Self-Regulatory Organizations; Boston Stock Exchange, Inc.; Order Granting Temporary Approval for One Year to Proposed Rule Change Permitting Competing Specialists on the Floor of the Exchange

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34078; File No. SR-BSE-93-12]

Self-Regulatory Organizations; Boston Stock Exchange, Inc.; Order

Granting Temporary Approval for One Year to Proposed Rule Change

Permitting Competing Specialists on the Floor of the Exchange

May 18, 1994.

On June 4, 1993, the Boston Stock Exchange, Inc. (``BSE'' or

``Exchange'') submitted to the Securities and Exchange Commission

(``SEC'' or ``Commission''), pursuant to section 19(b)(1) of the

Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4

thereunder,\2\ a proposed rule change to permit competing specialists

(``CSs'') on the floor of the Exchange and to adopt guidelines

governing their registration and activity. The proposed rule change was

published for comment in Securities Exchange Act Release No. 32549

(June 29, 1993), 58 FR 36229 (July 6, 1993).

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\1\15 U.S.C. 78s(b)(1) (1988).

\2\17 CFR 240.19b-4 (1993).

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In addition, on July 7, 1993, September 24, 1993, and October 12,

1993, the Exchange filed with the Commission Amendment Nos. 1, 2, and

3, respectively. The amendments were published for comment in

Securities Exchange Act Release No. 33089 (October 22, 1993), 58 FR

58205 (October 29, 1993). Amendment Nos. 1 and 3 were largely

technical, and resulted in deletions from the final text of the

rule.\3\ Amendment No. 2 adds to the procedures for CSs an index

arbitrage provision\4\ and a restriction on cash payment for order flow

by CSs in those stocks in which the specialist becomes registered as a

CS.\5\

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\3\The substance of Amendment No. 1 concerned a requirement that

appropriate Chinese Wall procedures be in place. In Amendment No. 2,

the Exchange deleted the substance of Amendment No. 1. The Exchange,

however submitted a separate proposed rule change (File No. SR-BSE-

93-17) establishing Chinese Wall procedures. See Securities Exchange

Act Release No. 33090 (October 22, 1993) 58 FR 58206. That proposal

is being separately approved today in conjunction with approval of

this rule proposal. Amendment No. 3 deleted a footnote that had been

added in Amendment No. 2.

\4\The index arbitrage provision mirrors that portion of the

NYSE's Rule 80A restriction on index arbitrage in situations where

the Dow Jones Industrial Average has declined by 50 points or more

from the previous day's closing value.

\5\The Commission notes that the current registered specialist

(the ``regular'' specialist) in a particular stock is not considered

a ``competing specialist'' in that stock under the proposal, and

therefore is not affected by this prohibition. If, however, it

applies to compete in a different stock, it is a ``competing

specialist'' in that stock and, pursuant to this rule change, may

not pay for any order flow in that stock.

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II. Description of the Proposal

The purpose of the proposed rule change is to permit competing

specialists on the floor of the BSE. Currently, each stock traded on

the BSE is assigned to one particular specialist. This contrasts with a

multiple market maker system where competing market makers compete for

order flow in the same securities. The BSE competing specialist

proposal will permit up to three specialists\6\ in each stock, who

would compete with each other for order flow.\7\ Each specialist will

have the same affirmative and negative obligations as are imposed

currently upon BSE specialists.

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\6\The proposal provides for both a ``regular'' specialist (the

current specialist) and up to two ``competing'' specialists. The

regular specialist would remain responsible for (1) updating

quotations, (2) coordinating all openings and reopenings to ensure

that they are unitary, (3) inputing quotations on ITS to reflect the

best BSE quote among all the specialists, and (4) coordinating

trading halts. The BSE will display only one consolidated quotation

to other markets in the National Market System.

\7\The scope of the pilot is further limited in that each

competitor may specialize in a maximum of 10 stocks unless the

Market Performance Committee (``MPC'') approves an increase of up to

20 stocks per applicant firm. The MPC may approve such an increase

on a case-by-case basis. The BSE has represented that, during the

pilot program, the total number of stocks subject to competition

will not exceed 360. See Securities Exchange Act Release No. 32549

(June 29, 1993), 58 FR 36229 (July 6, 1993).

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Moreover, the BSE rules governing the auction market principles of

priority, parity, and precedence remain unchanged.\8\ Thus, if the

specialists are quoting the same price (i.e., they are on price

parity), the earliest bid/offer at that price has time priority and

will be filled first up to its specified size; and if the specialists

are on both price and time parity, then all bids/offers equal to or

greater than the size of the contra-side order are on parity and

entitled to precedence over smaller ones (if it is possible to

determine the order of time such orders were made, they shall be filled

in that order).

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\8\See BSE Rules Ch. II Sec. 6.

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In addition to facilitating competition among the specialists, the

proposal permits preferenced order routing. Orders may be directed to

any specialist based on the request of the firm submitting the order,

or, if a particular specialist is not specified, then the orders will

be directed to the regular specialist.\9\ If an order is entered into

BSE's automated order routing system (``BEACON'') by a member firm

affiliated with a specialist, that order automatically will be routed

to that member firm's affiliated specialist, thereby preventing member

firms affiliated with a specialist from routing non-profitable orders

through BEACON to the other specialist when market conditions are

unfavorable.\10\

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\9\As noted below, however, if the CS is quoting the ITS/BBO and

clearly has established priority on the BSE floor, then the CS will

fill the order despite the default routing to the regular

specialist.

\10\Conversation between Karen Aluise, Assistant Vice President,

Boston Stock Exchange, and N. Amy Bilbija, Commission, on December

14, 1993.

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All limit orders in a pilot stock, regardless as to which

specialist they are sent, will be represented and executed strictly

according to time priority in BEACON. Once all limit orders at the

Intermarket Trading System best bid or offer (``ITS/BBO'') or better

are depleted, each specialist will be responsible for the market orders

directed specifically to it. BEACON (which handles approximately 95% of

all order flow on the BSE) will execute automatically\11\ an incoming

order against an order on the book, and only if there is no contra-side

agency order on the limit order book at the price will the incoming

order be routed to the designated specialist for execution.

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\11\BEACON will continue to expose all market and marketable

limit orders (on the designated specialist's BEACON terminal) for 15

seconds, prior to automatic execution at the ITS/BBO, for possible

price betterment.

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In addition to the rules discussed above, the proposal outlines

registration procedures and daily responsibilities for CSs. All

competing specialists will be responsible for:

a. Cooperating with the regular specialist regarding openings

and reopenings to ensure that they are unitary;

b. Keeping each other informed and communicating to inquiring

floor brokers the full size of any executable ``all or none'' orders

in their possession and representing such orders on a best efforts

basis to ensure the execution of the entire order at a single price

or prices, or not at all;

c. Communicating their markets to the regular specialist and

being responsible for their portion of the published bid and/or

offer; and

d. Conforming generally to all of the rules and policies

applicable to a regular specialist.

To register as a CS the applicant must submit a written application to

the Market Performance Committee (``MPC''), listing in order of

preference the stock(s) in which the applicant requests to compete. The

MPC will then review the application\12\ considering the following

factors:

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\12\The decision of the MPC may be appealed to the Executive

Committee.

Overall performance evaluation results of the

applicant;

Financial capability;

Adequacy of manpower on the floor;

Existence of an adequate information barrier policy in

the applicant firm;\13\ and

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\13\If the MPC finds that an applicant firm does not have

adequate information barrier procedures in place, it will deny that

firm status as a CS. Conversation between Karen Aluise, Assistant

Vice President, and N. Amy Bilbija, Commission, on March 7, 1994. As

noted above, the specific requirements for adequate information

barrier procedures are set forth in a separate proposal that is also

being approved in conjunction with this approval order.

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Objection by the regular specialist in a stock, with or

without cause.\14\

\14\Any objection by the regular specialists to permit

comptition in one or more of such specialist's stocks must be in

writing and filed with the Exchange within 48 hours (unless the

specialist is unavailable, in which case within 48 hours of becoming

available) of notice of filing of the competing specialist

application. Such an objection is not an automatic veto, but rather

is merely a factor to be considered by the MPC in reviewing the

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application.

In addition, all applicants must be registered with the Exchange as

specialists and must meet the current minimum requirements set forth in

chapter XV of the BSE rules, the minimum capital and equity

requirements as set forth in Chapters VIII and XII of the BSE rules,

and conform to all other performance requirements and standards set

forth in the Rules of the Exchange.

Any specialist seeking to terminate its status must so notify the

MPC at least three business days prior to the desired effective date of

such withdrawal from competition. Withdrawal from registration by a CS

will bar that CS from applying to compete in that same stock for 90

days following the effective date of withdrawal. When the regular

specialist requests to be relieved of a stock, the stock will be posted

for reallocation by the Stock Allocation Committee. In the interim, if

the MPC is satisfied that the CS can continue to maintain a fair and

orderly market in such stock, the CS will serve as the regular

specialist until the stock has been reallocated.\15\ Where there is

more than one CS in the stock, Exchange staff will place the stock with

a caretaker\16\ until reallocation.

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\15\Once the stock has been reallocted to a regular specialist,

that specialist will not have the right to object to competition in

such stock.

\16\A ``caretaker'' is a specialist from another specialist unit

who is chosen by the Exchange to temporarily act as the regular

specialist.

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The registration of any CS may be suspended or terminated by the

MPC upon a determination of any substantial or continued failure by

such CS to engage in dealings in accordance with the Constitution and

Rules of the Exchange.

Finally, the proposal amends the BSE Rule governing the

specialist's book, the contents of which are otherwise confidential, to

add a provision permitting specialists to disclose information in their

books to other specialists competing in the same stocks on a summary

basis as provided for in the procedures for CSs.

III. Summary of Comments

The Commission has received comment letters on the proposal from

the American Stock Exchange (``Amex),\17\ Chicago Stock Exchange

(``CHX''),\18\ Cincinnati Stock Exchange (``CSE''),\19\ and New York

Stock Exchange (``NYSE''),\20\ as well as BSE's responses thereto.\21\

The letters (with the exception of the CSE) raise similar concerns with

the BSE proposal about the preferencing feature, internalization of

order flow, payment for order flow, adequate information barrier

procedures, and the overall effect on auction market principles.\22\

These comments are discussed in more detail below.

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\17\See letters from Jules L. Winters, Chief Operating Officer,

Amercian Stock Exchange, to Jonathan G. Katz, Secretary, Commission,

dated August 26, 1993 (``Amex letter 1'') and March 18, 1994 (``Amex

letter 2'').

\18\See letter from Homer J. Livingston, President and Chief

Executive Officer, Chicago Stock Exchange, to Jonathan G. Katz,

Secretary, Commission, dated December 10, 1993 (``CHX letter'').

\19\See letter from Robert P. Ackermann, Vice President,

Regulation, Cincinnati Stock Exchange, to Jonathan G. Katz,

Secretary, Commission, dated July 29, 1993 (``CSE letter''). In sum,

the CSE argues that because their current Dealer Preferencing System

is analogous to the BSE proposal, the same restrictions should be

applied to both pilots, or, in the alternative, the Commission

should remove the restrictions from the CSE pilot. The restrictions

include prohibitions on direct cash payments for preferenced order

flow, prohibitions on use of short-sale arbitrage programs, and

limitations on the scope of the program. All of these restrictions

have been incorporated into the BSE proposal. See Amendments Nos. 1,

2, and 3.

\20\See letters from James E. Buck, Senior Vice President and

Secretary, New York Stock Exchange, to Jonathan G. Katz, Secretary,

Commission, dated August 25, 1993 (``NYSE letter 1''); and Daniel

Parker Odell, Assistant Secretary, New York Stock Exchange, to

Jonathan G. Katz, Secretary, Commission, dated October 29, 1993

(``NYSE letter 2'').

\21\See letters from Karen A. Aluise, Assistant Vice President,

Boston Stock Exchange, to Jonathan G. Katz, Secretary, Commission,

dated July 30, 1993 (``BSE letter 1''); John I. Fitzgerald,

Executive Vice President, Legal Affairs and Trading Services, Boston

Stock Exchange, to Jonathan G. Katz, Secretary, Commission, dated

September 16, 1993 (``BSE letter 2'') and November 10, 1993 (``BSE

letter 3'').

\22\The CSE, Amex, and NYSE also recommended that the issue of

competing specialist should be made part of the Market 2000 Study

along with the Amex competing dealer proposal. Division of Market

Regulation, U.S. Securities and Exchange Commission, Market 2000: An

Examination of Current Equity Market Developments (1994). The Amex's

competing dealer proposal seeks to alter the current rules of

priority in regard to the orders of regional exchange specialists

and third market makers that are directed to the Amex. The issues

raised in Amex's competing dealer proposal are fundamentally

different from the concerns raised by the competing specialist

proposal which seeks to alter the current rules to accomodate

competitors on the floor of the BSE. Specifically, the Amex's

proposal is intended to alter the treatment of incoming orders from

competing dealers, while the BSE proposal creates the ability for

competing specialists to compete on the floor of the Exchange.

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A. Preferencing

All four commentators attempted to draw an analogy between the

Cincinnati Dealer Preferencing Program (``CSE pilot'')\23\ and the BSE

proposal by alleging that the latter is in fact a preferencing system

despite the lack of a reference to the term ``preferencing'' in the

proposal.\24\ The NYSE also alleges that although the BSE rules

currently provide for the same auction market procedures as NYSE Rule

72, the competing specialist proposal effectively would change those

procedures by always giving priority to the designated specialist when

no other contra-side agency orders are present.\25\ The BSE, in

response, asserts that their priority, parity, and precedence rules

work the same way as the NYSE rules did, when competing specialists

were permitted on their floor, in that a BSE specialist quoting the

ITS/BBO would have priority over the other specialist who is quoting an

inferior market.\26\

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\23\The CSE pilot originally was approved as a six month pilot

for 60 issues per preferencing dealer. See Securities Exchange Act

Release No. 28866 (February 13, 1991), 56 FR 5854 (February 7,

1991). It was subsequently extended several times and is currently

approved through August 7, 1994. The number of CSE issues which a

dealer may preference has been increased periodically to 350. See

Securities Exchange Act Release Nos. 29885 (October 30, 1991), 56 FR

56676; 30353 (February 7, 1992) 57 FR 5918; 30809 (June 15, 1992) 57

FR 27990; 31011 (August 7, 1992), 57 FR 38704; 32280 (May 7, 1993)

58 FR 28422; 33975 (April 28, 1994).

\24\See NYSE letter 1; NYSE letter 2; CSE letter; CHX letter;

Amex letter 2.

\25\See NYSE letter 2.

\26\See BSE letter 2.

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B. Internalization

Internalization of order flow is the ability of diversified firms

to retain incoming customer orders by routing them to their affiliated

specialist for execution, thereby participating on both sides of the

transaction. The NYSE asserts that the BSE proposal could lessen

auction market depth and efficiency because the preferenced order flow

is internalized by specialists, does not participate in the auction

market, and is executed outside of it.\27\ The NYSE and Amex further

maintain that by allowing internalization of order flow, the BSE

proposal will diminish the efficiencies of auction market pricing by

denying preferenced orders any exposure to the primary market and

opportunity for price betterment thereon, and ultimately will lead to

market fragmentation.\28\

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\27\See NYSE letter 1.

\28\See Amex letter 1; Amex letter 2; NYSE letter 1.

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The NYSE believes the Commission should weigh possible positive

effects of competing specialists, such as fostering competition,

against the potential negative effects, such as distortion of the

auction market, and encourages the Commission to undertake a more

comprehensive study of preferencing in order to determine whether or

not it works to the benefit of the investing public.\29\ In response,

the BSE suggests that competition will heighten as the competing

specialists strive to establish priority on the BSE floor.\30\

Moreover, according to the BSE, liquidity in the national market will

increase at the ITS/BBO because (1) the competing specialists will be

forced to quote at the ITS/BBO to retain priority, and (2) the BSE

quote disseminated when two or more specialists are simultaneously

bidding at the same price will reflect their aggregated size.\31\

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\29\See NYSE letter 1; See also Amex letter 2.

\30\Consistent with traditional auction market principles, the

only instance where preferencing would force a competitor with

clearly established priority on the BASE floor to step aside to a

preferenced order is when the ITS/BBO is greater than the BSE BBO.

In such a circumstance, the BSE specialist does not have priority at

the ITS/BBO and therefore BEACON will route the order to whomever is

the designated specialist. Conversation between Karen Aluise,

Assistant Vice President, Boston Stock Exchange, and N. Amy Bilbija,

Commission, on December 16, 1993.

\31\The Commission notes that the BSE is aware that it may not

aggregate auto-quotes for dissemination in ITS because auto-quoting

in size is not permitted under the ITS Plan. An auto-quote is a

systemic pricing change mechanism that generally tracks on the

primary market.

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The NYSE and Amex also note that the BSE system in theory requires

marketable customer limit orders to be cleared before a preferenced

specialist can trade with its own order flow.\32\ The NYSE and Amex

maintain, however, that there is nothing to prevent BSE member firms

from withholding their limit orders from the market, and sending them

down to the exchange floor only when they have become marketable, at

which time they are paired off against the affiliated specialist for

execution.\33\ The NYSE and Amex further assert that BSE firms with

affiliated specialists would be motivated to act in such a fashion

because they would be providing each organization an ongoing

opportunity to trade as principal with its customers' market

orders.\34\ The BSE, however, maintains that BEACON will not

accommodate such a practice because the system does not accept paired

orders (where one side is an agency order and one side is a BSE market

maker as principal).\35\

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\32\See NYSE letter 1; Amex letter 2.

\33\See NYSE letter 2; Amex letter 2.

\34\See NYSE letter 2; Amex letter 2.

\35\Conversation between Karen Aluise, Assistant Vice President,

Boston Stock Exchange, and N. Amy Bilbija, Commission, on February

14, 1994. The Commission notes that the practice of withholding

limit orders may be inconsistent with achieving best execution of

customer orders and may unnecessarily interpose a dealer into an

agency transaction. See 15 U.S.C. 78k-1(a)(1)(C)(v) (1988).

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The BSE states, and the NYSE notes, that all BSE market and

marketable limit orders routed to a designated specialist will still

continue to be exposed for 15 seconds to allow the specialist to

execute the order at a price better than the ITS/BBO before automatic

execution at the ITS/BBO.\36\

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\36\In contrast, the NYSE asserts that in the CSE pilot agency

at-the-market and marketable limit orders are executed immediately

and automatically at the ITS/BBO without exposure for price

betterment. See NYSE letter 1.

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Finally, the Amex further asserts that increased internalization

resulting from the BSE proposal will lead to more order flow to the

BSE, which will in turn increase the amount of risk incurred by BSE

specialists. As a result, the Amex alleges, BSE specialists will ``lay

off'' their risk on the primary market specialist by means of

offsetting executions following a BSE transaction,\37\ thus increasing

the risk factor to the Amex specialists. The Amex concludes that this

potential increased risk, and the desire to foster protection of

customer orders, is the basis for its pending competing dealer

proposal.

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\37\See Amex letter 2.

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C. Effect on Auction Market Principles

The NYSE and Amex assert that the proposal represents a departure

from agency/auction principles and a movement toward ``dealerization''

of regional exchange markets by encouraging firms to set up CSs in

order to internalize preferenced order flow which is thereby denied the

chief benefits of auction market trading.\38\ The Amex further asserts

that:

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\38\See Amex letter 1.

This development can only increase concerns * * * regarding

regional exchange market making in primary exchange listed

securities--namely, increased market fragmentation, passive

quotations and autoquoting, failure to enhance price discovery and

provide price betterment, and failure to reflect full bid/offer

size.\39\

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\39\See Amex letter 1 (citing the Amex Market 2000 comment

letter, pp. 14-17).

The Amex also does not believe the BSE proposal will benefit the

investing public, asserting that for most securities there is little

evidence to support the proposition that increasing the number of

market making participants increases competition and provides price

betterment.\40\

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\40\See Amex Letter.

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The CHX letter, although more of a commentary on the CSE pilot than

on the BSE proposal, reaches the conclusion that it would be

inconsistent for the Commission to permit the CSE pilot to operate

without permitting the more traditional exchanges to compete by

providing similar systems of their own.\41\ In addition, the CHX takes

the position that the BSE proposal is a type of preferencing system,

but contains fewer negative aspects than does CSE's pilot. Therefore,

the CHX believes it would be illogical to permit the CSE pilot to

continue while disapproving the BSE proposal.\42\

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\41\See CHX letter.

\42\See CHX letter.

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D. Payment for Order Flow

Both the CSE pilot and the BSE proposal include a prohibition

against cash payments, by preferencing market makers and CSs

respectively, for preferenced order flow.\43\ The NYSE suggest that the

BSE's restriction may be broader than the CSE's because it appears to

apply to regular specialists as well as CSs.\44\ The BSE response,

however, emphasized that its restriction only applies to a CS in those

stocks in which he becomes registered as a CS. The NYSE, Amex, and BSE,

however, concur that the Commission should address the payment for

order flow issue on a national level. The NYSE suggests that the

Commission prohibit all dealers and specialists in all markets from

paying for order flow.\45\ The BSE response advocated a clear standard

for all industry participants, suggesting that the Commission either

prohibit all dealers and specialists in all markets from paying for

order flow or allow all such market participants to decide the issue

for themselves.\46\ The Amex agreed with the BSE in so far as the issue

should be addressed in a conceptually consistent manner rather than a

piecemeal approach.\47\

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\43\See Securities Exchange Act Release No. 28866 (February 7,

1991), 56 FR 5854 (February 13, 1991); and Securities Exchange Act

Release No. 33089 (October 22, 1993), 58 FR 58205 (October 29,

1993).

\44\See NYSE letter 2, FN 2.

\45\See NYSE letter 1; NYSE letter 2.

\46\See BSE letter 2; BSE letter 1; BSE letter 3.

\47\See Amex letter 1.

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E. Information Barriers

The NYSE and Amex commented on the BSE's original requirement that

competing specialists affiliated with upstairs firms must have and

maintain appropriate information barrier procedures as approved by any

SRO, noting that the BSE had no actual rules in place on the

establishment or enforcement of such procedures.\48\ In response, the

BSE separately filed information barrier procedures with the

Commission.\49\

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\48\See NYSE letter 1; Amex letter 1. The NYSE's Rule 98 and the

Amex's Rule 193 are those exchanges' procedures that deal with

integrated, or diversified, number firms acting as specialists on

the primary markets.

\49\See Securities Exchange Act Release No. 33090 (October 22,

1993), 58 FR 58206 (October 29, 1993). That proposal is being

approved concurrently with the instant proposed rule change.

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IV. Discussion

For the reasons discussed below, the Commission is approving the

BSE competing specialist proposal on a one-year pilot basis. During the

pilot the BSE will be required to monitor the pilot, collect data, and

submit reports as outlined below.

As a preliminary matter, the Commission supports efforts by

exchanges to provide increased market making and competition on their

trading floors or trading systems. Such efforts should increase the

provision of liquidity services by an exchange and enable it to compete

more effectively with other markets. The addition of specialist

competition on the BSE floor could help in this regard. At the same

time, the Commission is sensitive to the concerns of many of the

commentators about the structural implications of the preferencing

feature of the BSE proposal. The Commission believes that it is

important that the competing specialist program provide real quote

competition for the benefit of investors, and not simply a means for

firms to internalize their customer order flow while receiving

specialist designation and treatment. Accordingly, as discussed in more

detail below, the Commission only is approving the BSE proposal on a

one-year pilot basis. During that time, the BSE is expected to monitor

its pilot and provide the Commission with a report on its operation

detailing how the proposal has affected the quality of BSE's market,

including its effect on quote competition. The Commission expects the

BSE to adequately demonstrate, through the periodic reporting

requirements outlined below and other such data as the Exchange may

wish to generate, that there are in fact beneficial competitive effects

from the CS program. Specifically, the Commission expects the Exchange

to analyze the effects of the program on the quality of the market

making by BSE specialists as a result of competition. For the reasons

outlined below, if the BSE cannot provide such an analysis, the

Commission would have serious reservations about continuing the

preferencing feature of the program.

As discussed above, many of the commentators discussed their views

on CSE's preferencing pilot in commenting on the BSE proposal and made

certain conclusions about the effects of the BSE's proposal based on

the experience with the CSE preferencing pilot. Although the Commission

believes the discussion is useful, we note that the CSE differs in

market structure and in the details of the preferencing system. Under

the CSE's pilot, preferenced dealers have priority over same-priced

market maker or professional agency interest entered prior in time when

the preferenced dealer is interacting with the public agency market and

marketable limit orders that he or she represents as agent.50

Further, the CSE system does not currently provide for exposure for

orders that would allow for potential price improvement on incoming

orders. Instead, price improvement on the CSE is only possible if the

CSE dealer either (1) unilaterally improves the price before sending

the cross to the CSE for execution, or (2) voluntarily exposes the

improved order to the national consolidated quote system for possible

improvement before filling it at the ITS/BBO.

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\5\0See Securities Exchange Act Release No. 28866 (February 7,

1991), 56 FR 5854 (February 13, 1991).

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The BSE has attempted to design its proposal to enable customers to

receive best execution of their orders while stimulating competition

among specialists. As previously stated, the proposal does not alter

the auction market principles of priority, parity, and precedence. In

addition, limit orders will continue to be executed in accordance with

traditional auction market principles. Under the BSE proposal, all

limit orders will be represented and executed strictly according to

time priority according to the order of their receipt in Beacon,

irrespective of which specialist they are sent to. Further, all market

and marketable limit orders will continue to receive a 15 second

exposure for possible price improvement.51 Before an incoming

preferenced order is executed against the specialist, Beacon scans its

limit order book. If there is a contra-side order on the book, Beacon

will match up the two orders and execute without the specialist's

participation (unless the specialist opts to improve the price).

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\5\1See Division of Market Regulation, U.S. Securities and

Exchange Commission, Market 2000: An Examination of Current Equity

Market Developments, Study V (1994) (``Market 2000 Study'').

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The BSE proposal also is designed to provide for potential quote

competition. The only time the BSE's proposed preferencing feature can

force a non-designated specialist with clearly established priority on

the BSE floor to yield priority to a preferenced competitor, so that it

may trade as principal with the incoming preferenced order, is when (1)

the ITS/BBO is greater than the BSE BBO, and (2) there is no contra-

side agency order priced equal to or better than the ITS/BBO (i.e., all

limit orders at the price have been depleted). The BSE asserts that

this will enhance quote competition and, at a minimum, add liquidity at

the ITS/BBO.

The Commission recognizes that BSE specialists currently quote at

the best ITS price only 5% of the time.52 The proposal, however,

allegedly provides an incentive for specialists desiring to attract

order flow to quote more often at the ITS/BBO. If the BSE's assertion

is correct in that the specialists will be motivated to compete for

priority on the floor, then liquidity could be enhanced at the ITS/BBO.

In addition, if the specialists are simultaneously bidding at the same

price, the sizes will be aggregated for purposes of disseminating the

BSE quote.53 In sum, the proposal potentially could add depth at

the ITS/BBO if the BSE specialists begin to quote at the best ITS price

more frequently than is the practice today, and thereby improve the

overall quality of the BSE market place. Although it is unclear whether

the BSE proposal will have this result, the Commission intends to

carefully evaluate the effects on the quality of the BSE market from

this potential ``quote competition'' and whether the majority of

preferenced orders are executed by the affiliated specialist when

quoting at less than the ITS/BBO. As indicated above, the Commission

expects the BSE to provide sufficient evidence confirming the existence

of enhanced quote competition.

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\5\2Conversation between Jack Fitzgerald, Executive Vice

President, Bill Lee, Senior Vice President, Karen Aluise, Assistant

Vice President, and Ken Meaden, Assistant Vice President, Boston

Stock Exchange, and N. Amy Bilbija, Commission, on December 29,

1993.

53But see note 32, supra.

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With respect to the BSE proposal's effect on internalization of

order flow, and the potential for market fragmentation as a result, the

Commission's Division of Market Regulation (``Division'') recently

examined the extent of market fragmentation in its Market 2000 Study.

The Division found that multiple, varied market centers and competitors

for listed stocks has provided many benefits to the users of the

markets without impairing market quality or price discovery. The

Division concluded that concerns about fragmentation have been

overstated. However, the Commission is concerned that the

implementation of a preferencing system at one or more exchanges may

alter the analysis.

The potential effects of internalization by BSE specialists,

however, are difficult to analyze without some experience about the

effects of the pilot. The Commission does note that if the program of

competing specialists is used merely to expand the number of

specialists internalizing order flow rather than as a means of

improving the quality of BSE markets, then the proposal would raise

additional questions as to whether the competing specialists are acting

as active market makers and deserve specialist designation and the

benefits accruing thereto. Accordingly, although the BSE proposal may

result in more internalization of order flow, the Commission is not

willing at this time to conclude that it will be detrimental to the

quality of the equity markets, but instead intends to revisit this

issue at the expiration of the pilot. In reaching this conclusion, the

Commission emphasizes that the BSE proposal is limited in scope, and

best execution of customer orders in the context of fair competition is

still a primary objective. Under the proposal, customer orders will

continue to be able to interact, and the opportunity for price

improvement exists.

The preferencing feature of the competing specialist program also

raises questions about the use of payment for order flow by BSE

specialists. As discussed previously, during the pilot program a CS

will be prohibited from making cash payments for order flow in those

stocks in which it is registered as a CS. Such a prohibition is

important to assess the effects of the proposal and incentives for

market participants to take part in it and to benefit therefrom. The

Commission is still considering the concerns regarding the issue of

payment for order flow on the national level. On October 7, 1993, the

Commission published for comment Rule 11Ac1-3 and amendments to Rule

10b-10 under the Act relating to enhanced disclosure of payment for

order flow practices. The Commission also sought comments on various

alternative approaches to payment for order flow, such as banning the

practice outright, pass-through the payment to customers, and

decimalization.\54\ Accordingly, any final outcome in that rule making

procedure may ultimately effect the payment for order flow issue in the

BSE's pilot.

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\54\See Securities Exchange Act Release No. 33026 (October 6,

1993). The comment period on the proposal ended December 3, 1993,

and the Commission is still reviewing the comments and issues

presented.

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Finally, as discussed above, the Commission also is approving today

information barrier procedures for BSE specialists. These procedures

ensure that upstairs firms affiliated with BSE specialists will not

receive information advantages due to the relationship between the

entities.\55\

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\55\See Securities Exchange Act Release No. 34-34076 (May 18,

1994) approving BSE's information barrier proposal.

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Based on the above, the Commission believes it is appropriate to

allow the BSE to implement its competing specialist proposal on a one-

year pilot basis. In making this determination, the Commission has

carefully analyzed the potential benefits from competition, such as

better quotes, with the potential for increased internalization of

order flow. The Commission believes that the BSE has incorporated

features in its proposal to allow it to implement, for a one-year

period, a competing specialist system that will allow firms to

designate order flow to an affiliated specialist.

The Commission, nevertheless, believes that before the BSE proposal

will be extended beyond the one-year pilot period or approved on a

permanent basis, the BSE will have the burden to prove that its

proposal resulted in added depth and liquidity to its market and

improved quotations. The Commission emphasizes that if the Commission

is dissatisfied with the data or the market effects of the pilot, it

would not be inclined to extend the competing specialist program.

Accordingly, the Commission requests that the BSE provide, on a

quarterly basis, the following information:

1. A list indicating how many competing specialists are on the

Exchange.

2. A list identifying, for each competing specialist, the issues

in which they are competing.

3. The volume of ``preferenced'' trades in each issue; and the

percentage of total volume of trades sent to the BSE for execution

in each issue represented by ``preferenced'' volume.

4. The volume of ``preferenced'' share and transaction volume;

and the percentage of total BSE share and transaction volume the

``preferenced'' volume represents.

5. BSE's volume attributable to ITS commitments sent by other

ITS participant markets; and the percentage of such commitments

attributable to ``preferenced'' issues.

6. The number of ``preferenced'' orders executed by the non-

designated specialist(s).

7. The number of ``preferenced'' orders effected against the

limit order book, both in total and separately for each

``preferenced'' issue.

8. The number of limit orders placed on the book, as compared to

before the commencement of this pilot, both for the BSE as a whole

and separately for the stocks for which there are competing

specialists.

9. BSE's share of Tape trade reports, as compared to before the

commencement of this pilot.

Further, we request the Exchange to submit a report to the

Commission, discussing the data outlined above, eight months from the

date of commencement of the competing specialist pilot. The report

should discuss such data in terms of the effects of the competing

specialist pilot on the quality of the BSE market with respect to

depth, liquidity, and quote improvement.\56\

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\56\Should any other exchange attempt to implement a similar

system that is acceptable to the Commission, it should be noted that

the pilot period would be limited to the same one year period

afforded the BSE. At the end of such period, all such systems will

be subject to the same rigorous scrutiny regardless of how long they

may have been in operation.

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V. Conclusion

The Commission finds preliminarily that the proposed rule change is

consistent with the requirements of the Act and the rules and

regulations thereunder applicable to a national securities exchange,

and, in particular, with the requirements of section 6(b).\57\ In

particular, the Commission preliminarily believes the proposal is

consistent with section 6(b)(5) because it is designed to promote just

and equitable principles of trade, to foster cooperation and

coordination with persons engaged in regulating, clearing, settling,

processing information with respect to, and facilitating transactions

in securities, to remove impediments to and perfect the mechanism of

free and open market and a national market system.

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\57\15 U.S.C. 78f(b) (1988).

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It is Therefore Ordered, pursuant to section 19(b)(2) of the

Act,\58\ that the proposed rule change (SR-BSE-93-12) is approved for a

period of one year through May 18, 1995.

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\58\15 U.S.C. 78s(b)92) (1988).

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\59\

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\59\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-12739 Filed 5-24-94; 8:45 am]

BILLING CODE 8010-01-M