Order Competition Rule

Federal RegisterJan 3, 2023

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 242

[Release No. 34-96495; File No. S7-31-22]

RIN 3235-AM57

Order Competition Rule

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is proposing to amend the regulation governing the national market system (“NMS”) under the Securities Exchange Act of 1934 (“Exchange Act”) to add a new rule designed to promote competition as a means to protect the interests of individual investors and to further the objectives of an NMS. The proposed rule would prohibit a restricted competition trading center from internally executing certain orders of individual investors at a price unless the orders are first exposed to competition at that price in a qualified auction operated by an open competition trading center. The proposed rule would also include limited exceptions to this general prohibition. In addition, the Commission is proposing to amend the regulation governing the NMS to add new defined terms included in the proposed rule.

DATES:

Comments should be received on or before March 31, 2023.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (

https://www.sec.gov/rules/submitcomments.htm

); or

• Send an email to

rule-comments@sec.gov

. Please include File Number S7-31-22 on the subject line.

Paper Comments

• Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-31-22. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's website (

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

). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Operating conditions may limit access to the Commission's Public Reference Room. All comments received will be posted without change. Persons submitting comments are cautioned that the Commission does not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Dan Gray, Senior Special Counsel, Jennifer Dodd, Special Counsel, or Stacia Sowerby, Special Counsel, at (202) 551-5500, Office of Market Supervision, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment amendments to Regulation NMS [17 CFR 242.600 through 242.614] (“Regulation NMS”) that would add new 17 CFR 242.615 (“Proposed Rule 615”), add new defined terms to 17 CFR 242.600 (“Rule 600”) that are used in Proposed Rule 615, and make conforming amendments to defined terms in 17 CFR 242.602, 17 CFR 242.611, and 17 CFR 242.614; and conforming amendments to defined terms in 17 CFR 240.3a51-1, 17 CFR 240.13h-1, 17 CFR 242.105, 17 CFR 242.201, 17 CFR 242.204, and 17 CFR 242.1000.

Table of Contents

I. Introduction

II. Overview of Market Structure for NMS Stocks

A. Investors

B. Trading Centers

C. Order Types and Trading Costs

D. Quantitative Measures of Order Execution Quality and Trading Costs

1. Description of Quantitative Measures

2. Examples of Calculating Measures of Order Execution Quality and Trading Costs

III. Statutory and Regulatory Background

A. Statutory Framework for an NMS

B. Current Regulatory Components of the NMS for NMS Stocks

1. Rules Addressing Consolidated Market Data

2. Rules Addressing Order Handling and Execution

3. Rules Addressing Access to Trading Centers

4. Disclosure of Order Routing Practices and Order Execution Statistics

IV. Description of Proposed Rule 615

A. Overview of Order Competition Requirement

B. Coverage of Proposed Rule 615

1. Definition of Segmented Order

2. Definition of Open Competition Trading Center

3. Definition of Restricted Competition Trading Center

4. Definition of Originating Broker

5. Exceptions

C. Qualified Auction Requirements

1. Auction Messages

2. Auction Responses

3. Pricing Increment

4. Fees and Rebates

5. Auction Execution Priority

D. Open Competition Trading Center Requirements

E. Originating Broker Requirements

F. Broker-Dealer Requirements

G. National Securities Exchange Requirements

V. Request for Comment

VI. Paperwork Reduction Act Analysis

A. Summary of Collection of Information

1. Auction Messages

2. Identifying and Marking Segmented Orders

3. Originating Broker Certification

4. NMS Stock ATS Policies and Procedures To Exclude Subscribers

B. Proposed Use of Information

1. Auction Messages

2. Identifying and Marking Segmented Orders

3. Originating Broker Certification

4. NMS Stock ATS Policies and Procedures To Exclude Subscribers

C. Respondents

1. Auction Messages

2. Identifying and Marking Segmented Orders

3. Originating Broker Certification

4. NMS Stock ATS Policies and Procedures To Exclude Subscribers

D. Burdens

1. Auction Messages

2. Identifying and Marking Segmented Orders

3. Originating Broker Certification

4. NMS Stock ATS Policies and Procedures for Excluding Subscribers

E. Collection of Information Is Mandatory

F. Confidentiality of Information Collected

1. Auction Messages

2. Identifying and Marking Segmented Orders

3. Originating Broker Certification

4. NMS Stock ATS Policies and Procedures To Exclude Subscribers

G. Retention Period for Recordkeeping Requirements

H. Request for Comments

VII. Economic Analysis

A. Introduction

B. Baseline

1. Competition for Liquidity Provision in NMS Stocks

2. Segmentation of Individual Investor Order Flow

3. Institutional Investor Interactions With Retail Orders

4. Execution Quality of Individual Investor Marketable Orders in NMS Stocks

5. Variation in Wholesaler Execution Quality

6. Retail Broker Services

7. Rules Addressing Consolidated Market Data

C. Economic Effects

1. Benefits

2. Costs

3. Competition

4. Efficiency

5. Capital Formation

D. Reasonable Alternatives

1. Variation in Provisions Regarding Segmentation and Routing

2. Alternate Definitions of Segmented Orders

3. Variation in Auction Design

4. Variation in Exceptions to the Order Competition Requirement

5. Variation in the Definition of Open Competition Trading Centers

6. Wholesaler Information Barriers

7. Display Quotes in Retail Liquidity Programs

8. Creation of a Retail Best Bid and Offer

9. Disclosure of Execution Quality of Individual Investor Orders

E. Request for Comments

VIII. Regulatory Flexibility Act Certification

IX. Consideration of Impact on the Economy

Statutory Authority

I. Introduction

The Commission is proposing a new rule, Proposed Rule 615 of Regulation NMS, entitled the “Order Competition Rule,” to promote a more competitive, transparent, and efficient market structure for NMS stocks, with resulting benefits to investors. Proposed Rule 615 would require that certain orders of individual investors be exposed to competition in fair and open auctions, before such orders could be executed internally by trading centers that restrict order-by-order competition.

The Commission believes that the proposal would better advance each of the five Congressional objectives for an NMS set forth in section 11A of the Exchange Act.

In particular, Proposed Rule 615 is designed to benefit individual investors by promoting competition and transparency as means to enhance the opportunity for their orders to receive more favorable prices than they receive in the current market structure, as well as to benefit investors generally by giving them an opportunity to interact directly with a large volume of individual investor orders that are mostly inaccessible to them in the current market structure. This section provides an overview of that market structure and how that market structure may impact investors.

“Order-by-order” competition in this context means an opportunity to compete to trade with individual investor orders by offering the most favorable price for each order based on the particular characteristics of the order, including the nature of the NMS stock, the size of the order, and market conditions at the time the order is submitted. Section II below provides an overview of the current market structure for NMS stocks, including descriptions of key terms used in this release that readers may find useful to assess and comment on the Commission's proposal. Among many others, these terms include “individual investors,” “trading centers,” and “wholesalers.”

15 U.S.C. 78k-1 (“section 11A”). These objectives are: (1) economically efficient execution of securities transactions; (2) fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets; (3) the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities; (4) the practicability of brokers executing investors' orders in the best market; and (5) an opportunity, consistent with objectives 1 and 4, for investors' orders to be executed without the participation of a dealer. 15 U.S.C. 78k-1(a)(1)(C).

As discussed in sections II and VII below, individual investors primarily use market orders and marketable limit orders (collectively known as “marketable orders”) to trade in NMS stocks. Market participants who use these orders seek to trade immediately at the best available prices in the market. Broker-dealers route more than 90% of marketable orders of individual investors in NMS stocks to a small group of six off-exchange dealers, often referred to as “wholesalers.”

The wholesaling business is highly concentrated, with two firms capturing approximately 66% of the executed share volume of wholesalers as of the first quarter of 2022.

The practice of separately identifying and routing the marketable orders of individual investors to wholesalers is a form of “segmentation.” The term “segmentation” can refer to any practice by which a certain category of orders is identified and treated differently for execution than other categories of orders.

Table 3,

infra,

section VII.B.2.a.

See infra

note 372.

As discussed in the economic analysis in section VII.B.2 below, individual investor orders are segmented because they are “low-cost” flow—they impose lower adverse selection costs on liquidity providers than the unsegmented order flow routed to national securities exchanges. “Adverse selection” involves situations where buyers and sellers have different information, and specifically for a liquidity provider, refers to the extent to which prices move against it after a trade. For example, if the price of a stock drops right after a liquidity provider buys it, the liquidity provider has suffered from adverse selection. Generally, the more severe the adverse selection, the larger the “effective spread” that would be expected for a trade because liquidity providers require a wider effective spread to compensate them for the higher cost of adverse selection.

In this respect, the size of effective spreads can be interpreted as a measure of the average adverse selection that liquidity providers expect to suffer when trading with incoming orders. Data analysis conducted for this proposal reveals that the average adverse selection costs of orders routed to wholesalers are far lower than the average adverse selection costs of orders routed to national securities exchanges.

As explained in more detail in section II.D below, the “effective spread” of a trade is measured as double the difference between the trade's execution price and the midpoint of the national best bid and offer at the time of order receipt. Adverse selection reflects the “price impact” of a trade, which is measured as the difference between the midpoint of the national best bid and offer at the time of the trade and the midpoint of the national best bid and offer at a specified time (

e.g.,

one minute or five minutes) after the time of the trade.

Table 7,

infra,

section VII.B.4 (adverse selection costs, as measured by price impact, of marketable orders of individual investors in all NMS stocks are 71% lower at wholesalers (1.26 basis points) than on exchanges (4.40 basis points)).

The primary benefit of segmentation for individual investors is that it can provide an opportunity for their low-cost orders to be executed at better prices than those generally available on national securities exchanges, a practice known as “price improvement.”

As discussed in section VII below, wholesalers often provide some price improvement relative to the best publicly quoted prices for round lot sizes on national securities exchanges.

Section VII.B.4 below discusses an analysis of wholesaler trading data indicating the relationship between segmentation, adverse selection costs, and order execution quality.

Table 5,

infra,

section VII.B.4 (83.17% of marketable orders routed to wholesalers receive price improvement when compared to the best publicly quoted prices for round lot sizes on national securities exchanges, and 8.78% of marketable orders routed to national securities exchanges receive such price improvement). These better prices are due in large part to the ability of wholesalers to offer sub-penny prices that are not permitted on national securities exchanges and other trading centers. The current rules that govern sub-penny trading are discussed in section III.B.2.c below.

Price improvement, however, is not the same as competitive order execution. Today, the primary business model of wholesalers is to trade bilaterally as principal with individual investor orders (a form of “internalization”). Typically, the way broker-dealers choose a wholesaler for any particular order is not based on the

price the wholesaler is willing to provide for that order, as wholesalers do not display or otherwise indicate in real-time the prices at which they are willing to trade with individual investor orders. Instead, a wholesaler is often chosen by a formula that depends on past execution quality of the wholesaler, its relationship with the broker-dealer, and other factors. In addition, the bilateral nature of the wholesaler business model not only restricts contemporaneous competition among wholesalers, it also restricts opportunities for other market participants to trade with the low-cost flow. Once a wholesaler receives an individual investor's marketable order, the wholesaler's execution of the order does not face competition at all—the wholesaler typically executes the order internally without providing any opportunity for other market participants, including institutional investors, to compete to provide more favorable prices for the order.

This lack of order-by-order competition among market participants is particularly significant in the market for NMS stocks, which is an order-driven market in which a wide range of market participants, including institutional investors, seek to provide liquidity on national securities exchanges by posting orders for the approximately 12,000 NMS stocks. In contrast, the listed options market is a quote-driven market in which professional market makers dominate liquidity provision by displaying quotes in the more than 1,000,000 different options series. In sum, in the current market structure for NMS stocks, individual investor orders are not merely segmented; they also are isolated from order-by-order competition by a wide range of market participants, which, as discussed below, can affect the prices that individual investors receive for their orders.

As shown in Table 7,

infra,

section VII.B.4, wholesalers execute internally (in “principal transactions”) 90.44% of the dollar volume of executed marketable orders routed to them. As discussed in section VII.B.2.b below, wholesalers primarily obtain external executions of the remaining volume of the marketable orders in “riskless principal” transactions.

Data analysis suggests that opening up individual investor orders to order-by-order competition would lead to significantly better prices for those investors. In a fully competitive market, competition among liquidity providers would be expected to drive the amount of price improvement that an order receives to a level commensurate with its adverse selection cost (setting aside other relevant costs). All else equal, the lower an order's expected adverse selection cost, the greater would be the order's expected price improvement. However, as discussed in section VII.C.1.b below, the current isolation of individual investor orders from order-by-order competition results in suboptimal price improvement for such orders. The Commission labels this forgone price improvement “competitive shortfall.” Based on an analysis of trading data from the wholesalers and national securities exchanges in the first quarter of 2022, the competitive shortfall is estimated to be approximately 1.08 basis points per dollar traded by wholesalers or 1.08 cents for every $100 traded, with an estimated total annual competitive shortfall of $1.5 billion.

Table 18 and Table 19,

infra,

section VII.C.1.b (figures in text are for the CAT rebate base competitive shortfall estimates).

In addition to this competitive shortfall, the isolation of individual investor orders at wholesalers prevents other investors from having an opportunity to trade with this low-cost flow. Institutional investors that currently submit their own marketable orders on national securities exchanges and other trading centers potentially could trade at better prices if given an opportunity to interact with the marketable orders of individual investors in fair and open auctions.

For example, data analysis indicates that undisplayed liquidity often is available at trading centers other than wholesalers when a wholesaler executes marketable orders of individual investors at prices less favorable for the individual investor than the prices of the undisplayed liquidity.

Moreover, if institutional investors that currently pay a full “spread” (that is, the difference between the highest price bid and the lowest price offer) to access liquidity were able instead to interact in auctions with the marketable orders of individual investors that currently are mostly inaccessible to them, these institutional investors could benefit from lower spread costs.

See,

e.g.,

section VII.B.3,

infra,

discussing institutional investor interactions with retail orders.

Table 20,

infra,

section VII.C.1.b.

See,

e.g.,

Section VII.C.1.c,

infra,

discussing potential improved execution quality for institutional investor orders.

The Commission is proposing Rule 615 to encourage greater competition for individual investor order execution. Proposed Rule 615 generally would require that individual investor orders be exposed to order-by-order competition in fair and open auctions designed to obtain the best prices before such orders could be internalized by wholesalers or any other type of trading center that restricts order-by-order competition. As a result, individual investor orders could continue to receive the benefits of segmentation (

i.e.,

better prices that reflect the low adverse selection costs of those orders), but without the negative effects of those orders being isolated from order-by-order competition (

i.e.,

such better prices not fully reflecting the low adverse selection costs of those orders; and a substantial percentage of those orders seldom being accessible to institutional investors and other market participants). In sum, the auctions required by Proposed Rule 615 are intended to enhance competitive forces as a means to protect the interests of investors in the NMS.

In developing the specific elements of Proposed Rule 615, the Commission has been guided by this goal of benefiting investors by enhancing competition. The overriding objective of these elements of Proposed Rule 615 is to maximize the opportunity for a wide range of market participants to participate in auctions on terms that will promote the best possible prices for the orders of individual investors. In this respect, the Commission has drawn from its experience with the operation of existing auctions for orders in listed options and tailored Proposed Rule 615 to promote fair and open auctions that reflect the particular nature of the market for NMS stocks. As discussed in section IV below, these elements would include the wide dissemination of auction messages in consolidated market data, requirements that any fees and rebates be capped at a low level ($0.0005 per share for auction prices of $1 or more) and be flat across all market participants, and requirements for execution priority of auction responses that give no advantage to the broker-dealer that routed the marketable order of an individual investor to the auction.

In addition, the Commission has limited the scope of Proposed Rule 615 to contexts in which an auction could be most beneficial for individual investors. For example, individual investors that trade many times per day tend to use marketable orders that pose higher adverse selection risk for liquidity providers; hence, their orders would be outside the scope of the rule.

In addition, proposed exceptions are provided for orders with a market value of $200,000 or more and for orders with execution prices (including prices constrained by non-marketable limit prices) that are very favorable for individual investors (

i.e.,

the midpoint of the best displayed round lot

quotations or better).

These exceptions would not be mandatory, however, which means that broker-dealers could choose whether or not to route orders with these characteristics to an auction.

See

infra

section IV.B.1; section VII.D.2.c.

As discussed in section IV.B.1 below, a subset of non-marketable limit orders with prices not as favorable for individual investors (

i.e.,

beyond the midpoint of the best displayed round lot quotations) would not qualify for the proposed exceptions.

As discussed in section VII.D, the Commission assessed several alternatives to Proposed Rule 615, both to the design of the required auctions and to the auction approach itself. The Commission preliminarily considers Proposed Rule 615 to be the best approach for investors. As described throughout this release, and in more detail in section IV, Proposed Rule 615 is designed to maintain the price improvement benefits of the segmentation of individual investor orders and to enhance those benefits through the introduction of order-by-order competition with a wide range of market participants, including institutional investors, through an auction mechanism that is fast, low-cost, transparent, and fair.

The next two sections of this release are intended to provide background information on the current structure and regulation of the market for NMS stocks that will help promote understanding of the details of the Commission's proposal. Section II provides a general overview of the current market structure for NMS stocks, and section III provides background on the statutory and regulatory framework for NMS stocks. Section IV then describes the proposal in detail, and section V consolidates all Commission requests for comment on the proposal.

II. Overview of Market Structure for NMS Stocks

This section provides an overview of the market structure for NMS stocks,

particularly focusing on the types of market participants, order types, and trading costs that will be referred to throughout this release.

An understanding of the current market structure, particularly the trading costs of different types of market participants, including liquidity takers and liquidity providers, is critically important when assessing the rationale and objectives of Proposed Rule 615.

NMS stocks generally include equity securities other than options that are listed on a national securities exchange. Rule 600(b)(55) of Regulation NMS defines “NMS stock” as any NMS security other than an option, and Rule 600(b)(54) defines “NMS security” to mean any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective NMS plan for reporting transactions in listed options. The definition of NMS stock does not include securities that are not listed on a national securities exchange, sometimes referred to as “over-the-counter” or “OTC” securities.

A much more extensive discussion of the “market microstructure” of securities markets is provided by treatises on the subject.

See,

e.g.,

Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners (Oxford University Press 2003) (“Harris Treatise”); Joel Hasbrouck, Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading (Oxford University Press 2007) (“Hasbrouck Treatise”).

A. Investors

Section 11A(a)(2) of the Exchange Act

provides that the Commission should have due regard for the protection of “investors” when facilitating the establishment of an NMS. As used in this release, the term “individual investor” will refer to natural persons that trade relatively infrequently for their own or closely related accounts.

Individual investors generally trade in relatively small sizes that can be executed against immediately available liquidity.

15 U.S.C. 78k-1(a)(2).

For a discussion of the specific orders covered by Proposed Rule 615,

see

Proposed Rule 600(b)(91) (defining the term “segmented order”) and section IV.B.1 below (discussing the proposed definition of “segmented order”). As discussed in section IV.B, the Commission is proposing to add definitions to Rule 600(b) of Regulation NMS and adjust the numbering of current definitions accordingly. Throughout this release, unless otherwise noted, references to existing Rule 600(b) definitions are to the definitions as they are currently numbered. References to proposed new definitions are designated with “Proposed Rule 600(b)” and reflect the proposed adjusted numbering.

The term “institutional investor” as used in this release refers to investors that trade in much larger sizes and much more frequently than individual investors. Many institutional investors, such as pension funds and mutual funds, operate on behalf of a large number of individuals. Because institutional investors need to trade in large sizes that can exceed immediately available liquidity, their large “parent” orders typically will be broken into smaller “child” orders. Institutional investors typically are focused primarily on obtaining the best price for their large parent orders as a whole.

The child orders will be fed into the market gradually so as to minimize the extent to which market prices move away before the full size of a parent order is executed, which is known as “slippage.” One means for institutional investors to minimize slippage is to limit “information leakage” concerning the unexecuted portions of their large parent orders by closely controlling the impact of the execution of their child orders on market prices.

See,

e.g.,

Securities Exchange Act Release No. 61358 (Jan. 14, 2010), 75 FR 3594, 3604-3605 (Jan. 21, 2010) (“Equity Market Structure Concept Release”) (measuring the transaction costs of institutional investors “can be extremely complex” because their “large orders often are broken up into smaller child orders and executed in a series of transactions” and “[m]etrics that apply to small order executions may miss how well or poorly the large order traded overall.”).

B. Trading Centers

Trades in NMS stocks are executed at a number of different types of trading centers.

As discussed below, trading centers that currently trade NMS stocks can be divided into five categories: (1) national securities exchanges operating SRO trading facilities;

(2) alternative trading systems (“ATSs”) that trade NMS stocks (“NMS Stock ATSs”); (3) exchange market makers; (4) wholesalers; and (5) any other broker-dealer that executes orders internally by trading as principal or crossing orders as agent.

Rule 600(b)(95) of Regulation NMS defines “trading center” as a national securities exchange or national securities association that operates a self-regulatory organization (“SRO”) trading facility, an alternative trading system, an exchange market maker, an OTC market maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.

Rule 600(b)(89) of Regulation NMS defines “SRO trading facility” as, among other things, a facility operated by a national securities exchange that executes orders in a security.

“Broker” is generally defined in section 3(a)(4)(A) of the Exchange Act as any person engaged in the business of effecting transactions in securities for the account of others. 15 U.S.C. 78c(a)(4)(A). “Dealer,” in turn, is generally defined in section 3(a)(5)(A) of the Exchange Act as any person engaged in the business of buying and selling securities for such person's own account through a broker or otherwise. 15 U.S.C. 78c(a)(5)(A). The term “broker-dealer” is used in this release to encompass all brokers, all dealers, and firms that are both brokers and dealers.

National securities exchanges, among other things, operate SRO trading facilities that bring together purchasers and sellers of NMS stocks and execute their trades, fall within the definition of an exchange in section 3(a)(1) of the Exchange Act,

and are required to register under section 6 of the Exchange Act.

As discussed further in section III.A below, national securities exchanges are subject to a comprehensive regulatory regime that, among other things, requires that their rules not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act and not be designed to permit unfair discrimination between customers,

issuers, and broker-dealers. All national securities exchanges publicly display quotations for NMS stocks in consolidated market data and are known as “lit” trading centers. As discussed in section III.B.1 below, the best-priced quotations of round lots of national securities exchanges (highest priced bids to buy and lowest priced offers to sell) are included in the consolidated market data feeds currently disseminated by centralized securities information processors (“SIPs”). In the first quarter of 2022, 16 national securities exchanges executed 59.7% of share volume in NMS stocks.

Section 3(a)(1) of the Exchange Act defines “exchange” as, among other things, any organization that provides facilities for bringing together purchasers and sellers of securities. 15 U.S.C. 78c(1).

15 U.S.C. 78f.

Table 1,

infra,

section VII.B.1.

NMS Stock ATSs operate facilities that fall within the definition of an exchange in section 3(a)(1) of the Exchange Act, but, as discussed in section III.B.3.b below, they are exempted from that definition if they register as broker-dealers and otherwise comply with Regulation ATS under the Exchange Act.

No NMS Stock ATS currently displays quotations in NMS stocks in consolidated market data. The trading centers that do not display quotations are known as “dark” trading centers or “dark pools.” An NMS Stock ATS is required to provide fair access to its services if it had 5% or more of the average daily volume with respect to an NMS stock during four of the preceding six calendar months,

and as of November 30, 2022, one NMS Stock ATS discloses on its Form ATS-N that it is subject to these fair access requirements for securities that are available for trading on its platform.

In the first quarter of 2022, 32 ATSs executed 10.2% of volume in NMS stocks.

17 CFR 240.3a1-1(a)(2);

see

also

Securities Exchange Act Release No. 40760 (Dec. 8, 1998), 63 FR 70844, 70858 (Dec. 22, 1998) (“Regulation ATS Adopting Release”) (stating that the Commission would not consider making an assessment whether a particular system should register as an exchange unless such system exceeded the volume thresholds specified in 17 CFR 240.3a1-1(b): during three of preceding four calendar quarters, the system had (1) 50% or more of the average daily dollar trading volume in any security and 5% or more of the average daily dollar trading volume in any class of security; or (2) 40% or more of the average daily dollar trading volume in any class of securities).

See

Rule 301(b)(5);

infra

section III.B.3.b (discussing fair access requirements for NMS Stock ATSs).

See

Dealerweb Inc., Form ATS-N/OFA, Part III, Items 11 (Trading Services, Facilities and Rules) and Item 25 (Fair Access) (filed Oct. 24, 2022),

https://www.sec.gov/Archives/edgar/data/817462/000081746222000015/0000817462-22-000015-index.htm

(disclosing that the NMS Stock ATS is subject to the fair access requirements in symbols SPY and QQQ). This NMS Stock ATS generally limits its eligible subscribers to market makers, banks, broker-dealers, and asset managers with at least $10 under management.

See id.

at Part III, Item 1 (Types of Subscribers) and Item 2 (Eligibility for ATS Services). Access to Form ATS-Ns filed by NMS Stock ATSs are available on the Commission's website at

https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm

Table 1,

infra,

section VII.B.1.

An exchange market maker is defined in Rule 600(b)(32) of Regulation NMS as any member of a national securities exchange that is registered as a specialist or market maker pursuant to the rules of such exchange. Exchange rules typically require exchange market makers to provide liquidity by displaying quotations at which they are willing to buy and sell NMS stocks for their own account.

In this respect, exchange market makers fall within the definition of a “dealer” in section 3(a)(5) of the Exchange Act as buying and selling NMS stocks for their own accounts as part of a regular business. The on-exchange volume of exchange market makers in NMS stocks is included in the volume for national securities exchanges referenced above because it is reported by such exchanges.

See,

e.g.,

New York Stock Exchange LLC (“NYSE”) Rule 104 (Dealing and Responsibilities of DMMs) (requiring the exchange's Designated Market Makers (“DMMs”) to maintain a continuous two-sided quote for securities in which the DMM unit is registered with the exchange)

available at

https://nyseguide.srorules.com/rules

Wholesalers fall within the definition of an OTC market maker in Rule 600(b)(64) of Regulation NMS—any dealer that holds itself out as being willing to buy from and sell to its customers, or others, in the United States, an NMS stock for its own account on a regular or continuous basis otherwise than on a national securities exchange in amounts of less than block size. The term “wholesaler” is not defined in Regulation NMS, but commonly refers to an OTC market maker that seeks to attract orders from broker-dealers that service the accounts of individual investors,

referred to in this release as “retail brokers.”

The public order-routing reports required by 17 CFR 242.606 (“Rule 606”)

show that the six largest wholesalers collectively paid retail brokers $235 million in payment for order flow (“PFOF”) in the first quarter of 2022 for orders in NMS stocks.

Many retail brokers do not accept PFOF for marketable orders in NMS stocks routed to wholesalers, though the retail brokers that do accept PFOF represent 73.88% of the dollar volume of marketable orders of retail brokers routed to wholesalers.

Another type of business operated by some OTC market makers is known as a “single dealer platform,” which primarily seeks to attract the orders of institutional investors for internal execution.

Infra

section VII.B.3.

As discussed in section VII.B.1.a below, the Commission has identified six firms as wholesalers based on the public order routing disclosures of retail brokers. Retail broker services are discussed in section VII.B.6 below.

Rule 606 is discussed in section III.B.4 below.

See

infra

section VII.B.6.a.

See

Table 14,

infra

section VII.B.5.c.

Wholesalers do not display or otherwise reveal the prices at which they are willing to execute individual investor orders internally. Moreover, as discussed in section III.B.3 below, while they are subject to Commission and SRO requirements as broker-dealers, wholesalers are not subject to a statutory or regulatory requirement to provide fair access. They are not required to provide an opportunity for other market participants, including institutional investors and other exchange market makers, to compete on an order-by-order basis to provide the best prices for the individual investor orders that the wholesalers internalize. Some institutional investors, for example, consider this order flow to be “inaccessible.”

In the first quarter of 2022, six large wholesalers internally executed 23.9% of share volume in NMS stocks.

See,

e.g.,

Cowen, Inc., “Cowen Market Structure: Retail Trading—What's going on, what may change, and what can you do about it?” (Mar. 23, 2021),

available at

https://www.cowen.com/insights/retail-trading-whats-going-on-what-may-change-and-what-can-institutional-traders-do-about-it/

(“Market makers print most of these shares internally at their firm, so they trade off-exchange. One way we have for isolating retail volume is to look at the share of volume that trades off-exchange, but not in a dark pool. We refer to this as `inaccessible liquidity.' This is because most institutional orders—whether they are executed via algos directly or by high touch desks—primarily go to exchanges and dark pools.”).

Table 1,

infra,

section VII.B.1.

The fifth and final category of trading center that executes trades in NMS stocks is a catchall category encompassing broker-dealers that execute orders internally by trading as principal or crossing orders as agent. In the first quarter of 2022, over 230 broker-dealers (other than NMS Stock ATSs and OTC market makers) reported trades in NMS stocks, which accounted for the remaining 6.3% of share volume in NMS stocks.

Table 1,

infra,

section VII.B.1.

C. Order Types and Trading Costs

When seeking to buy and sell NMS stocks, investors submit orders through the broker-dealers that service their accounts. The order type most frequently used to trade by individual investors is a “market” order, which simply instructs a broker-dealer to seek an execution of the order at the best available price in the market. In contrast to market orders, a “limit order” specifies a “limit price”—a price

beyond which the investor is not willing to trade. Limit prices reflect an intention to “buy low and sell high.” For example, a buy order with a limit price of $20 means the investor would like to buy as soon as possible, but only at a price that is $20 or less. Conversely, a sell order with a limit price of $20 means the investor would like to sell as soon as possible, but only at a price that is $20 or more.

In practice, the likelihood and speed of execution of limit orders can vary greatly depending primarily on the relation between their limit prices and the best-priced quotations that are displayed by national securities exchanges in the consolidated market data feeds. As discussed in section III.B.1 below, these quotations are in “round lot” sizes, which currently are 100 shares or more for nearly all NMS stocks. The highest price bid for an NMS stock is known as the national best bid (“NBB”), and the lowest price offer for an NMS stock is known as the national best offer (“NBO”). Collectively, the NBB and NBO are known as the national best bid and offer (“NBBO”). When a limit order to buy has a limit price that is equal to or greater than the NBO, it is known as a “marketable” limit order because it can be executed immediately at the best displayed quote to sell. Similarly, a limit order to sell is marketable when it has a limit price that is equal to or less than the NBB.

Rule 600(b)(47) of Regulation NMS defines a “marketable limit order” as any buy order with a limit price equal to or greater than the NBO at the time of order receipt, or any sell order with a limit price equal to or less than the NBB at the time of order receipt.

For example, assume the NBB is $20.00 and the NBO is $20.10. A buy limit order with a price of $20.10 or higher is marketable, and a sell limit order with $20.00 or lower is marketable. Marketable limit orders are similar to market orders with respect to their willingness to trade immediately at the best displayed prices or better and will be referred to collectively in this release as “marketable orders.”

Investors that use marketable orders to trade immediately at the best available prices are known as “liquidity takers” and generally incur a trading cost for the service, known as a “spread.” In the example above, when the NBBO is $20.00 and $20.10, the quoted spread is 10 cents. An investor that wished to avoid paying a spread could use a “non-marketable” limit order in an attempt to become a “liquidity provider.” A non-marketable limit order to buy has a limit price that is less than the NBO, and a non-marketable limit order to sell has a limit price that is greater than the NBB.

For example, again using the example when the NBBO is $20.00 and $20.10, an investor could submit a buy limit order with a limit price of $20.00. This buy order is not marketable because it is priced less than the NBO of $20.10 and therefore cannot be executed immediately against the best displayed offer. A non-marketable limit order generally will “rest” on the continuous order book of a trading center awaiting the arrival of a contra-side marketable order against which it can execute. In the example, if the resting non-marketable limit order to buy were able to obtain an execution at its limit price of $20.00 (

e.g.,

by interacting with a contra-side marketable order to sell), the investor would have succeeded in trading at a price that was 10 cents lower than if the investor had used a marketable order and traded at the NBO of $20.10. The risk, however, of using a non-marketable limit order is that it may not execute at all if market prices move away from the order (

i.e.,

prices increase for buy orders and decrease for sell orders). If this happens, the investor will incur an opportunity cost by missing a trade.

Rule 600(b)(57) of Regulation NMS defines “non-marketable limit order” as any limit order other than a marketable limit order.

Using the example of an NBBO of $20.00 and $20.10, assume the investor submitted a non-marketable order to buy with a limit price of $20.00, but did not obtain an execution and the NBBO then rose to $20.15 and $20.25. Seeing that the market was moving away, the investor decided to cancel the unexecuted non-marketable order and replace it with a marketable order to buy, which then was executed at the new NBO price of $20.25. In this case, the investor incurred an opportunity cost of 15 cents—the difference between (1) the original NBO price of $20.10 that the investor likely could have obtained if the investor first had used a marketable order to buy at $20.10 rather than using the non-marketable order in an unsuccessful attempt to buy at $20.00, and (2) the price of $20.25 at which the investor actually obtained an execution.

In sum, an investor's decision of whether to use marketable orders or non-marketable orders to trade can depend on an often complex judgment of whether prices are likely to move in the short-term future. Individual investors, who typically do not follow market prices closely throughout a trading day, often will not feel in the best position to make this judgment and generally choose to be liquidity takers by using marketable orders to obtain the certainty of an immediate execution at a displayed price or better.

Accordingly, a key source of trading costs for individual investors are the spreads they pay when using marketable orders. The narrower the spreads, the lower the prices at which they will buy and the higher the prices at which they will sell, which translate into lower trading costs and higher investment returns. Conversely, wider spreads mean higher trading costs and lower investment returns.

Rule 606 order-routing reports reveal that customers of retail brokers used marketable orders for approximately 39-40% of their trades and used “other” orders for approximately 26-27% of their trades. Table 3,

infra,

section VII.B.2.a. As presented in Table 2 in section VII.B.2.a below, however, the PFOF rates received from wholesalers for these “other” orders almost exactly matched the rates received from wholesalers for marketable limit orders. Accordingly, it is likely that most of these other orders were marketable (

i.e.,

immediately executable at the best available prices), although the orders may have had particular characteristics that led them to be classified as other orders.

The spread costs of individual investors highlight the role played by liquidity providers in determining spreads. Liquidity providers determine spreads by setting the prices at which they are willing to trade with marketable orders as such orders are submitted by liquidity takers. Liquidity providers can include professional market intermediaries, such as exchange market makers and OTC market makers (including wholesalers), as well as investors that use non-marketable limit orders. For example, national securities exchanges, which display the quotations that determine the NBBO, all operate continuous order books. Unexecuted non-marketable orders that have been routed to an exchange rest on its continuous order book awaiting an opportunity for interaction with incoming contra-side orders. Using the NBBO example of $20.00 and $20.10, assume a national securities exchange has displayed limit orders resting on its continuous order book with limit prices that equal the NBBO, but then an institutional investor submits a buy order with a limit price of $20.02 for display on the continuous order book. At this point, there will be a new NBB of $20.02 and the NBBO spread will have been reduced from 10 cents to 8 cents. If an individual investor's market order to sell was routed to the exchange, the order would execute at the new NBB of $20.02, saving the individual investor two cents per share compared to the old NBB of $20.00.

For liquidity providers, the adverse selection costs of trading with a given

marketable order flow are a key factor for determining the prices at which they are willing to trade with such flow, particularly for professional market intermediaries. These market intermediaries generally seek to generate short-term trading profits by buying and selling on a continuous basis and capturing a spread between their buys and sells. Adverse selection costs reflect the extent to which prices move against the liquidity provider in the seconds and minutes after a trade, which increases the difficulty faced by the liquidity provider in successfully capturing a spread between buys and sells.

For example, assume an NBBO of $20.00 and $20.10, and a market maker provides liquidity by trading with a contra-side marketable sell order at the $20.00 NBB. The market maker may hope to profit by quickly providing liquidity to a contra-side marketable buy order at the $20.10 NBO and thereby earning a 10 cent spread. Seconds later, however, and before the market maker is able to liquidate the buy position, the NBBO declines to $19.85 and $19.95. In this case, the market maker has bought immediately prior to a 15 cent decline in the NBBO. This subsequent move in the NBBO is known as “price impact.” Instead of earning a 10 cent spread as it hoped by providing liquidity when the NBBO was $20.00 and $20.10, the market maker would realize a loss of 5 cents on its position if it then provided liquidity to a contra-side marketable buy order by selling at the new NBO of $19.95. Therefore, the market maker had an adverse selection cost of 15 cents. Accordingly, market makers assess the potential adverse selection costs of the liquidity-taking order flow with which they are likely to interact when setting the spreads at which they are willing to provide liquidity to such flow. Segmentation of marketable orders with low adverse selection costs is a means for liquidity providers to control such costs. As discussed in section VII,

the marketable orders of individual investors routed to wholesalers have adverse selection costs (as measured by price impact) that are approximately 71% lower than the adverse selection costs of orders routed to national securities exchanges. The low adverse selection costs of the segmented marketable orders of individual investors generally enable wholesalers to offer better prices for such orders than would be available for unsegmented orders routed to national securities exchanges.

See

Table 7,

infra,

section VII.B.4.

The trading examples thus far have assumed that trades occur at the NBBO prices, which are determined by round lot quotations displayed on national securities exchanges. In fact, however, trades can be executed on national securities exchanges at prices that are better than NBBO prices (“NBBO price improvement”). Marketable orders routed to access the NBBO at a national securities exchange can obtain NBBO price improvement in two primary contexts. First, a national securities exchange may have displayed orders on its continuous order book with sizes less than round lots, known as “odd lot quotations,” that are priced better than the NBBO. If a contra-side marketable order is routed to a national securities exchange with such an odd lot quotation, the contra-side marketable order will interact with the odd-lot quotation and receive a better price than the NBBO. Second, there may be undisplayed non-marketable limit orders resting on the continuous order book of a national securities exchange with prices that are better than such exchange's displayed quotations. One common example is an NBBO midpoint order. An NBBO midpoint order has an execution price that is pegged to, and accordingly fluctuates with, the midpoint of the NBBO. If the NBBO is $20.00 and $20.10, and an NBBO midpoint order to sell is resting on the continuous order book of a national securities exchange, a marketable order to buy that is routed to such exchange will execute at the NBBO midpoint price of $20.05 rather than the NBO of $20.10. By trading at the NBBO midpoint, the incoming marketable buy order has obtained an immediate execution without paying any spread, and the resting NBBO midpoint order to sell has not earned any spread. Institutional investors may use undisplayed NBBO midpoint orders because they provide an opportunity to trade with contra-sided marketable flow, but without the information leakage (and potential slippage) that could occur if their orders were displayed.

D. Quantitative Measures of Order Execution Quality and Trading Costs

A variety of quantitative measures can be used to assess the quality of order executions that broker-dealers obtain for their individual investor customers, as well as more generally the trading costs of liquidity takers and liquidity providers. 17 CFR 242.605 (“Rule 605”) of Regulation NMS,

for example, requires many trading centers, including national securities exchanges and wholesalers, to make data files publicly available on a monthly basis that include detailed measures of execution quality for marketable and non-marketable orders in NMS stocks. This section will describe some of the quantitative measures included in Rule 605 data, as well as provide concrete examples illustrating specifically how the measures are calculated. These quantitative measures are referenced extensively throughout this release to explain the rationale for and the potential economic effects of Proposed Rule 615.

Rule 605 is discussed in section III.B.4 below.

1. Description of Quantitative Measures

The following is a list, with brief descriptions, of quantitative measures of order execution quality and trading costs in NMS stocks that are included in, or can be derived from, Rule 605 data files. Specific examples of how the measures are calculated will be provided in section II.D.2 below.

As stated above, NBBO price improvement is the amount by which the execution price of a marketable order is better than the relevant NBBO quotation at the time a marketable order is received by a trading center.

For marketable buy orders, it is the amount by which the buy order received a price lower than the NBO at the time of order receipt. For marketable sell orders, it is the amount by which the sell order received a price higher than the NBB at the time of order receipt.

Rule 600(b)(36) of Regulation NMS defines “executed with price improvement” as, for buy orders, execution at a price lower than the NBO at the time of order receipt and, for sell orders, execution at a price higher than the NBB at the time of order receipt.

“NBBO quoted half-spread” is one-half of the difference between the NBO and NBB, as measured at the time when a marketable order is received by a trading center. The full quoted spread is halved to reflect the spread cost for establishing or liquidating a position (long or short). For example, if an investor uses a marketable order to buy at the NBO (incurring a half-spread to establish a long position), but then is able to use a non-marketable order to sell at the NBO (earning a half-spread to liquidate the long position), the investor would have paid a net spread of 0 cents on the “round-trip” transaction.

“Effective half-spread” is the half-spread actually paid by a marketable order. It is calculated by comparing execution prices with the NBBO midpoint, rather than the relevant NBB or NBO, at the time of order receipt.

Accordingly, a trading center's average effective half-spread for marketable orders may be narrower or wider than the NBBO quoted half-spread, depending on the extent to which execution prices at a trading center are inside, at, or outside NBBO prices.

Rule 600(b)(8) of Regulation NMS defines “average effective spread” as the share-weighted average of effective spreads for order executions

calculated, for buy orders, as double the amount of difference between the execution price and the midpoint of the NBB and NBO at the time of order receipt and, for sell orders, as double the amount of difference between the midpoint of the NBB and NBO at the time of order receipt and the execution price.

“Price impact” is the extent to which the NBBO midpoint moves against the liquidity provider for a marketable order in a short time period after the order execution. For Rule 605 reporting, the time period is five minutes after the time of order execution. For the analyses of CAT data provided in section VII.B.4 below, the time period is one minute after the time of order execution.

Price impact measures the extent of adverse selection costs faced by a liquidity provider and is closely related to realized half-spread (described next). When price impact and realized half-spread are calculated using the same post-trade time period, the difference between the effective half-spread and the realized half-spread on a trade will equal the price impact of the trade.

The analysis in section VII.B.4 below uses one minute to reflect the increase in trading speed in the years since Rule 605 was adopted.

See, e.g.,

Hasbrouck Treatise at 147 (“The execution cost based on the pretrade bid-ask midpoint (BAM) is also known as the effective cost. Since 2001, the U.S. SEC has required U.S. equity markets to compute effective costs and make summary statistics available on the Web . . . . The rule . . . also requires computation of the realized cost . . . . The difference between effective and realized costs is sometimes used as an estimate of the price impact of the trade. The realized cost can also be interpreted as the revenue of the dealer who sold to the customer . . . and then covered his position at the subsequent BAM.”).

“Realized half-spread” is calculated similarly to the effective half-spread, but, instead of using the NBBO midpoint at the time of order receipt, the realized spread calculation uses the NBBO midpoint a short time period after the execution of a marketable order.

For Rule 605 reporting, the time period is five minutes after the time of order execution. For the analyses of CAT data provided in section VII.B.4 below, the time period is one minute after the time of order execution.

When deciding to include realized spread statistics in Rule 605 reports, the Commission stated that the smaller the average realized spread, “the more market prices have moved adversely to the market center's liquidity providers after the order was executed,” which shrinks the spread “realized” by the liquidity providers.

The Commission further stated that the average realized spread statistic for market and marketable limit orders potentially could help “to spur more vigorous competition to provide the best prices to these orders to the benefit of many retail investors.”

In sum, by capturing the extent of adverse selection costs faced by liquidity providers, realized spreads are designed to provide a more accurate measure of the potential profitability of trading for liquidity providers than do effective spreads.

Rule 600(b)(9) of Regulation NMS generally defines “average realized spread” as the share-weighted average of realized spreads for order executions calculated, for buy orders, as double the amount of difference between the execution price and the midpoint of the NBB and NBO five minutes after the time of order execution and, for sell orders, as double the amount of difference between the midpoint of the NBB and NBO five minutes after the time of order execution and the execution price.

The analysis in section VII.B.4 below uses a one-minute period to reflect the increase in trading speed in the years since Rule 605 was adopted.

Securities Exchange Act Release No. 43590 (Nov. 17, 2000), 65 FR 75414, 75424 (Dec. 1, 2000).

Id.

See, e.g.,

Harris Treatise at 286 (“Informed traders buy when they think that prices will rise and sell otherwise. If they are correct, they profit, and whoever is on the other side of their trade loses. When dealers trade with informed traders, prices tend to fall after the dealer buys and rise after the dealer sells. These price changes make it difficult for dealers to complete profitable round-trip trades. When dealers trade with informed traders, their realized spreads are often small or negative. Dealers therefore must be very careful when trading with traders they suspect are well informed.”).

2. Examples of Calculating Measures of Order Execution Quality and Trading Costs

When the execution quality and trading cost measures described above are calculated and averaged for a large volume of orders at different trading centers, the results can reveal important information about the nature of the order execution quality and trading costs across different trading centers. Section VII below, which provides an economic analysis of Proposed Rule 615, makes extensive use of data analyses using these measures.

The following two examples are patterned on those analyses, particularly the empirical finding that the marketable orders of individual investors routed to wholesalers have adverse selection costs (as measured by price impact) that, on average, are approximately 71% lower than the marketable orders routed to national securities exchanges. The examples are intended to illustrate how quantitative measures of order execution quality and trading costs are calculated in these two contexts that are most relevant for understanding the empirical basis for Proposed Rule 615. The examples show how a difference in the adverse selection costs of order flow routed to two different trading centers can result in more price improvement and narrower effective spreads at the trading center with lower adverse selection costs (the wholesaler) than at the trading center with higher adverse selection costs (the exchange), yet still result in wider realized spreads (

i.e.,

spreads realized by the liquidity provider after estimating for adverse selection costs) at the wholesaler than at the exchange.

The first example below (“Exchange Example”) presents the execution of an unsegmented marketable order to buy at a national securities exchange at a price that matches the NBBO, and the second example below (“Wholesaler Example”) presents the execution of a segmented marketable order to buy of an individual investor at a wholesaler at a price better than the NBBO. The examples use the calculation methodology prescribed by Rule 605 of Regulation NMS, except that statistics are presented for the half-spread associated with a single buy or sell order rather than the full spread statistics prescribed for Rule 605, which are doubled to reflect estimates of round-trip (offsetting buy and sell) trading costs.

Half-spreads are used to more clearly present the calculations for the single order in each of the examples.

The definitions of “average effective spread” and “average realized spread” provided in Rule 600(b)(8) and (9) of Regulation NMS, which are incorporated in Rule 605, prescribe doubling of the amounts by which an order execution price differs from the NBBO midpoint at the time of order receipt (for effective spreads) and five minutes after the time of order execution (for realized spreads).

The data used for the two examples are labeled as follows: execution price of marketable order (“ExP”), NBB at time of order receipt (“NBB

”), NBO at time of order receipt (“NBO

”), NBBO midpoint at time of order receipt (“MP

”), and NBBO midpoint 5 minutes after time of order execution (“MP

”).

The execution quality and trading cost measures for the two examples of marketable orders to buy are calculated as follows:

NBBO quoted half-spread:

1/2

× (NBO

−NBB

)

NBBO price improvement: NBO

−ExP

Effective half-spread: ExP−MP

Price impact: MP

−MP

Realized half-spread: ExP−MP

The data and calculations for the two examples are as follows:

Exchange example

Wholesaler example

EXP

$110.05

$110.04.

NBB

$110.00

$110.00.

NBO

$110.05

$110.05.

$110.025

$110.025.

$110.055

$110.035.

NBBO PRICE IMPROVEMENT

0 cents

1 cent.

NBBO QUOTED HALF-SPREAD

2.5 cents

2.5 cents.

EFFECTIVE HALF-SPREAD

2.5 cents

1.5 cents.

PRICE IMPACT

3 cents

1 cent.

REALIZED HALF-SPREAD

<0.5 cents>

0.5 cents.

In the Exchange Example and Wholesaler Example, the NBBO is the same at the time of order receipt for both marketable buy orders, but the national securities exchange in the Exchange Example executes the order at the NBO with no NBBO price improvement, while the wholesaler in the Wholesaler Example executes the marketable buy order with NBBO price improvement of one cent. Consequently, the NBBO quoted half-spread is the same for both trades (2.5 cents), but the effective half-spread is wider for the liquidity provider on the national securities exchange (2.5 cents) than for the wholesaler (1.5 cents) because of the 1 cent NBBO price improvement provided by the wholesaler. The price impact of the order routed to the national securities exchange is 3 cents, while the price impact of the order routed to the wholesaler is only 1 cent. Accordingly, the adverse selection cost for the liquidity provider on the national securities exchange was 3 cents, while the adverse selection cost for the wholesaler was 1 cent.

The difference in adverse selection costs leaves the liquidity provider on the national securities exchange in the Exchange Example with a narrower realized half-spread of negative 0.5 cents, while the wholesaler in the Wholesaler Example preserves a positive realized half-spread of 0.5 cents. Stated another way, the wholesaler provided some NBBO price improvement (1 cent), but its adverse selection cost savings compared to the liquidity provider on the national securities exchange was 2 cents, and as a result the wholesaler was able to capture a realized half-spread that was one cent wider than the liquidity provider on the national securities exchange. If, however, the wholesaler had provided NBBO price improvement that matched its cost savings, the individual investor would have received NBBO price improvement of 2 cents rather than 1 cent. In this case, the realized half-spread for both the wholesaler and the liquidity provider on the national securities exchange would have been the same—negative 0.5 cents.

In this respect, the Exchange Example and Wholesaler Example highlight the key order-by-order competition objective of Proposed Rule 615. As discussed in section VII.C.2.b below, competition among a wide range of liquidity providers on national securities exchanges is intense and results in realized spreads for unsegmented orders that are narrower than the realized spreads captured by wholesalers for the segmented orders of individual investors. Another way of stating the same point is that wholesalers do not provide average NBBO price improvement that matches their savings in average adverse selection costs from securing the opportunity to trade first with the segmented orders of individual investors. Proposed Rule 615 would enable order-by-order competition to provide the best prices to the segmented marketable orders of individual investors. By providing an opportunity for a wide variety of liquidity providers to compete to provide the best prices for the segmented marketable orders of individual investors, Proposed Rule 615 is designed to expand the level of NBBO price improvement currently provided by wholesalers to match the low adverse selection costs of such orders.

III. Statutory and Regulatory Background

The development of today's market structure for NMS stocks has been guided by the Congressional determination set forth in section 11A of the Exchange Act that the United States should have an NMS in which multiple competing markets are linked together through communications and data processing facilities. This section III first will discuss the Exchange Act framework for an NMS. It then will summarize the rules that the Commission has adopted over the years to facilitate the development of an NMS, with particular focus on rules that address the handling and execution of investor orders in NMS stocks. Many aspects of Proposed Rule 615, as described in section IV below, are designed to build on the existing statutory framework and Commission rules discussed in this section III.

A. Statutory Framework for an NMS

Section 11A of the Exchange Act, enacted as part of the Securities Acts Amendments of 1975,

sets forth the statutory framework for an NMS. Section 11A(a)(2) directs the Commission, having due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets, to use its authority under the Exchange Act to facilitate the establishment of an NMS for securities in accordance with the Congressional findings and objectives set forth in section 11A(a)(1) of the Exchange Act.

Section 11A(a)(1)(C) sets forth the finding of Congress that it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure five objectives:

Public Law 94-29, 89 Stat. 97 (1975).

Section 11A(a)(3)(B) also provides the Commission the authority to require the SROs, by rule or order, “to act jointly . . . in planning, developing, operating, or regulating [an NMS] (or a subsystem thereof).”

(1) economically efficient execution of securities transactions;

(2) fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets;

(3) the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities;

(4) the practicability of brokers executing investors' orders in the best market; and

(5) an opportunity, consistent with the foregoing objectives of efficient execution of securities transactions and practicability of brokers executing investors' orders in the best market, for investors' orders to be executed without the participation of a dealer.

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

A variety of Exchange Act provisions grant the Commission specific

rulemaking authority in different contexts to fulfill its responsibility to facilitate the establishment of an NMS that assures the five objectives. Three of these Exchange Act authorizations are particularly relevant in the context of rules to address the handling and execution of investor orders in NMS stocks.

First, section 11A(c)(1)(E) addresses the routing of orders by broker-dealers. It authorizes the Commission to prescribe rules, as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the Exchange Act to assure that all exchange members and brokers-dealers transmit and direct orders for the purchase or sale of NMS stocks in a manner consistent with the establishment and operation of an NMS.

15 U.S.C. 78k-1(c)(1)(E).

Second, section 11A(c)(1)(F) grants rulemaking authority to assure equal regulation of all markets for NMS stocks, as well as of all exchange members and broker-dealers effecting transactions in NMS stocks.

The meaning of the term “equal regulation” is specified in section 3(b)(36), which provides that a class of persons or markets is subject to equal regulation if no member of the class has a competitive advantage over any other member thereof resulting from a disparity in their regulation under the Exchange Act which the Commission determines is unfair and not necessary or appropriate in furtherance of the purposes of the Exchange Act.

15 U.S.C. 78k-1(c)(1)(F).

Third, section 15(c)(5) addresses the practices of dealers, such as wholesalers. It authorizes the Commission to prescribe rules setting forth specified and appropriate standards with respect to dealing for dealers (other than specialists registered on a national securities exchange) acting in the capacity of a market maker or otherwise that are necessary or appropriate in the public interest and for the protection of investors, to maintain fair and orderly markets, or to remove impediments to and perfect the mechanism of an NMS.

15 U.S.C. 78

(c)(5).

In addition to these grants of rulemaking authority to facilitate the development of an NMS, section 6 of the Exchange Act

specifically addresses the types of access to trading services that one type of market—a national securities exchange—is required to provide to broker-dealers and market participants. Access to the trading services of a market is essential for that market to be linked together with other markets in an NMS.

15 U.S.C. 78f.

First, section 6(b)(2) requires that, subject to the provisions of section 6(c) relating to statutory disqualification and other concerns, the rules of the exchange must provide that any registered broker-dealer may become a member of such exchange.

Broker-dealers generally need to become exchange members, as an initial matter, to obtain access to many of the trading services of an exchange.

15 U.S.C. 78f(b)(2).

Second, section 6(b)(4) requires that the rules of the exchange provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities.

This provision recognizes that the opportunity for different market participants to access trading services at a market can be greatly affected by the charges for those services.

15 U.S.C. 78f(b)(4).

Third, section 6(b)(5) requires that the rules of the exchange are designed to, among other things, “remove impediments to and perfect the mechanism of a free and open market and [an NMS], and, in general, to protect investors and the public interest.”

Section 6(b)(5) further requires that the rules of the exchange are not designed “to permit unfair discrimination between customers, issuers, brokers, or dealers.”

These provisions broadly help ensure fair and efficient access to the trading services of national securities exchanges, both by requiring them to act affirmatively to promote high quality markets and by prohibiting them from acting negatively by unfairly discriminating between customers, issuers, or broker-dealers.

15 U.S.C. 78f(b)(5).

Id.

Finally, section 6(b)(8) requires that “the rules of the exchange do not impose any burden on competition not necessary or appropriate in furtherance of the purposes” of the Exchange Act.

This provision further restricts a national securities exchange's ability to limit access to its trading services in an anti-competitive manner.

15 U.S.C. 78f(b)(8).

To help ensure that national securities exchanges operate according to rules consistent with their statutory obligations, section 19(b)(1) of the Exchange Act

requires SROs,

including national securities exchanges, to file with the Commission any proposed rule change.

The Commission publishes for public comment all SRO proposed rule changes.

For new or materially modified trading services, a proposed rule change generally cannot become effective, and the national securities exchange cannot implement such rule change, until the Commission has approved it as consistent with the requirements of the Exchange Act.

15 U.S.C. 78s(b)(1).

See

15 U.S.C. 78c(b)(26) (defining “self-regulatory organization” to include, among other things, any national securities exchange or registered securities association).

Section 19(b)(1) of the Exchange Act defines a “proposed rule change” to be any proposed change in, addition to, or deletion from the rules of an SRO. 15 U.S.C. 78s(b)(1). Section 3(a)(27) of the Exchange Act generally defines “rules” to include the constitution, articles of incorporation, bylaws, and rules, or instruments corresponding to the foregoing and the stated policies, practices, and interpretations of an exchange, association, or clearing agency as the Commission, by rule, may determine to be necessary or appropriate in the public interest or for the protection of investors to be deemed to be rules of such exchange, association, or clearing agency. 15 U.S.C. 78c(a)(27). Rule 19b-4(b) under the Exchange Act defines “stated policy, practice, or interpretation” to mean, in part, any material aspect of the operation of the facilities of the SRO or any statement made generally available that establishes or changes any standard, limit, or guideline with respect to the rights, obligations, or privileges of persons or the meaning, administration, or enforcement of an existing rule. 17 CFR 240.19b-4(b).

See

15 U.S.C. 78s(b)(1).

If the Commission does not approve or disapprove a proposed rule change within the required timeframe prescribed by section 19 of the Exchange Act, it is “deemed to have been approved.” 15 U.S.C. 78s(b)(2)(D).

Section 15A of the Exchange Act

includes many requirements for the rules of a national securities association that are analogous to those prescribed for national securities exchanges. FINRA is currently the only registered national securities association. Broker-dealers that handle customer orders in NMS stocks or trade NMS stocks in the off-exchange market generally must become FINRA members.

Section 15A does not, however, impose fair access requirements on the broker-dealer members of FINRA. Accordingly, broker-dealers that trade internally are not subject to the statutory access requirements that apply to national securities exchanges under section 6 of the Exchange Act.

15 U.S.C. 78

-3.

See

15 U.S.C. 78

(b)(8). The Commission has proposed to amend 17 CFR 240.15b9-1, which provides an exemption from association membership for certain exchange members. Securities Exchange Act Release No. 95388 (July 29, 2022), 87 FR 49930 (Aug. 12, 2022) (proposing to replace a

de minimis

allowance with narrower exemptions from association membership).

B. Current Regulatory Components of the NMS for NMS Stocks

Over the years since 1975, the Commission has used its Exchange Act

authority to adopt a series of rules to fulfill its regulatory responsibility to facilitate the establishment of an NMS. In doing so, it particularly has emphasized the importance of promoting competition as a means to protect investors and to achieve the five statutory objectives for an NMS. In its request for comment on issues relating to market fragmentation in 2000,

for example, the Commission stated that the section 11A findings and objectives can be summed up in two fundamental principles. First, the interests of investors (both large and small) are preeminent, “especially the efficient execution of their securities transactions at prices established by vigorous competition.”

Second, investor interests are best served by a market structure that, to the greatest extent possible, maintains the benefits of “

both

an opportunity for interaction of all buying and selling interest” in individual securities and “fair competition among all types of market centers” seeking to provide a forum for the execution of securities transactions.

The Commission further stated that competition among multiple competing markets can isolate investor orders and that this “may reduce competition

on price,

which is one of the most important benefits of greater interaction of buying and selling interest in an individual security.”

Securities Exchange Act Release No. 42450 (Feb. 23, 2000), 65 FR 10577 (Feb. 28, 2000) (“Market Fragmentation Concept Release”).

Id.

at 10580.

Id.

(emphasis in original).

Id.

(emphasis in original).

In 2005, the Commission adopted Regulation NMS to consolidate the NMS rules it had previously adopted under section 11A and to include new rules designed to modernize and strengthen equity market structure.

It again emphasized the importance of competition among orders to obtain the best prices for investors, stating that this basic principle was recognized in the legislative history of section 11A: “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.”

The Commission summed up its approach to achieving an NMS as resisting 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.”

Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005) (“Regulation NMS Adopting Release”).

Id.

at 37499 (quoting H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975)). The Commission further quoted this legislative history for section 11A of the Exchange Act to emphasize the importance of ensuring that investor orders are able to be executed in a market with the best price: “`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.'”

Id.

at 37499 n.13.

Id.

Four categories of the Regulation NMS rules are particularly important in the context of Proposed Rule 615: (1) consolidated market data; (2) order handling and execution; (3) access to trading centers; and (4) disclosure of order routing practices and order execution statistics.

1. Rules Addressing Consolidated Market Data

Several rules under Regulation NMS set forth requirements for consolidated market data, which, as defined in Rule 600(b)(19) and (21) of Regulation NMS, includes information concerning quotations and transactions in NMS stocks. 17 CFR 242.601 (“Rule 601”) provides for the dissemination of transaction information; 17 CFR 242.602 (“Rule 602”) provides for the dissemination of quotation information; 17 CFR 242.603 (“Rule 603”) requires, among other things, the national securities exchanges and national securities associations to act jointly for disseminating consolidated market data; and 17 CFR 242.608 (“Rule 608”) addresses the joint-NMS plans that currently are responsible for operating the facilities for collecting and disseminating consolidated market data in NMS stocks.

In 2020, the Commission adopted a new rule and amended existing rules to establish a new infrastructure for consolidated market data and to update and significantly expand the content of consolidated market data (“MDI Rules”).

The MDI Rules have not yet been implemented and, as discussed below, given their unimplemented status, the description of Proposed Rule 615 in section IV below reflects the regulatory structure currently in place for consolidated market data. Section VII below addresses the economic effects of Proposed Rule 615, taking into account both the regulatory structure currently in place and the unimplemented MDI Rules. This section III.B.1 first will briefly summarize the currently implemented regulatory structure for consolidated market data. It then will discuss the status of the implementation of MDI Rules and how it would not affect the operation of and need for Proposed Rule 615.

Securities Exchange Act Release No. 90610 (Dec. 9, 2020), 86 FR 18596 (Apr. 9, 2021) (“MDI Adopting Release”);

see also

The Nasdaq Stock Market LLC, et al

SEC,

No. 21-1100 (D.C. Cir. May 24, 2022) (upholding these Commission amendments to market data rules adopted in the MDI Adopting Release). The MDI Adopting Release provides a comprehensive discussion of the current arrangements for consolidated market data, as well as the adopted but unimplemented rules to change these current arrangements.

a. Current Regulatory Structure for Consolidated Market Data

As stated in section II.B above, consolidated market data currently is collected and disseminated by the centralized SIPs. For quotation information, only the 16 exchanges that currently trade NMS stocks provide quotation information to the SIPs for dissemination in consolidated market data.

FINRA has the only SRO display-only facility (the ADF) for quotations. No broker-dealer, however, currently uses the ADF to display quotations in NMS stocks in consolidated market data. For transaction information, all of the national securities exchanges that trade NMS stocks and FINRA provide real-time transaction information to the SIPs for dissemination in consolidated market data. Such information includes the symbol, price, and size of the transaction. A notable difference, however, between the transaction information provided by the national securities exchanges and the transaction information provided by FINRA is that the identity of the particular exchange that executed a trade is included in consolidated market data, while the

identity of the particular FINRA member responsible for reporting a trade, such as a wholesaler or other type of broker-dealer, is not included in consolidated market data.

Currently, these national securities exchanges are: Cboe BYX Exchange, Inc. (“Cboe BYX”); Cboe BZX Exchange, Inc. (“Cboe BZX”); Cboe EDGA Exchange, Inc. (“Cboe EDGA”); Cboe EDGX Exchange, Inc. (“Cboe EDGX”); Investors Exchange LLC (“IEX”); Long-Term Stock Exchange, Inc. (“LTSE”); MEMX LLC (“MEMX”); MIAX Pearl, LLC (“MIAX PEARL”); Nasdaq BX, Inc. (“Nasdaq BX”); Nasdaq PHLX LLC (“Nasdaq Phlx”); The Nasdaq Stock Market LLC (“Nasdaq”); NYSE; NYSE American LLC (“NYSE American”); NYSE Arca, Inc. (“NYSE Arca”); NYSE Chicago, Inc. (“NYSE CHX”); and NYSE National, Inc. (“NYSE National”). The Commission approved rules proposed by BOX Exchange LLC (“BOX”) for the listing and trading of certain equity securities that would be NMS stocks on a facility of BOX known as BSTX LLC (“BSTX”), but BSTX is not yet operational.

See

Securities Exchange Act Release Nos. 94092 (Jan. 27, 2022), 87 FR 5881 (Feb. 2, 2022) (SR-BOX-2021-06) (approving the trading of equity securities on the exchange through a facility of the exchange known as BSTX); 94278 (Feb. 17, 2022), 87 FR 10401 (Feb. 24, 2022) (SR-BOX-2021-14) (approving the establishment of BSTX as a facility of BOX). BSTX cannot commence operations as a facility of BOX until, among other things, the BSTX Third Amended and Restated Limited Liability Company Agreement approved by the Commission as rules of BOX is adopted.

Id.

at 10407.

Separate from the dissemination of real-time transaction information in consolidated market data, FINRA publishes statistics on trading volume at member firms, including ATSs and wholesalers, that are aggregated on a weekly basis. Publication of the aggregate volume statistics is delayed by two weeks for some NMS stocks and by four weeks for others. The statistics are

available at

https://www.finra.org/filing-reporting/otc-transparency

b. Unimplemented MDI Rules

When implemented, the MDI Rules will modify the current regulatory structure for consolidated market data in two respects. First, they will enhance the content of consolidated market data by defining three new data elements as “core data”

—(1) information about better priced quotations in higher priced stocks (to be implemented through a new definition of “round lot”

and the inclusion of certain “odd-lot information”),

(2) information about quotations that are outside of the best-priced quotations (to be implemented through a new “depth of book data” definition),

and (3) information about orders that are participating in auctions (to be implemented through a new definition of “auction information”).

As discussed below in section III.B.1.b.ii, the MDI Rules will enhance the content of consolidated market data, but the enhanced content of consolidated market data still will not include all of the quotation information currently available to market participants that purchase proprietary data feeds that are disseminated individually by national securities exchanges. Second, the MDI Rules will enhance the provision of consolidated market data by adopting a new decentralized model that replaces the SIPs with “competing consolidators”

and “self-aggregators.”

Under the decentralized model, the relevant SROs (national securities exchanges that trade NMS stocks and FINRA) will be required to provide their data directly to multiple competing consolidators and self-aggregators rather than to a centralized SIP.

The term “core data” is defined in section 600(b)(21) of Regulation NMS.

The term “round lot” is defined in section 600(b)(82) of Regulation NMS.

The term “odd lot information” is defined in section 600(b)(59) of Regulation NMS.

The term “depth of book data” is defined in section 600(b)(26) of Regulation NMS.

The term “auction information” is defined in section 600(b)(5) of Regulation NMS.

The term “competing consolidator” is defined in section 600(b)(16) of Regulation NMS.

The term “self-aggregator” is defined in section 600(b)(83) of Regulation NMS.

Rule 603(b) of Regulation NMS requires, among other things, every national securities exchange on which an NMS stock is traded and national securities association to make available to all competing consolidators and self-aggregators its information with respect to quotations for and transactions in NMS stocks.

i. Implementation of the MDI Rules

In the MDI Adopting Release in 2020, the Commission outlined a phased transition plan for the implementation of the MDI Rules.

The first step was the filing of amendments to the effective NMS market data plan(s) as required under Rule 614(e) of Regulation NMS.

The Commission's approval of such amendments will be the starting point for the rest of the implementation schedule. While the Commission can approve NMS plan amendments within 90 days of the date of their publication in the

Federal Register

if the Commission finds them to be consistent with the standards set forth in Rule 608 of Regulation NMS,

the Commission may, under rule 608(b)(2)(i), institute proceedings to determine whether to approve or disapprove proposed amendments, which proceedings must conclude within 180 days of notice publication of the proposed amendments but can be extended by an additional 120 days.

Therefore, the maximum time permitted under rule 608 for Commission action is 300 days.

MDI Adopting Release,

supra

note 81, 86 FR at 18698-18701.

17 CFR 242.614(e). The participants of the effective NMS market data plan(s) filed proposed amendments on Nov. 5, 2021, which were published for comment in the

Federal Register

. Securities Exchange Act Release Nos. 93615 (Nov. 19, 2021), 86 FR 67800 (Nov. 29, 2021); 93625 (Nov. 19, 2021), 86 FR 67517 (Nov. 26, 2021); 93620 (Nov. 19, 2021), 86 FR 67541 (Nov. 26, 2021); 93618 (Nov. 19, 2021), 86 FR 67562 (Nov. 26, 2021) (“MDI Plan Amendments”).

17 CFR 242.608(b)(2).

17 CFR 242.608(b)(2). The Commission instituted proceedings to determine whether to approve or disapprove the MDI Plan Amendments. Securities Exchange Act Release Nos. 94310 (Feb. 24, 2022), 87 FR 11748 (Mar. 2, 2022); 94309 (Feb. 24, 2022), 87 FR 11763 (Mar. 2, 2022); 94308 (Feb. 24, 2022), 87 FR 11755 (Mar. 2, 2022); 94307 (Feb. 24, 2022), 87 FR 11787 (Mar. 2, 2022).

After the Commission finds that the plan amendments required under Rule 614(e) are consistent with the Rule 608 standards and approves such amendments, the next step will be a 180-day development period, during which competing consolidators can register with the Commission. The development period is followed by a 90-day testing period.

Once the testing period concludes, a 180-day parallel operation period will begin during which the SIPs and the decentralized consolidation model will operate in parallel.

MDI Adopting Release,

supra

note 81, 86 FR at 18699-700.

During the parallel operation period, the SIPs will continue to disseminate the data that they currently disseminate and competing consolidators will be permitted to offer consolidated market data products, including odd-lot information. Because the round lot definition will be implemented during a later phase consistent with the MDI Adopting Release, the SIPs and competing consolidators will collect, consolidate and disseminate NMS data that will be based on the current national securities exchange definitions of round lot.

Id.

at 18699-18701.

Within 90 days of the end of the parallel operation period, the operating committee(s) of the effective NMS plan(s), in consultation with relevant market participants, will make a recommendation to the Commission as to whether the SIPs should be decommissioned. The SIPs will only cease operations to the extent that the Commission approves an amendment pursuant to Rule 608 to the effective NMS plan(s) to effectuate such a cessation.

Id.

at 18701. Following the cessation of the operations of the SIPs, the changes necessary to implement the new round lot sizes will be tested for 90 days and then implemented.

Id.

The Commission also is proposing to accelerate implementation of the round lot sizes.

See

Securities Exchange Act Release No. 96494 (Dec. 14, 2022) (File No. S7-30-22) (Regulation NMS: Minimum Pricing Increments, Access Fees, and Transparency of Better Priced Orders) (“Minimum Pricing Increments Proposal”). The Commission encourages commenters to review that proposal to determine whether it might affect their comments on this proposing release.

The plan participants of two effective NMS plans filed the MDI Plan Amendments on November 5, 2021.

On September 21, 2022, the Commission disapproved the proposed amendments.

100

As a result, new proposed amendments pursuant to Rule 608 will need to be developed and filed for implementation of the MDI Rules.

See supra

note 93.

100

Securities Exchange Act Release Nos. 95848 (Sept. 21, 2022), 87 FR 58544 (Sept. 27, 2022); 95849 (Sept. 21, 2022), 87 FR 58592 (Sept. 27, 2022); 95850 (Sept. 21, 2022), 87 FR 58560 (Sept. 27, 2022); 95851 (Sept. 21, 2022), 87 FR 58613 (Sept. 27, 2022).

The Commission does not believe that the subsequent implementation of the MDI Rules would substantially affect the operation of Proposed Rule 615. In the existing regulatory structure, the national securities exchanges and FINRA would be required to provide the SIPs with the necessary data (including the auction messages specified in Proposed Rule 615(c)(1)) and the quotation and transaction information specified in the proposed definition of “open competition trading center” in Proposed Rule 600(b)(64) of Regulation NMS). When the MDI Rules are subsequently implemented, a

decentralized model would replace the SIPs, and the national securities exchanges and FINRA would provide this information directly to the competing consolidators and self-aggregators pursuant to Rule 603(b) of Regulation NMS.

101

The MDI Adopting Release states that the benefits of a decentralized model for consolidated market data are gains in efficiency and innovation for delivering consolidated market data, reduced content and latency differentials between consolidated market data and proprietary market data, and increased market resiliency. MDI Adopting Release,

supra

note 81, 86 FR at 18778. As discussed in section III.B.1.b.ii below, the Commission does not believe that these benefits of the MDI Rules substantially reduce the need to propose Rule 615 to address the goals stated herein.

As noted above, auction information is to be included in the expanded content of consolidated market data that can be disseminated by competing consolidators under the MDI Rules. Market participants in the decentralized model will have a choice of whether to purchase consolidated market data products that include auction information, as well as any of the other components of consolidated market data.

102

The fees that ultimately are approved for the different components of consolidated market data will affect the extent to which market participants choose to purchase auction information,

103

but, as discussed above, the fees are not known at this time. Any fees for auction information will be required to be fair, reasonable, and not unreasonably discriminatory,

104

and, as such, the Commission does not anticipate that such fees would be so high as to deter a substantial number of market participants interested in participating in auctions under Proposed Rule 615 from purchasing consolidated data products that include auction information.

102

See, e.g.,

id.

at 18751 (competing consolidators will not be required to offer consolidated market products that “include all of the content of expanded core data” and market participants “may choose not to take in all of the new core data elements in every instance.”).

103

See, e.g.,

id.

at 18764 (because fees will depend on future action by the effective NMS system plans, the Commission “cannot be certain of the level of those fees or whether such fees would provide discounts” for those end users who wish to receive subsets of consolidated market data).

104

See, e.g.,

id.

at 18773 (the fees for the data content underlying consolidated market data must be “fair, reasonable and not unreasonably discriminatory”).

ii. Implementation of the MDI Rules Will Not Substantially Reduce the Need To Propose Rule 615 To Address the Goals Stated Herein

As stated in section I above, Proposed Rule 615 is designed to promote order-by-order competition and thereby achieve two primary goals for the benefit of investors—(1) obtain better prices for the execution of the marketable orders of individual investors that currently are segmented at wholesalers, and (2) expand opportunities for such individual investor orders to meet directly with other investor orders without the participation of a dealer (such as a wholesaler). The MDI Rules would not substantially reduce the need to propose Rule 615 to address the goals stated herein.

The MDI Rules will enhance the content of consolidated market data and thereby benefit those market participants that currently use SIP data and decide to purchase the enhanced elements of consolidated market data. As the MDI Adopting Release stated, however, implementation of the MDI Rules will not expand the content of data already available to sophisticated market participants that purchase the proprietary data feeds that are individually disseminated by the national securities exchanges.

105

The Commission stated its understanding that “approximately 50 to 100 firms purchase all of the proprietary [depth-of-book] feeds from the exchanges and do not rely on the SIP data for their trading.”

106

Moreover, these 50 to100 firms that currently use proprietary data feeds play a significant role in the current market structure.

107

For example, the MDI Adopting Release stated that “nearly all orders entered in the [NMS], including retail orders, touch a component (typically the order router of the executing broker) that uses proprietary data in order to reduce execution costs and improve execution quality.”

108

Furthermore, the Commission understands that the wholesalers, as six of the highest volume trading firms in the U.S. equity markets, currently pay for and use the proprietary data feeds. One wholesaler submitted a comment on the MDI Rules stating that it would be unable to remain competitive, even after the MDI Rules were implemented, without continuing to purchase proprietary data feeds.

109

105

See, e.g.,

id.

at 18752 (“[a]lthough expanded core data will not contain all of the data contained in proprietary [depth of book] feeds, the Commission believes that it will contain data that will be useful for market participants”);

id.

at 18754 (the potentially lower cost of consolidated market data “will come at the expense of losing the full set of data currently available via proprietary feeds,” because the consolidated market data definition “does not include all data elements currently available via proprietary data feeds.”).

106

Id.

at 18728.

107

See, e.g.,

id.

at 18734 n. 1724 (Commission analysis showed that 91.6% of the message volume on exchanges in a sample week came from just 50 firms that use proprietary data feeds).

108

Id.

at 18734.

109

Id.

at 18793 n. 2386 (commenters agreed that “switching to new consolidated market data would come with this expense of losing some data compared to the proprietary data feeds,” with one stating that it would be “unable to remain competitive even after the final amendments are in place without continuing to purchase proprietary data feeds.”);

see also

id.

at 18795 (stating possibility that potential participants in automated market making and other latency sensitive trading businesses could not “compete effectively without using the data that would remain exclusive to proprietary feeds”).

Statements in the MDI Adopting Release addressing the benefits of the MDI Rules are consistent with a conclusion that the MDI Rules can benefit SIP data users that currently do not purchase the proprietary data feeds, but will not substantially reduce the need to propose Rule 615 to address the goals stated herein. For example, the MDI Adopting Release stated that the “odd-lot aggregation methodology” of the MDI Rules “would benefit market participants by promoting tighter spreads in all stocks, especially high priced ones.”

110

All of the odd lot quotations that will be aggregated, however, were already included in an order-by-order basis in the proprietary data feeds that the Commission understands the wholesalers use. As the MDI Adopting Release stated, the inclusion of odd-lot quote information in core data will improve transparency and “reduce information asymmetry between market participants who already receive this information through proprietary [depth-of-book] feeds and market participants who choose to subscribe to this aspect of core data and previously did not receive this information.

111

110

MDI Adopting Release,

supra

note 81, 86 FR at 18615.

111

Id.

at 18753.

In addition, the MDI Adopting Release states that “because richer, more timely consolidated market data may enhance the ability of broker-dealers to obtain the most favorable terms reasonably available under the circumstances, including the best reasonably available price and other factors, for their customer orders, broker-dealers should consider the availability of consolidated market data for purposes of evaluating best execution.”

112

The availability of additional quotation information in consolidated market data, however, is unlikely to affect the wholesalers' and retail brokers' evaluation of best execution because the Commission understands that wholesalers already would be expected, under FINRA

guidance,

113

to use a more complete set of quotation information (

i.e.,

proprietary data feeds) than will be available in the expanded MDI data when evaluating best execution today, and retail brokers use wholesalers as executing brokers to obtain the best terms reasonably available.

112

Id.

at 18605 (footnotes omitted).

113

The MDI Adopting Release referred to this FINRA guidance concerning the relevance of proprietary data feeds to a broker-dealer's best execution efforts under FINRA rules.

Id.

at 18605 n. 94 (quoting FINRA Notice to Members 15-46, Guidance on Best Execution Obligations in Equity, Options and Fixed Income Markets at 3 n. 12 (Nov. 2015),

available at

https://www.finra.org/rules-guidance/notices/15-46

(“FINRA Notice 15-46”). The relevant portion of FINRA Notice 15-46 provides the following guidance on compliance with FINRA Rule 5310: “[A] firm that regularly accesses proprietary data feeds, in addition to the consolidated SIP feed, for its proprietary trading, would be expected to also be using these data feeds to determine the best market under prevailing market conditions when handling customer orders to meet its best execution obligations.”

The MDI Adopting Release also stated that “as a result of the new round lot definition and the inclusion of odd-lot quotations in core data, retail investors will be able to see, and more readily access, better-priced quotations.”

114

Such information will, depending on the fees yet to be determined for such information (as stated above), enable those retail investors that purchase such information (or for those retail investors whose broker-dealers purchase it for them) to see and more readily access better-priced quotations than the current NBBO disseminated by the SIPs. To do so, retail investors will need to direct their own orders to the particular trading center that is displaying a better-priced quotation. As stated in the MDI Adopting Release, however, most retail investors rely on their broker-dealers for execution of their orders, and the additional quotation information will likely be used by more sophisticated retail investors that are able to process quotation information and self-direct their orders.

115

114

Id.

at 18601.

115

See, e.g.,

id.

at 18753 (“the Commission believes, as suggested by commenters, that retail brokers may allow some sophisticated retail investors to directly utilize the expanded content of core data and realize the benefits discussed below”).

The MDI Adopting Release also stated that “through the addition of depth of book data and auction information in core data, the scope of NMS information will, to a greater extent, allow some market participants to trade in a more informed, competitive, and efficient manner.”

116

The phrase “some market participants” as discussed above, refers to those market participants that currently rely on SIP data for trading and not the proprietary data feeds. For the marketable orders of individual investors that currently are routed to wholesalers, the expansion of depth of book data in consolidated market data will not affect the information used for their execution because the Commission understands that wholesalers currently use proprietary data feeds for evaluating the best execution of their orders, which include more information than the expanded consolidated market data of the MDI Rules.

116

Id.

at 18601.

An aspect of the MDI Rules that will affect the public evaluation of wholesaler order execution quality is smaller round lot sizes for quotations in NMS stocks with prices greater than $250 per share. These quotations determine the NBBO, and smaller round lot sizes can lead to narrower NBBO spreads. As discussed in section II above, the NBBO is a benchmark used to assess the market for an NMS stock, as well as to retrospectively assess the level of execution quality for an order. Accordingly, although implementation of the MDI Rules will not increase the information available to wholesalers in proprietary data feeds, changes in the round lot definition could narrow the NBBO as a public benchmark for the execution quality of the marketable orders of individual investors.

The Commission does not believe, however, the smaller round lot sizes for NMS stocks with prices that exceed $250 per share will substantially affect the need for Proposed Rule 615 in terms of improved order execution quality for the marketable orders of individual investors. In particular, Proposed Rule 615 would encompass all NMS stocks, while the new round lot definition will encompass a much smaller range of NMS stocks and trading volume. In the MDI Adopting Release, for example, Table 3 and Table 4 set out the range of stocks and volume estimated to be affected by the new round lot definition. This information is summarized below:

Round lot tier

Number of NMS stocks

% Average daily share volume

% Average daily dollar volume

% Instances of smaller NBBO

$0-$250

9,023

97.12

71.93

n/a

$250.01-$1,000

117

2.79

23.24

26.6

$1,000.01-$10,000

0.09

4.82

47.7

$10,000+

0.00

0.02

n/a

First, as stated in the MDI Adopting Release, “most stocks, approximately 98.5%, will remain unaffected” by the new round lot definition.

117

The 98.5% of unaffected NMS stocks with prices of $250 or less represented 97.12% of total NMS stock share volume and 71.93% of total NMS stock dollar volume. Thus, the great majority of NMS stocks and their volume would not be affected by the narrowing of the NBBO benchmark that will result from the new round lot definition in the MDI Rules.

118

117

MDI Adopting Release,

supra

note 81, 86 FR at 18743 (Table 4).

118

Id.

at 18753 (“Even though the new round lot definition would expand information on odd-lots that may be priced better than the current NBBO in some stocks, most stocks would not be affected by the new round lot definition.”) (footnotes omitted).

Second, for the estimated 1.5% of high-priced NMS stocks (over $250) that will be affected by the reduction in round lot sizes, the Commission estimated that most of the dollar volume (23.24% of total NMS stock dollar volume) will occur within the $250.01-$1,000 tier, but in this tier, the NBBO spread will be reduced for only 26.6% of the trading day.

119

For the remaining 73.4% of the trading day in these NMS stocks, the NBBO spread in these NMS stocks will be unaffected.

120

Accordingly, even for the 1.5% of NMS stocks that will be affected by the revised round lot definition, NBBO spreads were estimated to remain unaffected for the most of the trading day.

119

Id.

at 18743 (Table 3).

120

Id.

(Table 4). For NMS stocks with prices of $1000.01 to $10,000, which represented 4.82% of trading volume, the Commission estimated that, taking into account the new round lot definition, the NBBO spread would be reduced to some extent for 47.7% of the trading day.

Id.

(Tables 3-4).

This conclusion is consistent with statements in the MDI Adopting Release. For example, the MDI Adopting Release states that “the size of the change in the NBBO spread, conditional

on the NBBO being smaller, will also be substantial.”

121

The phrase “conditional on the NBBO being smaller”

122

means that the reduction in size of the half spread is limited to the 1.5% of stocks and their volume that, as discussed above, will be affected by the new odd lot definition. As a result, there will be a significant reduction in half spread of the NBBO for those stocks, but this reduction is conditional on the minority of the trading day for 1.5% of NMS stocks when NBBO spreads actually will be affected by the new round lot definition.

121

Id.

at 18744.

122

Similarly, the following statement in the MDI Adopting Release is conditional on those instances where the NBBO spread is smaller: “The Commission believes that, in particular, for securities with a significant amount of dollar trading volume, there will be significant changes to (tightening of) the quoted spread displayed under the new round lot definition.”

Id.

at 18743.

Third and finally, the NBBO as a benchmark for order execution quality does not, as discussed in section II.C above, reflect the availability of prices better than round lot displayed quotations. Such better prices include displayed odd lot quotations and undisplayed orders at national securities exchanges, as well as the availability of NBBO price improvement at wholesalers that is enabled by the low adverse selection costs of the marketable orders of individual investors. In the MDI Adopting Release, the Commission considered whether a narrowing of the NBBO spread would affect the order execution quality of retail investors.

123

While it stated that a narrowing of the NBBO spread would, by definition, reduce the level of NBBO price improvement if execution prices for retail investors remained the same,

124

the Commission stated that “retail investors might or might not” experience an improvement in execution quality, “as measured by execution prices,” from wholesalers.

125

The Commission stated that a retail broker commented that retail investors would not receive better execution prices under the new round lot sizes because wholesalers already offer price improvement to retail investors that exceeds the potential improvements in the NBBO from the new round lot size.

126

Another commenter stated that all investors, including retail investors, would experience reduced execution costs from a tighter NBBO no matter where the execution took place.

127

The Commission concluded that it was “uncertain” whether the execution quality that retail investors receive from wholesalers would change if the NBBO spread narrows because the effect “would depend on how the change in the NBBO compared to the current price improvement offered by wholesalers,” as well as on “changes in the degree of price improvement wholesalers will offer in stocks with tighter NBBOs, which is uncertain.”

128

123

Id.

at 18747 (section addressing “effects of internalization on retail order flow”).

124

Id.

(“it may become more difficult for the retail execution business of wholesalers to provide price improvement and other execution quality metrics at levels similar to those provided under the 100 share round lot definition today”).

125

Id.

126

Id.

127

Id.

128

Id.

As stated above, the Commission understands that wholesalers already would be expected, under FINRA guidance, to use proprietary data feeds, which contain a fuller set of quotations than will be included in the new round lot definition, when, among other things, evaluating best execution. Consequently, the new round lot definition will not change the quotation data used by wholesalers to determine prices for executing the orders of individual investors, but rather will change the NBBO as benchmark for analysis of order execution quality at wholesalers.

129

Moreover, narrowing the NBBO as a benchmark for execution quality of wholesalers will affect all wholesalers equally. For example, if the average NBO for an NMS stock declined by two cents, the NBO as a benchmark would reduce the calculation of NBBO price improvement by two cents for all wholesalers and therefore leave them in the same relative position when compared to each other. The Commission does not believe that implementation of the new round lot definition in the MDI Rules will substantially affect the need for Proposed Rule 615 in terms of an improvement in the order execution quality of the marketable orders of individual investors.

129

Id.

at 18745 (“the new round lot definition will also improve transaction cost analysis and best execution analysis in higher priced stocks, which are benchmarked against the NBBO”).

2. Rules Addressing Order Handling and Execution

Broker-dealers owe their customers a duty of best execution when handling and executing customer orders.

130

This duty of best execution derives from common law agency principles and fiduciary obligations, and is incorporated in SRO rules and enforced through the antifraud provisions of the Federal securities laws.

131

The Commission has stated that “the duty of best execution generally requires broker-dealers to execute customers' trades at the most favorable terms reasonably available under the circumstances,

i.e.,

at the best reasonably available price.”

132

Broker-dealers should periodically assess the quality of competing markets to assure that order flow is directed to the markets providing the most beneficial terms for their customer orders.

133

In doing so, broker-dealers must take into account price improvement opportunities, and whether different markets may be more suitable for different types of orders or particular securities.

134

130

The Commission also is proposing a new rule addressing the best execution obligations of broker-dealers.

See

Securities Exchange Act Release No. 96496 (Dec. 14, 2022) (File No. S7-32-22) (Regulation Best Execution) (“Regulation Best Execution Proposal”). The Commission encourages commenters to review that proposal to determine whether it might affect their comments on this proposal.

131

See

MDI Adopting Release,

supra

note 81, 86 FR at 18605. In addition, FINRA has codified a duty of best execution in its rules, requiring a broker-dealer to “use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.” FINRA Rule 5310, “Best Execution and Interpositioning.”

132

See

MDI Adopting Release,

supra

note 81, 86 FR at 18605 (quoting Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37538);

see also

Geman

SEC,

334 F.3d 1183, 1186 (10th Cir. 2003) (quoting

Newton

Merrill, Lynch, Pierce, Fenner & Smith, Inc.,

135 F.3d 266, 270 (3d Cir. 1998)) (“[T]he duty of best execution requires that a broker-dealer seek to obtain for its customer orders the most favorable terms reasonably available under the circumstances.”); and

Kurz

Fidelity Management & Research Co.,

556 F.3d 639, 640 (7th Cir. 2009) (describing the “duty of best execution” as “getting the optimal combination of price, speed, and liquidity for a securities trade”).

133

See

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37538.

134

See id.

After the enactment of section 11A in 1975, which included as an objective the practicability of brokers' executing investor orders in the best market,

135

the Commission adopted rules that prescribe requirements for the handling and execution of orders in NMS stocks in certain contexts. These rules were often designed, at least in part, to promote best execution of investors' orders. Three rules in Regulation NMS, discussed below, specifically address the handling and execution of orders in NMS stocks—17 CFR 242.604 (“Rule 604,” also known as the “Limit Order Display Rule”), 17 CFR 242.611 (“Rule 611,” also known as the “Order Protection Rule”), and 17 CFR 242.612 (“Rule 612,” also known as the “Sub-Penny Rule”).

135

Section 11A(a)(1)(C)(iv) of the Exchange Act;

see also

supra

note 57 and accompanying text.

a. Limit Order Display Rule

The Limit Order Display Rule was originally adopted in 1996 as Rule 11Ac1-4 and redesignated as Rule 604 with the adoption of Regulation NMS in 2005.

136

It establishes minimum display requirements for customer limit orders that are not executed immediately, which, as discussed in section II.C above, can be referred to as “non-marketable” limit orders. In contrast to marketable limit orders, non-marketable limit orders cannot be executed immediately at the NBBO. Rule 604 requires specialists and OTC market makers to display the price and full size of customer limit orders when these orders represent buying and selling interest that is at a better price than a specialist's or OTC market maker's public quotation.

137

Specialists and OTC market makers also must increase the size of their quotation for a particular security to reflect a limit order of greater than

de minimis

size when the limit order is priced equal to the specialist's or OTC market maker's disseminated quotation and that quotation is equal to the NBBO.

138

136

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37570. Modifications included conforming terms to those adopted with Regulation NMS, such as changing references from “covered security” to “NMS stock.”

Id.

at 37572.

137

Rule 604(b)(1) provides exceptions for, among other things, orders executed immediately upon receipt and odd lot orders.

138

See

Securities Exchange Act Release No. 37619A (Sep. 6, 1996), 61 FR 48290, 48290 (Sep. 12, 1996) (Order Execution Obligations) (adopting final rules to require the display of customer limit orders and amending a rule governing publication of quotations) (“1996 Order Handling Release”); Rule 604(a).

In adopting Rule 604, the Commission observed that the enhanced transparency of such orders would increase the likelihood that customer limit orders would be executed because contra-side market participants would have a more accurate picture of trading interest in a given security, and that the increased visibility would enable market participants to interact directly with limit orders, rather than rely on the participation of a dealer for execution.

139

The Commission also stated that the display requirement (together with other amendments being made at the time) would help ensure the disclosure of customer and market maker buying and selling interest that had, prior to adoption of Rule 604, been hidden from many market participants.

140

139

See

1996 Order Handling Release,

supra

note 138, 61 FR at 48293.

140

Id.

at 48292. The Commission also adopted amendments to require a market maker to publish quotations for any listed security when it is responsible for more than 1% of the aggregate trading volume for that security and to make publicly available any superior prices that a market maker privately quotes through certain electronic communications networks (“ECNs”).

Id.

at 48292. Also, at the same time it adopted the Limit Order Display Rule in 1996, the Commission deferred action on a proposed rule to address the handling of customer market orders of less than block size, referred to as the “Price Improvement Rule.”

Id.

at 48322. This proposed rule would have required specialists and OTC market makers to provide their customer market orders an opportunity for price improvement. The proposal included a non-exclusive safe harbor to satisfy the price improvement obligation that included exposing the customer order for 30 seconds at an improved price in a published quotation. The proposal sought to improve opportunities in auction and dealer markets for market orders to interact directly with other market orders and public limit orders, consistent with the goals of an NMS.

Id.

b. Order Protection Rule

In 2005, the Commission adopted the Order Protection Rule as Rule 611 of Regulation NMS. Rule 611(a) applies to “trading centers,” which is defined broadly in Rule 600(b)(95) as a national securities exchange or national securities association that operates an SRO trading facility, an ATS, an exchange market maker, an OTC market maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.

Rule 611(a)(1) requires trading centers to implement written policies and procedures reasonably designed to prevent trade-throughs—the execution of an order at a price that is inferior to the price of a “protected quotation.”

141

To be protected, a quotation must be immediately and automatically accessible up to its full displayed size, must be the best-priced quotation (highest bid to buy and lowest offer to sell) in round lot sizes of an exchange or FINRA, and must be disseminated in consolidated market data.

142

Accordingly, Rule 611 provides for intermarket price protection only of an exchange's or FINRA's best bid and offer (“BBO”). It does not establish time priority among the same-priced quotations at different trading centers, nor does it protect “depth-of-book” quotations (quotations with prices outside an exchange's or FINRA's BBO) or odd lot quotations (quotations with sizes of less than one round lot).

141

Rule 600(b)(70) defines “protected bid” or “protected offer” as a quotation in an NMS stock that: (i) is displayed by an automated trading center; (ii) is disseminated pursuant to an effective NMS plan; and (iii) is an automated quotation that is the best bid or best offer of a national securities exchange, or the best bid or best offer of a national securities association.

142

Rule 600(b)(71) defines “protected quotation” as a protected bid or a protected offer. As stated in section II.B.1 above, no FINRA member currently uses the ADF, its facility for displaying quotations, to disseminate quotations in consolidated market data. Today, only exchanges display protected quotations under Rule 611.

In adopting Rule 611, the Commission stated that 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 individual investors, to monitor.

143

One of the Commission's concerns when adopting Rule 611 was the internalization of individual investor orders by broker-dealers. The Commission observed that the great majority of internalized trades are the small trades of individual investors, and that, in 2003, nearly 1 out of every 30 of these trades, of which there are millions, appears to have been executed at a price inferior to an automated and accessible quotation.

144

The Commission stated that Nasdaq's data submitted in response to the Rule 611 proposal appeared to indicate a need for regulatory action to reinforce the fundamental principle of best price for all NMS stocks.

145

143

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37505.

144

Id.

at 37508.

145

Id.

In response to the Commission's proposal to adopt Regulation NMS, The Nasdaq Stock Market, Inc. (n.k.a. Nasdaq) submitted data to show that the trade-through rates for Nasdaq stocks in some trading centers had dropped from the Fall of 2003 to the Fall of 2004, and that the reduction during that time was a result of fewer independently operating ECNs. The Commission stated “[i]t 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.”

Id.

(footnote omitted).

c. Sub-Penny Rule

Also in 2005, the Commission adopted the Sub-Penny Rule as Rule 612 of Regulation NMS to establish a minimum pricing increment for NMS stocks. Specifically, paragraph (a) of Rule 612 provides that no national securities exchange, national securities association, ATS, vendor, or broker or dealer shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller than $0.01 if that bid or offer, order, or indication of interest is priced equal to or greater than $1.00 per share.

146

Rule 612 does not, however, prohibit a sub-penny trade by a wholesaler or other internalizing broker-dealer, as long as the trade did not result from an impermissible sub-penny quotation,

order, or indication of interest.

147

For example, Rule 612 does not prevent wholesalers, after they receive an order from a broker, from choosing to execute that order in a transaction at a sub-penny price. This includes a trade executed at a price that is a sub-penny increment better than the best displayed quotation in consolidated market data.

148

This sub-penny trading exception is not available to market participants on exchanges and ATSs,

149

in contrast, because those trading centers operate by accepting, matching, and executing orders from market participants. Exchanges and ATSs, with limited exceptions, may only execute orders at a sub-penny price if the price is the NBBO midpoint.

150

Also, exchanges with retail liquidity programs (“RLPs”) have been granted an exemption from Rule 612 to provide executions in tenths of a penny.

151

The Commission has granted exemptions for these programs to promote competition between exchanges and OTC market makers (which, as discussed above, includes wholesalers).

152

As discussed in section VII below, however, the great majority of marketable orders of individual investors continue to be routed first to wholesalers.

146

17 CFR 242.612(a). Paragraph (b) of Rule 612 sets forth a minimum increment of $0.0001 for prices less than $1.00 per share.

147

The Commission also is proposing to amend Rule 612 regarding sub-penny trading.

See

Minimum Pricing Increments Proposal,

supra

note 98. The Commission encourages commenters to review that proposal to determine whether it might affect their comments on this proposing release.

148

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37556 (the Commission stated that sub-penny executions due to price improvement are generally beneficial to retail investors).

149

The regulatory framework for ATSs is discussed in section III.B.3 below.

150

Neither Rule 612 nor any other Commission rule or interpretation states that exchanges and ATSs may execute midpoint orders at a sub-penny amount (

e.g.,

if the NBBO is 10.00-10.01 to execute at the mid-point price of 10.005). However, the Commission has stated that Rule 612 will not prohibit a sub-penny execution resulting from a midpoint or volume-weighted algorithm or from price improvement, so long as the execution did not result from an impermissible sub-penny order or quotation. Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37556. Undisplayed “floating” midpoint orders (

i.e.,

orders that re-price when the exchange BBO changes), for example, are permissible under Rule 612, and the Commission has approved numerous rule proposals by national securities exchanges for their use.

See, e.g.,

Securities Exchange Act Release Nos. 89563 (Aug. 14, 2020), 85 FR 51510 (Aug. 20, 2020) (SR-PEARL-2020-03) (order approving proposed rule change by MIAX PEARL to establish rules governing the trading of equity securities, including a midpoint peg order type); and 78101 (June 17, 2016), 81 FR 41142 (June 23, 2016) (File No. 10-222) (order approving IEX's registration as a national securities exchange, including the exchange's inclusion of a midpoint pegged order type in its rulebook).

151

Several exchanges operate RLPs. These are programs for retail orders seeking liquidity that allow market participants to supply liquidity to such retail orders by submitting undisplayed orders priced at least $0.001 better than the exchange's protected best bid or offer. Each program results from a Commission approval of a proposed rule change made on Form 19b-4 combined with a conditional exemption, pursuant to section 36 of the Exchange Act, from Rule 612 to enable the exchange to accept and rank (but not display) the sub-penny orders.

See, e.g.,

Securities Exchange Act Release Nos. 85160 (Feb. 15, 2019), 84 FR 5754 (Feb. 22, 2019) (SR-NYSE-2018-28) (approving the NYSE RLP on a permanent basis and granting the exchange a limited exemption from the Sub-Penny Rule to operate the program); 86194 (June 25, 2019), 84 FR 31385 (July 1, 2019) (SR-BX-2019-011) (approving Nasdaq BX's retail price improvement program on a permanent basis and granting the exchange a limited exemption from the Sub-Penny Rule to operate the program).

152

Id. See

also

Securities Exchange Act Release No. 73702 (Nov. 28, 2014), 79 FR 72049 (Dec. 4, 2014) (SR-BX-2014-048) (approving Nasdaq BX's (f/k/a NASDAQ OMX BX Inc.) establishment of its retail price improvement program on a pilot basis). In granting the original exemption from Rule 612, the Commission stated that the vast majority of “marketable retail orders” are internalized by OTC market makers, and that retail investors can benefit from such arrangements to the extent that OTC market makers offer them price improvement over the NBBO. This price improvement is typically offered in sub-penny amounts. The Commission explained that OTC market makers typically select a sub-penny price for a trade without quoting at that exact amount or accepting orders from retail customers seeking that exact price; and that exchanges—and exchange member firms that submit orders and quotations to exchanges—cannot compete for “marketable retail order flow” on the same basis, because it would be impractical for exchange electronic systems to generate sub-penny executions without exchange liquidity providers or retail brokerage firms having first submitted sub-penny orders or quotations, which the Sub-Penny Rule expressly prohibits. The Commission explained that the limited exemption granted to operate the retail price improvement program should promote competition between exchanges and OTC market makers in a manner reasonably designed to minimize the problems that the Commission identified when adopting the Sub-Penny Rule.

Id.

at 72053.

3. Rules Addressing Access to Trading Centers

As stated above, access to trading centers and their services is a critically important component of the NMS as a means to link trading centers together in a unified system. For example, the Regulation NMS rules addressing the display of quotations, the display of customer limit orders, and protection of customer orders cannot achieve their objectives if market participants do not have fair and efficient means to access those trading centers that display quotations and execute orders.

153

See

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37538. The rules discussed in this section address requirements that apply to trading centers providing access to their services. Exchange Act Rule 15c3-5, in contrast, addresses access, but in the context of risk management controls for broker-dealers with market access.

For purposes of assessing access requirements in today's NMS, trading centers for NMS stocks can be divided into three distinct regulatory categories: national securities exchanges, NMS Stock ATSs, and internalizing broker-dealers (including wholesalers). As discussed below, the statutory access requirements and the Commission's access rules currently apply to exchanges and ATSs, as well as to FINRA members that display quotations in consolidated market data through FINRA's ADF (of which there currently are none). In contrast, broker-dealers that do not display quotations in consolidated market data and that trade outside of an ATS, such as wholesalers, are not subject to any fair access requirements under the Exchange Act or Commission rules. While subject to Commission and SRO rules for broker-dealers, internalizing broker-dealers are not prohibited from restricting access to their trading mechanisms and the investor orders that they internalize. An internalizing broker-dealer is not required, for example, to provide other market participants, including institutional investors and liquidity providers on exchanges, with any opportunity to compete to provide the best prices to the individual investor orders that the broker-dealer executes internally.

a. Access Rules for National Securities Exchanges

As stated in section III.A above, the Exchange Act directly requires national securities exchanges to provide fair access in four contexts.

154

Section 6(b)(2) specifies that exchange rules must allow “any” broker-dealer registered with the Commission, unless subject to a specified disqualification, to become a member of the exchange. Section 6(b)(4) requires that exchange rules provide for the “equitable” allocation of “reasonable” dues, fees, and other charges among members, issuers, and other persons using exchange facilities. Section 6(b)(5) broadly requires that exchange rules be designed, among other things, to remove impediments to and perfect the mechanism of a free and open market and an NMS, and that exchange rules are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers. And section 6(b)(8) requires that exchange rules do not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act.

154

See supra

notes 61-66 and accompanying text.

In addition to these broad statutory requirements for all national securities exchanges, the Commission has adopted 17 CFR 242.610 (“Rule 610”) of Regulation NMS, which addresses access to displayed quotations.

Specifically, Rule 610(a) prohibits any national securities exchange that operates an SRO trading facility

155

from imposing unfairly discriminatory terms that would prevent or inhibit any person from obtaining efficient access through a member of the national securities exchange to the quotations in an NMS stock displayed through its SRO trading facility. This provision is designed to prohibit national securities exchanges from limiting “piggyback access” as a means by which non-members obtain access to exchange quotations through the services of an exchange member.

156

Piggyback access, for example, allows non-members to obtain access to a national securities exchange's quotations without the need to obtain (and pay for) direct connectivity to the exchange.

155

Rule 600(b)(89) defines an “SRO trading facility” as a facility operated by or on behalf of a national securities exchange or a national securities association that executes orders in a security or presents orders to members for execution.

156

See

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37539. Rule 610(c) also limits the fees that can be charged for accessing an exchange's best-priced displayed quotations, and Rule 610(d) addresses locking and crossing quotations.

b. Access Rules for NMS Stock ATSs

In 1998, the Commission initiated a new regulatory regime for ATSs with the adoption of Regulation ATS.

157

An ATS is a trading system that falls within the definition of exchange in Section 3(b)(1) of the Exchange Act, but is exempted from such definition by Rule 3a1-1 under the Exchange Act if the trading system complies with Regulation ATS.

158

For an NMS Stock ATS,

159

Regulation ATS requires, among other things, that the NMS Stock ATS must register with the Commission as a broker-dealer and must file a Form ATS-N, a publicly available document that includes detailed disclosures about the NMS Stock ATS's operations.

157

See

Regulation ATS Adopting Release, 63 FR 70844,

supra

note 27. “Regulation ATS” consists of 17 CFR 242.300 through 242.304 (“Rule 300” through “Rule 304” under the Exchange Act).

158

17 CFR 240.3a1-1.

159

In 2018, the Commission amended Regulation ATS with respect to the requirements that apply to NMS Stock ATSs. Securities Exchange Act Release No. 83663 (July 18, 2018), 83 FR 38768 (Aug. 7, 2018) (“ATS-N Adopting Release”).

In addition, Regulation ATS includes two separate types of access requirements that potentially can apply to an NMS Stock ATS. First, Rule 301(b)(3) imposes order display and execution access requirements on an NMS Stock ATS that displays orders to any person and had 5% or more of average daily volume reported in an NMS stock during four of the preceding six calendar months. Similar to Rule 610, the “execution access” requirement of Rule 301(b)(3) is limited to access to displayed quotations in consolidated market data. As stated above in section III.B.1, FINRA's ADF is a facility for broker-dealers (including ATSs) to display quotations in consolidated market data. Currently, no NMS Stock ATS that displays quotations uses the ADF to display its quotations in consolidated market data, and no NMS Stock ATS is subject to the execution access requirement of Rule 301(b)(3).

Second, Rule 301(b)(5) imposes “fair access” requirements with respect to an NMS stock in which the NMS Stock ATS had 5% or more of the average daily volume reported during four of the preceding six calendar months. This fair access requirement requires an NMS Stock ATS (1) to establish written standards for granting access to trading on its systems, (2) to not unreasonably prohibit or limit any person in respect to access to services offered by such ATS by applying the written access standards in an unfair or discriminatory manner, (3) to maintain records of grants, denials, and limitations of access, and (4) to report the information required by Form ATS-R on grants, denials, and limitations of access. When it adopted Regulation ATS, the Commission emphasized that the fair access requirements of Rule 301(b)(5) apply to a far broader range of services than the “execution access” requirements of Rule 301(b)(3), which are limited to access to quotations. Specifically, the Commission stated that although it was adopting rules to require ATSs with significant trading volume to publicly display their best bid and offer and provide equal access to those orders, direct participation in ATSs offers benefits in addition to execution against the best bid and offer. The Commission gave as an example that direct participants could enter limit orders into the system, rather than just execute against existing orders on a fill-or-kill basis,

160

and that direct participants could view all orders, not just the best bid or offer, which provides important information about the depth of interest in a particular security. The Commission further observed that some ATSs also allowed direct participants to enter “reserve” orders which hide the full size of an order from view. Because of these advantages to direct participants in an ATS, access to the best bid and offer through an SRO provided an incomplete substitute. Therefore, the Commission adopted rules to require most ATSs that have a significant percentage of overall trading volume in a particular security to comply with fair access standards.

161

160

A fill-or-kill order is an order with instructions to cancel the order if it cannot be executed in its full size.

161

Regulation ATS Adopting Release,

supra

note 27, 63 FR at 70872 (footnote omitted).

In sum, the fair access requirements of Rule 301(b)(5) encompass all of the trading services of an NMS Stock ATS. When adopting these requirements, the Commission emphasized that an “alternative trading system must apply [fair access] standards fairly and is prohibited from unreasonably prohibiting or limiting any person with respect to trading in any equity securities.”

162

See id.

at 70873.

Currently, only a single NMS Stock ATS discloses on its Form ATS-N that it is subject to these fair access requirements for securities that are available for trading on its platform.

163

NMS Stock ATSs that are not subject to fair access requirements are not prohibited from unfairly discriminating with respect to the trading services they offer broker-dealers and other market participants.

163

See supra

note 29 and accompanying text.

c. Access Rules for ADF Participants

As stated in section III.B.2 above, Rule 611 protects the best-priced displayed quotations of FINRA members that use the ADF to display quotations in consolidated market data (though no FINRA member currently uses the ADF to do so). In adopting Rule 611, the Commission recognized that assuring fair and efficient access to FINRA members displaying quotations in the ADF would be essential, given that other market participants were required by rule to not trade through such quotations.

164

The ADF falls within the definition of an “SRO display-only facility” in Rule 600(b)(88) because it merely displays the quotations of its participants and neither executes orders itself nor presents orders to ADF participants for execution. Instead, market participants must obtain their own means of access to ADF participants to trade with ADF protected quotations. Accordingly, the Commission adopted Rule 610(b) to promote such access to ADF participants.

165

Rule 610(b)(2) imposes

the same piggyback access requirement that applies to exchanges under Rule 610(a), thereby assuring that market participants can obtain indirect access to an ATS's or broker-dealer's quotations in the ADF.

164

See

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37540 (discussing Rule 610, which addresses means of access to quotations). The Regulation NMS Adopting Release refers to National Association of Securities Dealers (“NASD”) members. NASD was the predecessor association to what today is FINRA.

165

See

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37502-03;

see also

id.

at 37539-43.

In addition, however, Rule 610(b)(1) imposes an access requirement that is particularly tailored to address concerns presented by FINRA members (including NMS Stock ATSs) displaying quotations in the ADF. Specifically, Rule 610(b)(1) requires that any trading center that displays quotations in NMS stocks through an SRO display-only facility must provide a level and cost of access to such quotations that is substantially equivalent to the level and cost of access to quotations displayed by SRO trading facilities (such as national securities exchanges). The Commission emphasized that the phrase “level and cost of access” would encompass both (1) the policies, procedures, and standards that govern access to quotations of the trading center, and (2) the connectivity through which market participants can obtain access and the cost of such connectivity.

166

The Commission further stated that trading centers that choose to display quotations in an SRO display-only facility would be required to bear the responsibility of establishing the necessary connections to afford fair and efficient access to their quotations, and the nature and cost of these connections for market participants seeking to access the trading center's quotations would need to be substantially equivalent to the nature and cost of connections to SRO trading facilities.

167

166

Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37549.

167

Id.

In addition to these heightened access requirements for FINRA members (including NMS Stock ATSs) that display quotations in the ADF, the Commission stated that FINRA, as the self-regulatory authority responsible for enforcing compliance by ADF participants with the requirements of the Exchange Act, would need to evaluate the connectivity of ADF participants to determine whether they meet the requirements of Rule 610(b)(1).

168

The Commission also stated that the addition of a new ADF participant would constitute a material aspect of the operation of FINRA's facilities, and thus require the filing of a proposed rule change pursuant to section 19(b) of the Exchange Act that would offer an opportunity for public notice and comment.

169

168

Id.

169

Id.

4. Disclosure of Order Routing Practices and Order Execution Statistics

Rule 606 of Regulation NMS requires broker-dealers to publish quarterly reports on their routing of customer orders in NMS stocks, and Rule 605 of Regulation NMS requires market centers to make data files publicly available on a monthly basis that include a variety of statistics on their execution of orders in NMS stocks.

170

When it originally adopted the two rules in 2000, the Commission stated that, by increasing the visibility of order execution and routing practices, the rules were “intended to empower market forces with the means to achieve a more competitive and efficient [NMS] for public investors.”

171

170

The rules that the Commission originally adopted were designated as Rule 11Ac1-6 and Rule 11Ac1-5. The Commission re-designated Rule 11Ac1-6 as Rule 606 and Rule 11Ac1-5 as Rule 605 when it adopted Regulation NMS in 2005. Regulation NMS Adopting Release,

supra

note 78, 70 FR at 37538. The term “market center,” as defined in Rule 600(b)(46) of Regulation NMS, is somewhat narrower than trading center. Market centers include, for example, national securities exchanges, ATSs, and OTC market makers (including wholesalers), but do not include the broad catch-all category of trading center that encompasses any broker-dealer that executes orders internally as principal or agent.

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Securities Exchange Act Release No. 43590 (Nov. 17, 2000), 65 FR 75414, 75427 (Dec. 1, 2000). The Commission enhanced the order routing disclosure requirements of Rule 606 when it amended the rule in 2018. Securities Exchange Act Release No. 84528 (Nov. 2, 2018), 83 FR 58338 (Nov. 19, 2018).

Rule 606 requires broker-dealers to disclose, among other things, the percentage of non-directed customer orders routed to different trading centers, as well as the financial inducements offered by these trading centers to attract order flow.

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Information must be provided for four types of orders—market orders, marketable limit orders, non-marketable limit orders, and other orders. The enhanced disclosures include a requirement to disclose net aggregate amounts of PFOF received from trading centers or amounts paid to them (such as transaction fees on exchanges), both as a total dollar amount and an amount per 100 shares.

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A “non-directed order” is defined in Rule 600(b)(56) of Regulation NMS to mean any order from a customer other than a directed order, and a “directed order” is defined in Rule 600(b)(27) of Regulation NMS to mean an order from a customer that the customer specifically instructed the broker-dealer to route to a particular venue for execution.

Rule 605 requires market centers to disclose standardized statistics about the execution quality they achieve for “covered orders,” as defined in Rule 600(b)(22) of Regulation NMS.

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In general, the definition of covered orders excludes order types for which the customer requests special handling that could detract from the goal of achieving comparable statistics for similar order types across different market centers. Unlike the Rule 606 disclosures, the Rule 605 data files are not designed to be human-readable and instead consist of a large volume of detailed statistics for each of the NMS stocks in which a market center receives covered orders. The data files are published in a format that is designed to be downloaded and processed with analysis software, such as a spreadsheet program, which then can be used to generate summary reports for viewing.

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Rule 605(a)(1). The Commission also is proposing to amend the order execution quality disclosures required by Rule 605.

See

Securities Exchange Act Release No. 96493 (Dec. 14, 2022) (File No. S7-29-22) (Disclosure of Order Execution Information). The Commission encourages commenters to review that proposal to determine whether it might affect their comments on this proposing release.

IV. Description of Proposed Rule 615

A. Overview of Order Competition Requirement

Paragraph (a) of Proposed Rule 615 sets forth the rule's core competition requirement. It states that a restricted competition trading center shall not execute a segmented order internally

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until after a broker-dealer has exposed such order to competition at a specified limit price in a qualified auction operated by an open competition trading center. As discussed below in this section IV: (1) segmented order, open competition trading center, restricted competition trading center, and qualified auction are new terms proposed to be defined in Rule 600(b) of Regulation NMS; (2) certain exceptions to the order competition requirement are set forth in paragraph (b) of Proposed Rule 615; (3) the requirements for a qualified auction are specified in paragraph (c) of Proposed Rule 615; and (4) the requirements with respect to segmented orders that would be imposed on open competition trading centers, originating brokers, all broker-dealers, and national securities exchanges are set forth in paragraphs (d) through (g) of Proposed Rule 615.

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The applicability of paragraph (a) of Proposed Rule 615 to “internally” executed transactions is designed to accommodate the practice of some trading centers that both execute orders internally and obtain executions of orders externally by seeking liquidity at other trading centers.

Cf.

Rule 600(b)(95) of Regulation NMS (definition of “trading center” includes “any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent”).

The term “segmented order,” as proposed to be defined in Proposed Rule 600(b)(91) of Regulation NMS, is a

key term determining the scope of Proposed Rule 615 and is designed to encompass those orders of individual investors with relatively low adverse selection costs.

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In addition, paragraphs (b)(2) and (b)(3) of Proposed Rule 615 would provide exceptions for larger orders ($200,000 or more) and orders that are executed at favorable prices for individual investors (orders executed at the NBBO midpoint or better); paragraph (b)(4) would provide an exception for limit orders that have a limit price that is equal to or more favorable for the segmented order than the NBBO midpoint (

i.e.,

non-marketable segmented orders with a limit price that is equal to or lower than the midpoint for buy orders and equal to or higher than the NBBO midpoint for sell orders); and paragraph (b)(5) would provide an exception for orders sized less than one share and for the fractional component, if any, of a segmented order if no qualified auction is available to execute the fractional share or fractional component.

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As discussed in IV.B.1 below, the proposed definition of “segmented order” would exclude very active traders whose orders are likely to impose a much higher level of adverse selection costs on liquidity providers than the less-active accounts that are more typical of individual investors. This is done by limiting the proposed definition of “segmented orders” to orders for accounts in which the average daily number of trades executed in NMS stocks was less than 40 in each of the six preceding calendar months.

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As discussed in section IV.B.1 below, the proposed definition of “segmented order” does not include a limit price component. Compliance with the order competition requirement for limit orders would vary depending on the relation of any limit price and an execution price to the NBBO. For example, segmented orders that have a limit price, or are executed at a price, equal to or more favorable for the segmented order than the NBBO midpoint or better, would have an exception under paragraph (b)(3) or (b)(4) of Proposed Rule 615(b). Segmented orders with a limit price beyond the NBBO midpoint (higher for segmented orders to buy and lower for segmented orders to sell) could still qualify for the exception in Proposed Rule 615(b)(3) if they were executed at the NBBO midpoint or better (

i.e.,

such an order would have been executed at a more favorable price for the segmented order than its limit price).

The purpose of the order competition requirement is to expose segmented orders to competition to provide the best prices on an order-by-order basis and thereby minimize the transaction costs incurred by individual investors when they use marketable orders. Proposed Rule 615 would allow flexibility for broker-dealers, wholesalers, and other restricted competition trading centers in how they comply with the rule. A broker-dealer could choose, subject to its best execution responsibilities as discussed further below, to route a segmented order directly to a qualified auction, to an open competition trading center, or to a national securities exchange. Alternatively, a broker-dealer could route such segmented order to another destination, such as a routing broker-dealer, a wholesaler, or other restricted competition trading center, which, in turn, could route the segmented order to a qualified auction, to an open competition trading center, or to a national securities exchange.

For illustrative purposes, the following is one example of how a segmented order could be handled and executed in compliance with Proposed Rule 615. Assume that a broker-dealer routed a customer's segmented order to a wholesaler. The wholesaler that received the segmented order could select a price at which it was willing to execute a segmented order internally. Before executing internally, however, the wholesaler would be required to submit the segmented order to a qualified auction with a specified limit price. As discussed further below, the specified limit price is not a price at which the wholesaler is guaranteeing to execute (

i.e.,

it is not a “reserve” price or a “backstop” of the segmented order).

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Rather, the specified limit price would inform auction responders on how to price their orders and also, if the segmented order did not receive an execution in the qualified auction, would be the price (or better) at which the wholesaler or other restricted competition trading center subsequently could execute the segmented order as soon as reasonably possible.

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If the segmented order is not executed in the qualified auction, however, the wholesaler could choose to execute the segmented order internally at the specified limit price or better.

The wholesaler that submitted the segmented order to a qualified auction would have a choice of whether to participate in the qualified auction by submitting its own auction response. The wholesaler could, for example, use its selected price for execution of the segmented order as the specified limit

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