. Rowe Price Reproposal Letter”) at 2; Letter from George U. Sauter, Managing Director, The Vanguard Group, Inc., to Jonathan G. Katz, Secretary, Commission, dated Jan. 27, 2005 (“Vanguard Reproposal Letter”) at 2.

Id.

See, e.g.

, Letter from Barbara Roper, Director of Investor Protection, Consumer Federation of America, to Jonathan G. Katz, Secretary, Commission, dated June 17, 2004 (“Consumer Federation Letter”) at 2; Letter from Ari Burstein, Associate Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 (“ICI Letter”) at 7.

Other commenters, in contrast, opposed any intermarket trade-through rule.

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.

Approximately 448 commenters on the proposal and reproposal opposed a trade-through rule. Approximately 179 of these commenters utilized “Letter Type C,” which primarily supported an opt-out exception to the proposed rule, but also suggested that having no trade-through rule would be simpler. Letter Type C is posted on the Commission's Internet Web site

(http://www.sec.gov/rules/proposed.shtml

). The remaining commenters included securities industry participants, particularly electronic markets and their participants, a variety of local political and community groups and individuals, and 34 members of Congress.

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

and (2) trading in Nasdaq stocks currently is more efficient than trading in NYSE stocks.

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.

See, e.g.

, Letter from Kim Bang, President & Chief Executive Officer, Bloomberg Tradebook LLC, to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 (“Bloomberg Tradebook Letter”) at 10; Letter from Eric D. Roiter, Senior Vice President & General Counsel, Fidelity Management and Research Company, to Jonathan G. Katz, Secretary, Commission, dated June 22, 2004 (“Fidelity Letter I”) at 11; Letter from Suhas Daftuar, Managing Director, Hudson River Trading, to Jonathan G. Katz, Secretary, Commission, dated August 13, 2004 (“Hudson River Trading Letter”) at 1; Letter from Edward J. Nicoll, Chief Executive Officer, Instinet Group Incorporated, to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 (“Instinet Letter”) at 14; Letter from Edward S. Knight, The Nasdaq Stock Market, Inc., to Jonathan G. Katz, Secretary, Commission, dated July 2, 2004 (“Nasdaq Letter II”) at 6 and Attachment III.

See, e.g.

, Letter from Ellen L. S. Koplow, Executive Vice President and General Counsel, Ameritrade Holding Corporation, to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 (“Ameritrade Letter I”), Appendix at 10; Letter from William O'Brien, Chief Operating Officer, Brut LLC, to Jonathan G. Katz, Secretary, Commission, dated July 29, 2004 (“Brut Letter”) at 10; Fidelity Letter I at 11; Instinet Letter at 3, 9 and Exhibit A; Nasdaq Letter II at 6 and Attachment II; Letter from Bruce N. Lehmann & Joel Hasbrouck, Organizers, Reg NMS Study Group, to Jonathan G. Katz, Secretary, Commission (no date) (“NMS Study Group Letter”) at 4; Letter from David Colker, Chief Executive Officer & President, National Stock Exchange, to Jonathan G. Katz, Secretary, Commission, dated June 29, 2004 (“NSX Letter”) at 3; Letter from Huw Jenkins, Managing Director, Head of Equities for the Americas, UBS Securities LLC, to Jonathan G. Katz, Secretary, Commission, dated June 30, 2004 (“UBS Letter”) at 4.

The Commission has carefully evaluated the views of these commenters on both the original proposal and the reproposal. In addition, Commission staff has prepared several studies of trading in Nasdaq and NYSE stocks to help assess and respond to commenters' claims. The studies and the Commission's conclusions are discussed in detail below. In general, however, the Commission has found that current trade-through rates are not lower for Nasdaq stocks than NYSE stocks, despite the fact that nearly all quotations for Nasdaq stocks are automated, rather than divided between manual and automated as they are for exchange-listed stocks. Moreover, the majority of the trade-throughs that currently occur in NYSE stocks fall within gaps in the coverage of the existing ITS trade-through rules that will be closed by the Order Protection Rule. Consequently, the Commission believes that the Order Protection Rule, by establishing effective intermarket protection against trade-throughs, will materially reduce the trade-through rates in both the market for Nasdaq stocks and the market for exchange-listed stocks.

In addition, the commenters' claim that the Order Protection Rule is not needed because trading in Nasdaq stocks, which currently does not have any trade-through rule, is more efficient than trading in NYSE stocks, which has the ITS trade-through provisions, also is not supported by the relevant data.

This conclusion is particularly evident when market efficiency is examined from the perspective of the transaction costs of long-term investors, as opposed to short-term traders. The data reveals that the markets for Nasdaq and NYSE stocks each have their particular strengths and weaknesses. In assessing the need for the Order Protection Rule, the Commission has focused primarily on whether effective intermarket protection against trade-throughs will materially contribute to a fairer and more efficient market for investors in Nasdaq stocks, given their particular trading characteristics, and in exchange-listed stocks, given their particular trading characteristics. Thus, the critical issue is whether each of the markets would be improved by adoption of the Order Protection Rule, not whether one or the other currently is, on some absolute level, superior to the other. The Commission believes that effective intermarket protection against trade-throughs will produce substantial benefits for investors in both markets and, therefore, has adopted the Order

Protection Rule for both Nasdaq and exchange-listed stocks.

See infra

, section II.A.1.b.

a. Trade-Through Rates in Nasdaq and NYSE Stocks

The first principal factual contention of commenters on the original proposal who were opposed to a trade-through rule is premised on the claim that there are fewer trade-throughs in Nasdaq stocks, which are not covered by any trade-through rule, than in NYSE stocks, which are covered by the ITS trade-through provisions.

One commenter asserted that, outside the exchange-listed markets, competition alone had been sufficient to create a “no-trade through zone.”

To respond to these commenters, the Commissions staff reviewed public quotation and trade data to estimate the incidence of trade-throughs for Nasdaq and NYSE stocks.

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.

When considered as a percentage of number of trades, the overall trade-through rate for both Nasdaq and NYSE stocks was 2.5%. When considered as the size of traded-through quotations as a percentage of total share volume, the overall rates for Nasdaq and NYSE stocks were, respectively, 1.9% and 1.2%.

In addition, the staff study found that the amount of the trade-throughs was significant—2.3 cents per share on average for Nasdaq stocks and 2.2 cents per share for NYSE stocks.

See, e.g.

, Bloomberg Tradebook Letter at 10; Fidelity Letter I at 11; Hudson River Trading Letter at 1; Instinet Letter at 14; Nasdaq Letter II at 6 and Attachment III.

Letter from Kevin J. P. O'Hara, Chief Administrative Officer & General Counsel, Archipelago Holdings, Inc., to Jonathan G. Katz, Secretary, Commission, dated September 24, 2004 (“ArcaEx Letter”) at 3.

Memorandum to File, from Office of Economic Analysis, dated December 15, 2004 (analysis of trade-throughs in Nasdaq and NYSE issues) (“Trade-Through Study”). The Trade-Through Study has been placed in Public File No. S7-10-04 and is available for inspection on the Commission's Internet Web site (

http://www.sec.gov

). To eliminate false trade-throughs, the staff calculated trade-through rates using a 3-second window—a reference price must have been displayed one second before a trade and still have been displayed one second after a trade. In addition, the staff eliminated quotations displayed by the American Stock Exchange LLC (“Amex”) from the analysis of Nasdaq stocks because they were manual quotations. Finally, the staff used the time of execution of a trade, if one was given, rather than time of the trade report itself. This methodology was designed to address manual trades, such as block trades, that might not be reported for several seconds after the trade was effected manually.

Trade-Through Study, Tables 4, 11. The 7.9% and 7.2% figures include the entire size of trades that were executed at prices inferior to displayed quotations.

Id.

at 2. The 1.9% and 1.2% figures include only the total displayed size of quotations that were traded through by trades executed at prices inferior to the displayed quotations.

Id.

, Tables 3, 10.

The staff study also revealed that a large volume of block transactions (10,000 shares or greater) trade through displayed quotations. Block transactions represent approximately 50% of total trade-through volume for both Nasdaq and NYSE stocks.

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.

The two gaps in ITS coverage therefore account for most of the trade-through volume in NYSE stocks. The Order Protection Rule, by closing these gaps in protection against trade-throughs, will establish much stronger price protection than the ITS provisions.

Id.

, Tables 4, 11.

Id.

, Table 11.

Commenters opposed to the trade-through reproposal offered a number of criticisms of the staff study. Such criticisms generally fall into two categories: (1) Possible reasons why the staff study might have overestimated trade-through rates, particularly for Nasdaq stocks; and (2) even assuming the estimated trade-through rates were accurate, arguments for why such rates do not support a conclusion that the Order Protection Rule is needed or will benefit the markets, particularly for Nasdaq stocks. These criticisms are evaluated below.

i. Accuracy of Estimated Trade-Through Rates

Several commenters asserted that the staff study overestimated trade-through rates because it failed to consider the existence of reserve size and sweep orders in the Nasdaq market, which could have caused “false positive” trade throughs.

In theory, order routers could intend to sweep the market of all superior quotations before trading at an inferior price, but if they did not effectively sweep both displayed size and reserve size, the superior quotations would not change and the staff study would report a false indication of a trade-through when the trade in another market occurred at an inferior price. In practice, however, those who truly intend to sweep the best prices are quite capable of routing orders to execute against both displayed and estimated reserve size, thereby precluding the possibility of a false positive trade-through. Indeed, although commenters asserted that the staff study failed to consider the existence of reserve size for Nasdaq stocks, the validity of their own argument is premised on the failure of sophisticated market participants to consider the existence of reserve size when routing sweep orders.

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

It currently is impossible to determine from publicly available trade and quotation data whether the initiator of a trade-through in one market has simultaneously attempted to sweep better-priced quotations in other markets.

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

Thus, it is

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

After implementation of Rule 611, such orders generally will be marked as intermarket sweep orders pursuant to the exceptions set forth in Rule 611(b)(5) and (6). As discussed in note 317 below, the Commission intends to request that the NMS trade reporting plans consider collecting and disseminating special modifiers for all trades that are executed pursuant to an exception from Rule 611. Such modifiers would greatly enhance transparency and minimize the potential for false appearances of violations of Rule 611.

Memorandum to File, from Office of Economic Analysis, dated April 6, 2005, at 1 (supplemental trade-through analysis—reserve size analysis,

sample day activity analysis, and analysis of quote depth) (“Supplemental Trade-Through Study”). For example, the Supplemental Trade-Through Study found that, when the trade-through statistics are adjusted to reflect possible instances in which sweep orders could have failed to execute against reserve size, the estimated trade-through rates for Nasdaq stocks declined slightly from 2.5% of total trades to 2.3% of total trades, and from 7.9% of total share volume to 7.7% of total share volume. These small reductions do not support the assertion of commenters that market participants systematically fail to take out reserve size when routing sweep orders. Rather, the reductions are much more consistent with the random distribution of trade volume that would be expected to occur in the traded-through markets from time to time.

ArcaEx noted that it was common practice in the market for exchange-listed stocks to send commitments to trade through the ITS to avoid trading through quotations in other markets. Letter from Kevin J. P. O'Hara, Chief Administrative Officer and General Counsel, Archipelago Holdings, Inc., to Jonathan G. Katz, Secretary, Commission, dated Jan. 26, 2005 (“ArcaEx Reproposal Letter”), Annex A at 1. Given the slowness with which ITS commitments to trade often are processed and manual quotations are updated, ArcaEx suggested that trade-through rates for exchange-listed stocks might be overestimated. The Commission agrees that this criticism may well be valid to some extent. Thus, the trade-through rates for NYSE stocks in the staff study may be overstated for ArcaEx and other markets trading exchange-listed stocks. The occurrence of apparent trade-throughs in exchange-listed stocks caused by manual quotations under the current ITS provisions is addressed in the Order Protection Rule by protecting only automated quotations.

One commenter asserted that the staff study was flawed because its sample trading days involved unusual trading activity.

Commission staff chose the sample trading days, however, only after affirming that they were representative of normal trading. To respond to this commenter's claim, Commission staff reaffirmed that all four days were well within the norms for trading volume and price volatility.

In addition, the trade-through rates remained quite stable across the four days (

e.g.

, ranging only from 2.3% to 2.6% for Nasdaq stocks).

ArcaEx Reproposal Letter, Annex A.

Supplemental Trade-Through Study at 3.

Id.

Two commenters asserted that, even if the staff study's estimate of trade-through rates was correct for the trading days chosen in the Fall of 2003, such rates are now outdated for Nasdaq stocks because of structural changes in the market.

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

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

Indeed, Nasdaq's own data illustrates this possibility.

Although Nasdaq asserts that the reduction in trade-through rates from 2003 to 2004 is a result of fewer independently operating ECNs, its data undercuts this explanation. For example, Nasdaq's data shows that the trade-through rate at internalizing securities dealers dropped from 3.2% in 2003 to 1.4% in 2004.

It is unlikely that ECN consolidation could have caused such a major reduction in trade-through rates at securities dealers when they execute their customer orders internally.

The great majority of internalized trades are the small trades of retail investors. The fact that, in 2003, nearly 1 of 30 of these millions of trades appears to have been executed at a price inferior to an automated and accessible quotation is troubling. Given that one of the primary benefits of the Order Protection Rule is to backstop a broker's duty of best execution on an order-by-order basis, Nasdaq's data appears to indicate a continuing need for regulatory action to reinforce the fundamental principle of best price for all NMS stocks.

Nasdaq Reproposal Letter, Exhibit 1 at 4.

Nasdaq also mentions “less developed” matching systems as contributing to the high rate of trade-throughs in Fall 2003, but does not identify any major technology advances from Fall 2003 to Fall 2004 that would have enabled the reduction in trade-through rates at internalizing securities dealers.

. at 4.

Nasdaq also criticized the staff study for failing to address whether large block trades “intentionally avoid interacting with the posted quotes.”

Far from demonstrating a flaw in the staff study, however, the fact that large trades intentionally avoid interacting with displayed quotations was one of the primary reasons identified in the Reproposing Release supporting the need for intermarket order protection.

The opportunity for displayed limit orders to begin interacting with this substantial volume of block trades is likely to be one of the most significant incentives for increased display of limit orders after implementation of the Order Protection Rule. Moreover, the Order Protection Rule will promote a more level playing field for retail investors that currently see their smaller displayed orders bypassed by block trades.

Nasdaq Reproposal Letter, Exhibit 1 at 4.

See also

UBS Reproposal Letter at 4 (describing numbers in staff study as “inflated” because they included institutional block trades).

69 FR at 77434.

Two commenters did not believe the staff study should have included trades larger than quoted size, asserting that “[e]ven in a hard CLOB environment, orders larger than the inside quote would still 'trade through' the inside quote in effect at the time the order was received.”

These commenters do not appear to have understood the methodology of the staff study or the operation of a central limit order book (“CLOB”). As discussed above, large trades would not have been identified as trade-throughs in the staff study if orders simultaneously had been routed to sweep displayed quotations with superior prices. To exclude such trades from its analysis, the study used a three-second quotation window in which the lowest best bid or the highest best offer during the three-second period must be traded-through before a trade was identified as a trade-through. The 3-second quotation window particularly was designed to allow sufficient time for quotations to update to reflect the arrival of sweep orders (just as in a CLOB environment, the execution of a large order simultaneously would eliminate all superior-priced quotations). In sum, large orders would trade

with

, rather than trade

through

, the superior-priced displayed quotations, thereby leaving only quotations that did not have superior prices to the trade price. Such large orders therefore would not have been identified as trade-throughs in the staff study.

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

Commenters also criticized the staff study for allegedly failing to consider

the effect of locked or crossed quotations for Nasdaq stocks.

By using a 3-second quotation window, however, the staff study excluded any trade-throughs that would have been caused by short periods of locking or crossing quotations. The staff analysis appropriately did not exclude longer periods of

locked

quotations. Indeed, locked quotations do not qualify for an exception from the Order Protection Rule—both the best bid and best offer are readily accessible at the same price and should not be traded through. Quotations rarely are

crossed

for three seconds and therefore are unlikely to have caused a material number of false trade-throughs.

Bloomberg Reproposal Letter at 5; Nasdaq Reproposal Letter, Exhibit 1 at 5.

See, e.g.

, Nasdaq Reproposal Letter, Exhibit 1 at 5 n. 14 (“rare” for market to be crossed for the entirety of the three-second window).

Finally, commenters asserted a variety of arguments relating to timing latencies in the quotation and trade data that might have caused the staff study to include false trade-throughs, including delayed trade reports, flickering quotations, stale quotations, manual quotations, and poor clock synchronization.

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

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

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

Trade-Through Study, Table 1.

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

The occurrence of false indications of trade-throughs caused by manual quotations in exchange-listed stocks is addressed in the Order Protection Rule by protecting only automated quotations that are immediately accessible and immediately updated.

See infra

, section II.A.2 (discussion of need to limit coverage of Order Protection Rule to automated quotations).

Fidelity incorrectly believed that the staff study failed to use the time of trade execution derived from audit trail data when analyzing trade-through rates in Nasdaq stocks.

Fidelity also attached to its comment letter a paper prepared by two academics, Robert Battalio and Robert Jennings, which included a variety of criticisms of the staff study and the Reproposing Release in general (“Battalio/Jennings Paper”).

Among other things, the Battalio/Jennings Paper cited an academic paper which, for trading in Nasdaq stocks in 1996 and 1997, found significant delays between the time of trade execution reflected in proprietary trading center data and the time of trade report in public data disseminated by Nasdaq as Plan processor.

The authors of the Battalio/Jennings Paper, however, did not account for significant improvements in the quality of trade data for Nasdaq stocks since 1997. In particular, the NASD developed and implemented a new order audit trail system (“OATS”).

As summarized in a 1998 NASD Notice to Members, OATS specifically was designed, among other things, to address the discrepancies between proprietary trade data and trade data reported to Nasdaq's Automated Confirmation Transaction Service (“ACT”):

Letter from Eric D. Roiter, Senior Vice President and General Counsel, Fidelity Management & Research Company, to Jonathan G. Katz, Secretary, Commission, dated Mar. 28, 2005 (“Fidelity Reproposal Letter II”) at 2.

Robert Battalio and Robert Jennings,

Analysis of the Re-Proposing Release of Reg NMS and the OEA's Trade-Through Study

(Mar. 28, 2005) (attached to Fidelity Reproposal Letter II). Other claims made in the Battalio/Jennings Paper are addressed below at notes 151-158, 296 and accompanying text.

Battalio/Jennings Paper at 12-13. For example, the academic study of 1996-1997 Nasdaq data found that 65% of trades were reported with delays of more than 8 seconds.

See, e.g.

, NASD Notice to Members 98-82 (Oct. 1998) at 1.

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

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

the two times differed.

The Battalio/Jennings Paper therefore was mistaken when it stated that “[w]ith the data OEA chose to use, we simply cannot conclude anything about actual trade-through rates” and when it “urge[d] the OEA to revise their methodology and conduct a trade-through analysis using audit-trail data.”

The staff study did indeed use audit trail data when available for Nasdaq stocks and therefore provides a reasonable basis for estimating true trade-through rates for Nasdaq stocks.

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

Battalio/Jennings Paper at 20.

As noted above, however, the data for exchange-listed stocks may be more affected by timing latencies because it is generated by both automated and manual markets. The trade-through rates estimated in the staff study therefore may somewhat overstate the true trade-rates for NYSE stocks. Given that the ITS trade-through provisions currently apply to exchange-listed stocks, however, the Commission does not believe that the possibility that true trade-through rates potentially are lower than estimated in the staff study detracts from the strong policy reasons to maintain and strengthen trade-through protection for exchange-listed stocks. Rather, eliminating any trade-through protection for exchange-listed stocks could lead to rates that are as high, or higher, than were conservatively estimated for Nasdaq stocks, which have not been subject to any trade-through restrictions.

Moreover, the evidence from the staff study itself indicates that the concerns about delayed trade reporting discussed at length in the Battalio/Jennings Paper with respect to historical data have largely been resolved. For example, if delayed trade reporting were truly a serious problem that caused the staff study to be flawed, one would expect to see significant rates of trade-throughs by a single trading center's trades of its own quotations—the two data feeds would be out of synchronization with each other because trades were reported slower than quotation updates. In fact, however, the staff study found very low trade-through rates for single trading centers of their own quotations.

The primary exception is for trades reported on Nasdaq that trade through Nasdaq quotations, but Nasdaq, unlike the other major markets, does not consist of a single trading center. Rather, it includes the NASDAQ Market Center, several ECNs, and many market makers that trade, to a great extent, separately. Thus, the trade-through rates for Nasdaq reflect true trade-throughs among different trading centers, not false trade-throughs of a single trading center of its own quotations.

See, e.g.

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

Finally, problems with clock synchronization at the various trading centers are unlikely to have materially detracted from the accuracy of the staff study. The great majority of time stamps were assigned to quotations and trades as the data was received by a single entity—Nasdaq as the Plan processor for Nasdaq stocks and SIAC as the Plan processor for NYSE stocks.

One commenter, however, asserted that the two Plan processors themselves had major clock synchronization problems between quotation data and trade data.

100

If this were in fact the case, the staff study likely would have found a high rate of trade-throughs by a single market of its own quotations, because the Plan processor's time stamps for the market's quotations would have been out of synchronization with its time stamps for the market's trades. As noted in the preceding paragraph, the staff study found few trade-throughs by a single market of its own quotations, thereby indicating that the Plan processors' quotation data and trade data are not materially out of synchronization.

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

See, e.g.

, Fidelity Reproposal Letter at 3; Nasdaq Reproposal Letter, Exhibit 1 at 4.

100

Angel Reproposal Letter at 3.

ii. Significance of Trade-Through Rates

Some commenters questioned whether the trade-through rates found by the staff study were significant enough to warrant adoption of the trade-through reproposal.

101

They believed, for example, that the rates were low, particularly when considered as a percentage of total trades (2.5% for both Nasdaq and NYSE stocks) and as the percentage of total share volume represented by the total displayed size of quotations that were traded through (1.9% and 1.2%, respectively, for Nasdaq and NYSE stocks).

102

They therefore asserted that the rates did not demonstrate a serious problem or a need for regulatory action to address trade-throughs.

101

ArcaEx Reproposal Letter at 6; Fidelity Reproposal Letter at 8; Instinet Reproposal Letter at 6 n. 6; Nasdaq Reproposal Letter, Exhibit 1 at 4; UBS Reproposal Letter at 4.

102

The 1.9% and 1.2% figures include only the total displayed size of quotations that were traded through by trades executed at prices inferior to the displayed quotations.

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

103

In evaluating the need for the Order Protection Rule, the different measures vary in their relevance depending on the particular objective under consideration.

103

See, e.g.

, Trade-Through Study at 1-2 and Tables 1, 4, 6, 7-8, 11, 13.

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

execution of customer market orders. The staff study found that 1 of every 40 trades (2.5%) for both Nasdaq and NYSE stocks have an execution price that is inferior to the best displayed price, or approximately 98,000 trades per day in Nasdaq stocks alone.

104

As discussed above,

105

investors (and particularly retail investors) often may have difficulty monitoring whether their orders receive the best available prices, given the rapid movement of quotations in many NMS stocks. The Commission believes that furthering the interests of these investors in obtaining best execution on an order-by-order basis is a vitally important objective that warrants adoption of the Order Protection Rule.

104

., Tables 1, 8. In October 2004, there were 3.9 million average daily trades reported in Nasdaq stocks. Source:

http://www.nasdaqtrader.com.

The average trade-through rate of 2.5% for Nasdaq stocks yields average daily trade-throughs of approximately 98,000.

105

Supra

, note 53 and accompanying text.

The percentage of total trades that receive inferior prices also is quite relevant when assessing the need to promote fair and orderly treatment of limit orders for NMS stocks. Many of the limit orders that are bypassed are small orders that often will have been submitted by retail investors. One of the strengths of the U.S. equity markets and the NMS is that the trading interests of all types and sizes of investors are integrated, to the greatest extent possible, into a unified market system. Such integration ultimately works to benefit both retail and institutional investors. Retail investors will participate directly in the U.S. equity markets, however, only to the extent they perceive that their orders will be treated fairly and efficiently. The perception of unfairness created when a retail investor has displayed an order representing the best price for an NMS, yet sees that price bypassed by 1 in 40 trades, is a matter of a great concern to the Commission. The Order Protection Rule is needed to maintain the confidence of all types of investors that their orders will be treated fairly and efficiently in the NMS.

The third principal objective for the Order Protection Rule is to promote greater depth and liquidity for NMS stocks and thereby minimize investor transaction costs. Depth and liquidity will be increased only to the extent that limit order users are given greater incentives than currently exist to display a larger percentage of their trading interest. The potential upside in terms of greater incentives for display is most appropriately measured in terms of the share volume of trades that currently do not interact with displayed orders. It is this volume of trading interest that will begin interacting with displayed orders after implementation of the Order Protection Rule.

The share volume of trade-throughs, rather than the number of trade-throughs, is most useful for assessing the effect of the Order Protection Rule on depth and liquidity because very small trades represent such a large percentage of trades in today's markets, but a small percentage of share volume. For example, the staff study found that, for Nasdaq stocks, 100-share trades represented 32.7% of the number of trade-throughs, but only 0.8% of the share volume of trade-throughs.

106

Thus, the number of trade-throughs is useful for assessing the number of investors, particularly retail investors, affected by trade-throughs, while the share volume of trade-throughs is useful for assessing the extent to which depth and liquidity are affected by trade-throughs. For example, 41.1% of the share volume of trade-throughs in Nasdaq stocks is attributable to trades of greater than 1000 shares that bypass quotations of greater than 1000 shares.

107

Addressing the failure of this substantial volume of trading interest to interact with significant displayed quotations is a primary objective of the Order Protection Rule.

106

Trade-Through Study, Table 6.

107

In contrast, the share volume of quotations that currently are traded through grossly underestimates the potential for increased incentives to display because it reflects only the current size of displayed quotations in the

absence

of strong price protection. As a result, the share volume of quotations that currently are traded through is a symptom of the problem that the Order Protection Rule is designed to address—a shortage of quoted depth—rather than an indication of the benefits that the Order Protection Rule will achieve. For example, when many Nasdaq stocks can trade millions of shares per day, but have average displayed size of less than 2000 shares at the NBBO, it will be nearly impossible for trade-throughs of displayed size to account for a large percentage of total share volume—there simply is not enough displayed depth.

108

Small displayed depth is evidence of a market problem, not market quality.

108

See

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

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

109

this message is unlikely to be missed by those who watched their quotations being traded through. Certainly, the routine practice of trading through displayed size is most unlikely to prompt market participants to display even greater size.

109

See

Trade-Through Study, Tables 4 and 11.

Thus, the Commission believes that the percentage of share volume in a stock that trades through displayed and accessible quotations is a useful measure for assessing the potential increase in incentives for display of limit orders after implementation of the Order Protection Rule. In particular, the dual measurements of percentage of share volume of traded-through quotations (an overall 1.9% for Nasdaq stocks) and the percentage of share volume of trades that bypass displayed quotations (an overall 7.9% for Nasdaq stocks) likely represent the lower and upper bounds for a potential improvement in depth and liquidity after implementation of the Order Protection Rule.

Commenters opposing the trade-through reproposal questioned whether protection against trade-throughs would lead to any increase in the use of limit orders, particularly given the many reasons militating against display (

e.g.

, displayed limit orders give a free option to all other market participants to trade at the limit order price).

110

The Commission is aware of a variety of reasons that currently deter market participants from displaying their trading interest in full. Indeed, it is the existence of these negative factors, combined with a shortage of positive incentives for display, that have contributed to the relatively small displayed depth at the best prices that characterizes the market for many NMS stocks today. A large investor interested in buying 50,000 shares of a stock is unlikely to suddenly decide to display all of its trading interest simply because its order is given trade-through

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

110

See, e.g.

, Instinet Reproposal Letter at 6 and n. 6; UBS Reproposal Letter at 3.

Moreover, because of the enormous volume of trading in NMS stocks, even a small percentage improvement in depth and liquidity could lead to very significant dollar benefits for investors in the form of reduced transaction costs. As discussed in section II.A.6 below, for example, the annual implicit transaction costs of large institutional investors are estimated at more than $30 billion in 2003.

111

As a result, even a small percentage reduction in these costs because of improved depth and liquidity would result in very substantial annual savings for millions of mutual fund and pension fund investors. The Commission therefore believes that the estimated trade-through rates in the staff study support the need for enhanced protection of limit orders as a means to promote greater depth and liquidity in NMS stocks.

111

Implicit transaction costs are associated with the prices at which trades are executed, in contrast with explicit transaction costs such as commissions. Implicit costs include the adverse price movements experienced by institutional investors when searching for the liquidity and executing the orders necessary to trade in large size.

See infra

, notes 146, 300-305, 990, and accompanying text.

b. Efficiency of Trading in Nasdaq and NYSE Stocks

A few commenters on the original proposal submitted empirical data to support their claim that trading in Nasdaq stocks currently is more efficient than trading in NYSE stocks.

112

Specifically, they submitted tables asserting that effective spreads in Nasdaq stocks in the S&P 500 are significantly narrower than effective spreads in NYSE stocks in the S&P 500.

113

To help assess and respond to the views of commenters on market efficiency, the Commission staff analyzed Rule 11Ac1-5 reports and other trading data to evaluate the markets for Nasdaq and NYSE stocks.

114

112

Instinet Letter, Exhibit A; Nasdaq Letter II, Attachment II. One commenter on the reproposal referred the Commission to an academic study of trading in Nasdaq and NYSE stocks, asserting that its conclusion was that “bid-ask spreads were shown to be narrower and liquidity shown to be greater in Nasdaq stocks.” STANY Reproposal Letter at 8. The referred study was Lehn, Patro, and Shastri,

Information Shocks and Stock Market Liquidity: A Comparison of the New York Stock Exchange and Nasdaq

(presented at the American Enterprise Institute on June 10, 2004) (available at

www.aei.com

). The commenter misinterpreted, however, the results of the study. The study found that “during both the calm and stress periods, quoted and effective bid-ask spreads are significantly lower for NYSE versus Nasdaq stocks, a result generally consistent with the existing literature.”

. at 2. Finally, the Mercatus Center referenced several statistical studies in its comment letter and concluded that the findings of such studies are mixed. Letter from Susan E. Dudley, Director, Regulatory Studies Program, Mercatus Center, George Mason University, to Jonathan G. Katz, Secretary, Commission, dated May 24, 2004 (“Mercatus Center Letter”) at 3.

113

Nasdaq and Instinet based their tables on statistics derived from the reports (“Dash 5 Reports”) on order execution quality made public by markets pursuant to Exchange Act Rule 11Ac1-5 (redesignated as Rule 605 under Regulation NMS). Their source for these reports is Market Systems, Inc. (“MSI”), a private vendor that collects the reports of all markets each month and includes them in a searchable database. MSI also is the source of the Dash 5 Reports used in the staff analyses.

114

Memorandum to File, from Office of Economic Analysis, dated December 15, 2004 (comparative analysis of execution quality for NYSE and NASDAQ stocks based on a matched sample of stocks) (“Matched Pairs Study”); Memorandum to File, from Division of Market Regulation, dated December 15, 2004 (comparative analysis of Rule 11Ac1-5 statistics by S&P Index) (“S&P Index Study”). The Matched Pair Study and S&P Index Study are in Public File No. S7-10-04 and are available for inspection on the Commission's Internet Web site (

http://www.sec.gov

In its comment on the reproposal, Nasdaq argued that the staff studies contained flaws in their methodologies.

115

With respect to the S&P Index Study, Nasdaq stated that the execution quality statistics were drawn from an atypical month and that the methodology for analyzing effective spreads favored higher-priced NYSE stocks over lower-priced Nasdaq stocks. The S&P Index Study presented statistics from January 2004, however, because this was the month selected by Nasdaq in the comment letter that it submitted on the proposal in July 2004. Moreover, the general statistics reported by Nasdaq for later months do not appear to differ materially from those for January 2004.

116

In addition, the S&P Index Study analyzed investor transaction costs in terms of a percentage of investment rather cents per share because, as discussed below, the percentage of investment methodology most reflects economic reality for investors.

117

115

Nasdaq Reproposal Letter, Exhibit 1 at 1.

116

See, e.g.

, id., Exhibit 1 at 15 (table showing that blended effective spread statistics in terms of cents-per-share for both market orders and marketable limit orders generally declined throughout 2004 for both Nasdaq and NYSE stocks).

117

To the extent Nasdaq has more low-priced stocks than the NYSE, the Dash 5 statistics favor Nasdaq in the larger order size categories because of “bracket creep” “

i.e.

, it typically will be easier to execute a 2000 share order in a $5 stock ($10,000 total volume) than to execute a 2000 share order in a $40 stock ($80,000 total volume), assuming the stocks are otherwise comparable.

With respect to the Matched Pairs Study, Nasdaq asserted that it largely examined small stocks. Nasdaq noted, for example, that more than 25% of the stocks included in the Matched Pairs Study were not eligible for NYSE listing and that only 10% of the stocks were included in the Nasdaq-100 Index. The purpose of the Matched Pairs Study, however, was to compare execution quality in Nasdaq and NYSE across a broad range of stocks, not solely for large stocks or those that were eligible for NYSE listing. Although 25% of the stocks may not have been eligible for NYSE listing, the staff analysis used matching criteria more directly designed to produce an “apples-to-apples” comparison—market capitalization, price, average daily dollar volume (adjusted downward by 30% for Nasdaq stocks to reflect trade reporting practices in such stocks), and relative price range. The Commission therefore believes that the staff studies provide a valid basis to compare trading in Nasdaq stocks and NYSE stocks.

The staff studies indicate that the execution quality statistics submitted by commenters on the original proposal are flawed. The claimed large and systematic disparities between Nasdaq and NYSE effective spreads disappear when an analysis of execution quality more appropriately controls for differences in stocks, order types, and order sizes.

118

The staff studies reveal that both the market for Nasdaq stocks and the market for NYSE stocks have significant strengths. But, as discussed below, both markets also have weaknesses that could be reduced by strengthened protection against trade-throughs.

118

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

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

119

They were

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

120

119

The effective spread is a useful measure of transaction costs for market orders, particularly for small order sizes, because it reflects the prices actually received by investors when compared to the best quotes at the time a market received an order. Consequently, unlike the quoted spread, the effective spread reflects any cost to investors caused by movement in prices during a delay between receipt of an order and execution of an order. In other words, the effective spread penalizes slow

markets for failing to execute trades at their quoted prices at the time they received an order. It therefore provides an appropriate criterion with which to compare execution quality between automated and manual markets for comparable stocks, order types, and order sizes. As discussed below, however, effective spread statistics do not capture transaction costs that are attributable to low fill rates—the failure to obtain an execution—for marketable limit orders.

120

S&P Index Study, Table 1.

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

121

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

Accordingly, investors must accept trade-offs when deciding whether to submit market orders or marketable limit orders (particularly when the limit price equals the current market price). Use of a limit price generally assures a narrower spread by precluding an execution at an inferior price. By precluding an execution, however, the limit price may cause the investor to “miss the market” if prices move away (for example, if prices rise when an investor is attempting to buy). Effective spreads for marketable limit orders therefore represent transaction costs that are conditional on execution, while effective spreads for market orders much more completely reflect the entire implicit transaction cost for a particular order. Market orders represent only approximately 14% of the blended flow of market and marketable limit orders in Nasdaq stocks (reflecting the fact that ECNs now dominate Nasdaq order flow and limit orders represent the vast majority of ECN order flow).

122

In contrast, market orders represent approximately 36% of the blended order flow in NYSE stocks.

123

Accordingly, the effective spread statistics for marketable limit orders, and particularly for orders in Nasdaq stocks, must be considered in conjunction with the fill rate for such orders “ while a narrow spread is good, the benefits are greatly limited if investors are unable to obtain an execution at that spread. The analyses presented by the commenters, however, did not address the respective fill rates for Nasdaq stocks and NYSE stocks or reflect the inherent differences in measuring the transaction costs of market orders and marketable limit orders.

122

Most market orders in Nasdaq stocks are executed by market-making dealers pursuant to agreement with their correspondent or affiliated brokers.

123

Matched Pairs Study at 1.

The analyses prepared by Commission staff are designed to provide appropriate evaluations of comments on the efficiency of trading in Nasdaq and NYSE stocks. In particular, they are more finely tuned to evaluate trading for different types of stocks with varying trading volume, different types of orders, and different sizes of orders. These analyses indicate that the markets for Nasdaq and NYSE stocks each have weaknesses that an intermarket price protection rule could help address. By “weakness,” the Commission simply means that there appears to be considerable room for improvement. For example, the effective spread statistics for large, electronically-received market orders in NYSE stocks show significant “slippage”—the amount by which orders are executed at prices inferior to the national best bid or offer (“NBBO”) at the time of order receipt.

124

Slippage often results in effective spreads for large orders that are many times wider than the effective spreads for small orders in the same NYSE stocks. By protecting automated quotations, the Order Protection Rule should enhance the depth and liquidity available for large, electronic orders in NYSE stocks and thereby improve their execution quality.

124

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

For Nasdaq stocks, the Rule 11Ac1-5 statistics reveal very low fill rates for larger sizes of marketable limit orders (

e.g.

, 2000 shares or more), which generally fall below 50% for most Nasdaq stocks. Contrary to the assertion of some commenters,

125

certainty of

execution

for large marketable limit orders clearly is not a strength of the current market for Nasdaq stocks. Certainty of a fast response is a strength, but much of the time the response to large orders will be a “no fill” at any given trading center.

126

125

See, e.g.

, Instinet Reproposal Letter at 7; Nasdaq Letter II at 6. In addition to effective spread statistics, Instinet submitted statistics indicating that combined market and marketable limit orders in Nasdaq stocks were more likely to be executed at or inside the NBBO than such orders in NYSE stocks. Instinet Letter, Table I-C. These statistics, however, only reflect orders that in fact receive an execution—not the large volume of orders in Nasdaq stocks that fail to receive any execution at all.

126

Some commenters asserted that the large number of limit orders in Nasdaq stocks indicates that sufficient incentives exist for the placement of limit orders in such stocks.

See, e.g.

, Instinet Letter at 11; Letter from Thomas N. McManus, Managing Director & Counsel, Morgan Stanley & Co. Incorporated, to Jonathan G. Katz, Secretary, Commission, dated August 19, 2004 (“Morgan Stanley Letter”) at 14. Strengthened intermarket trade-through protection, however, is designed to improve the

quality

of limit orders in a stock, particularly their displayed size, and thereby promote greater depth and liquidity. This goal is not achieved, for example, by a large number of limit orders with small sizes and high cancellation rates.

Two commenters on the reproposal disputed whether low fill rates for marketable limit orders in Nasdaq stocks indicate any weakness that needed to be addressed.

127

Instinet, for example, believed that “the Commission is misplaced in its contention that low fill rates in Nasdaq stocks are a weakness of that market,” and that they are a phenomenon “intrinsic to electronic markets in which market participants are free to cancel and replace orders.”

128

Instinet also noted that many market centers in Nasdaq stocks have significant reserve size in addition to displayed size and that market participants commonly routed oversized marketable limit orders to attempt to interact with reserve size.

129

Similarly, Nasdaq stated that the staff studies “erroneously conclude that differential fill rates for large marketable limit orders in Nasdaq-listed and NYSE-listed stocks are evidence of a defect in Nasdaq's market structure,” and that they failed “to consider a widely used order routing technique of intentionally sending oversized orders at displayed quotes searching (also known as “pinging”) for reserves within the many limit order books trading Nasdaq-listed securities.”

130

Nasdaq also asserted that marketable limit orders are “exceedingly popular in electronic venues where they have effectively supplanted market orders as the order of choice in accessing availability liquidity at the current price.”

131

127

Instinet Reproposal Letter at 6-7; Nasdaq Reproposal Letter at 5.

128

Instinet Reproposal Letter at 6-7.

129

Instinet Reproposal Letter at 7. Instinet also asserted that low fill rates for large marketable limit orders might be attributable to the frequent locking of markets in low-priced stocks. In fact, however, the Dash 5 fill rates for large orders in low-priced stocks generally are higher than those for high-priced stocks, likely because the dollar value of such orders is low (

i.e.

, 5000 shares of a $5 stock ($25,000) generally will be easier to trade than 5000

shares of a $50 stock ($250,000)).

See infra,

text accompanying notes 141-142 (average fill rates for large orders in low-priced stocks in Nasdaq-100 Index are much higher than fill rates for most other stocks in Index).

130

Nasdaq Reproposal Letter at 5.

131

Id.,

Exhibit 1 at 8.

The Commission continues to believe that fill rates for large marketable limit orders are a useful measure of order execution quality for Nasdaq stocks. They are especially useful because they measure the availability of both displayed and undisplayed liquidity, whereas simply measuring displayed size would understate the total liquidity readily available for Nasdaq stocks. Indeed, the existence of “pinging” orders searching for reserve size in Nasdaq stocks at electronic markets is widely known. Such oversized orders (

i.e.

, orders with sizes greater than displayed size) could as aptly be labeled “liquidity search” orders as “pinging” orders. Given the relatively small displayed size in nearly all Nasdaq stocks (

i.e.

, significantly less than 2000 shares),

132

orders with sizes of 2000 to 4999 shares and 5000 to 9999 shares (the two largest Dash 5 size categories) generally will exceed the displayed size. Thus, low fill rates demonstrate that the total displayed and reserve liquidity available for Nasdaq stocks at any particular trading center typically is small compared to the demand for liquidity at the inside prices. Moreover, increased displayed liquidity—a principal goal of the Order Protection Rule—would promote market efficiency by reducing the uncertainty and costs associated with the need for market participants to “ping” electronic markets for liquidity that is held in reserve.

132

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

The Reproposing Release did not suggest, however, that the

differential

fill rates for large marketable limit orders in Nasdaq and NYSE stocks were useful in comparing the liquidity and depth available in each market. Instead, the Reproposing Release focused on the most relevant Dash 5 statistic for each market, given its particular trading characteristics. As noted above, the significant amount of “slippage” in the execution of electronically-received large market orders in NYSE stocks suggest that improved incentives for display of automated trading interest will help improve execution quality for NYSE stocks. Notably, Instinet and Nasdaq agreed that slippage rates for automated market orders represented a problem in the market for NYSE stocks.

133

Because market participants generally choose not to submit market orders to electronic markets in Nasdaq stocks, however, the fill rates for marketable limit orders are a more relevant Dash 5 statistic to assess depth and liquidity in Nasdaq stocks.

133

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

Accordingly, the Commission's concern with fill rates for larger orders in Nasdaq stocks is not that they are lower than those for NYSE stocks, but that they are very low in absolute terms—often falling well below 50%.

134

Moreover, the larger order sizes typically account for a small percentage of executed shares compared to the executed shares of smaller order sizes.

135

When considered in conjunction with one another, the low fill rates and small percentage of executed shares indicate substantial room for improvement in depth and liquidity in many Nasdaq stocks. An important objective for Regulation NMS as a whole is to facilitate more efficient trading in larger sizes, an objective that has become much more important to large investors since decimalization.

136

An improvement in fill rates for larger sized orders (or an increase in their percentage of executed shares) would evidence progress toward this objective.

134

See, e.g.

, Matched Pairs Study, Table 10.

135

See, e.g.

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

See infra,

notes 138-139 and accompanying text.

136

See

Reproposing Release, 69 FR at 77425.

Fill rates for marketable limit orders, however, offer only indirect evidence of the total transaction costs incurred by investors. They indicate that no execution was obtained for an investor order at a particular trading center, but do not indicate how the investor subsequently fared in obtaining an execution. As discussed above, there are significant trade-offs between marketable limit orders and market orders. The use of a restrictive limit price at the NBBO precludes any slippage in execution price, but also may cause an investor to miss the market if prices subsequently move away from the order (

i.e.

, rise when an investor is attempting to buy or fall when an investor is attempting to sell). To evaluate the total transaction costs associated with an order that goes unfilled or receives a partial fill, it is necessary to know the price at which the investor ultimately obtained an execution for its full order.

To help the Commission evaluate and respond to commenters' criticisms and, in particular, to supplement its analysis of fill rates as a measure of depth and liquidity for Nasdaq stocks and to evaluate the extent to which missed fills may lead to higher investor transaction costs, Commission staff also examined execution quality statistics for marketable limit orders in Nasdaq-100 Index stocks that are executed outside the best quotes at the Inet ATS and the NASDAQ Market Center.

137

By definition, such orders have been placed with liberal limit prices that give more flexibility for executions away from the NBBO than orders with limit prices that are restrictively set at the NBBO. Accordingly, the slippage rates for such orders give another indication of

available liquidity for Nasdaq-100 stocks.

137

Memorandum to File, from Division of Market Regulation, dated April 6, 2005 (analysis of Rule 11Ac1-5 statistics for Nasdaq-100 Index) (“Nasdaq-100 Index Supplemental Study”). The Nasdaq100 Index Supplemental Study has been placed in Public File No. S7-10-04 and is available for inspection on the Commission's Internet Web site (

http://www.sec.gov

). The staff examined Nasdaq-100 stocks in response to Nasdaq's suggestion that they are most appropriate for evaluating execution quality in the market for Nasdaq stocks.

See

Nasdaq Reproposal Letter, Exhibit 1 at 1, 11. The statistics are from December 2004 and are equal-stock weighted to give a more representative view of trading across all stocks, rather than a view concentrated on a few stocks that are much more actively traded than the others.

The statistics for outside-the-quote executions in marketable limit orders buttress a conclusion that there is significant room for improved depth and liquidity in Nasdaq stocks. For example, the Inet ATS did not fill 83.0% of its large marketable limit orders.

138

Of the orders it executed, 19.5% of shares were executed outside the quote by an average of 2.7 cents. Thus, while the overall quoted and effective spreads for executed shares for large orders were, respectively, 1.6 cents and 2.5 cents, the spread for outside the quote executions was 7.0 cents—438% wider than the narrow quoted spread. The statistics for the NASDAQ Market Center are similar. It did not fill 68.4% of its large marketable limit orders.

139

Of the orders it executed, 14.7% were executed outside the quote by an average of 2.3 cents. The overall quoted and effective spreads for large orders were, respectively, 1.6 cents and 2.5 cents, compared to 6.2 cents for outside the quote executions—388% wider than the narrow quoted spread. The outside-the-quote spreads provide the best available indication of execution quality that otherwise would have been obtained at the time orders were placed for the 83.0% and 68.4% of shares that were not filled due to their restrictive limit price. The outside-the-quote spreads also are relevant in assessing the reasons why market participants most often use marketable limit orders with limit prices at the NBBO rather than market orders when trading Nasdaq stocks.

138

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

139

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

In addition, the supplemental staff study separately examined fill rates and executed share volume for types of Nasdaq-100 stocks where liquidity for orders with large share sizes can reasonably be expected to be highest.

140

These stock groupings were selected primarily to assess whether low fill rates for large marketable limit orders are an inherent part of the structure of the market for Nasdaq stocks. Specifically, the supplemental staff study calculated fill rates and executed share volume for the three Nasdaq stocks with the largest capitalization—Microsoft, Intel, and Cisco. These three stocks are widely recognized among all Nasdaq stocks as having markets with significant depth and liquidity. In addition, the supplemental staff study examined the seven Nasdaq-100 stocks with share prices of less than $10 per share. Liquidity for orders with large

sizes in these stocks can be expected to be higher than for stocks with higher prices because the

dollar

sizes are much smaller (

e.g.

, a 5000 share order in a $5 stock totals $25,000, whereas a 5000 share order in a $30 stock totals $150,000). In terms of economic reality, therefore, large orders in a low-priced stock generally are easier to execute than large orders in a higher-priced stock, assuming the stocks are otherwise compa

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