Self-Regulatory Organizations; Midwest Stock Exchange, Inc.; Order Approving Proposed Rule Change and Amendment No. 1 to Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval to Amendment No. 2 to Proposed Rule Change Relating to Agency Crosses Between the Disseminated Exchange Market

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33708; File No. SR-MSE-93-05]

Self-Regulatory Organizations; Midwest Stock Exchange, Inc.;

Order Approving Proposed Rule Change and Amendment No. 1 to Proposed

Rule Change and Notice of Filing and Order Granting Accelerated

Approval to Amendment No. 2 to Proposed Rule Change Relating to Agency

Crosses Between the Disseminated Exchange Market

March 3, 1994.

I. Introduction

On March 2, 1993, the Midwest Stock Exchange, Inc. (``MSE,''

``Exchange'' or ``Chicago Stock Exchange'')\1\ submitted to the

Securities and Exchange Commission (``SEC'' or ``Commission''),

pursuant to section 19(b)(1) of the Securities Exchange Act of 1934

(``Act'')\2\ and rule 19b-4 thereunder,\3\ a proposed rule change

relating to the execution of agency cross transactions at a price

between the disseminated Exchange market. On December 10, 1993, the MSE

submitted to the Commission Amendment No. 1 to the proposed rule change

in order to summarize and respond to a comment letter it received in

opposition to this proposal.\4\ On February 16, 1994, the MSE submitted

Amendment No. 2 to the proposed rule change to specify that the

proposal only applies to block trades and to clarify the Exchange's

position regarding specialist participation in cross transactions.\5\

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\1\As of July 8, 1993, the MSE changed its name to the Chicago

Stock Exchange, Inc. (``CHX''). See Securities Exchange Act Release

Nos. 32488 (June 18, 1993), 58 FR 34284 (June 24, 1993) (File No.

SR-MSE-93-13) (immediate effectiveness of proposed rule change to

amend the MSE's Certificate of Incorporation and Constitution to

effect a name change); and 32489 (June 18, 1993), 58 FR 34285 (June

24, 1993) (File No. SR-MSE-93-16) (immediate effectiveness of

proposed rule change to make conforming changes to the MSE Rules.)

\2\15 U.S.C. 78s(b)(1) (1988).

\3\17 CFR 240.19b-4 (1991).

\4\See letter from David T. Rusoff, Foley & Lardner, to Beth A.

Stekler, Attorney, Division of Market Regulation, SEC, dated

December 9, 1993 (``Amendment No. 1'').

\5\See letter from David T. Rusoff, Foley & Lardner, to Sharon

Lawson, Assistant Director, Division of Market Regulation, SEC,

dated February 15, 1994 (``Amendment No. 2'').

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The proposed rule change was published for comment in Securities

Exchange Act Release No. 33500 (January 21, 1994), 59 FR 4128 (January

28, 1994). One comment letter was received on the proposal.\6\ This

order approves the proposed rule change, including both amendments.

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\6\See letter from Robert Hill, Vice President, The Chicago

Corporation, to the Executive Committee, MSE, dated October 20, 1992

(``Hill comment letter''). The Hill comment letter was forwarded to

the Commission as part of Amendment No. 1, supra, note 4.

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II. Description of the Proposal

Article XX, Rule 23 of the Exchange's rules outlines the current

method for the execution of cross transactions on the MSE.\7\ Under

that rule (in conjunction with the MSE's priority rule), a member or

member organization effecting a cross transaction first must assure

that all existing bids or offers, at or better than the cross price,

are filled at their limits.\8\ Thereafter, the member or member

organization must publicly announce both sides of the cross; the

member's offer must be higher than its bid by at least the minimum

variation permitted for that security.\9\ Rule 23 then allows the

member or member organization to execute the cross transaction at its

bid or offer. Under this method, however, another member can ``break

up'' the cross, by trading with either the bid or offer side of the

transaction when it is presented to the crowd. According to the

Exchange, the ability of the specialist, in particular, to participate

in a cross transaction decreases the likelihood of the order sending

firm receiving an immediate execution.

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\7\In a cross transaction, a member or member organization that

holds an order to buy and an order to sell an equivalent amount of

the same security wishes to execute the orders against each other.

Because it already holds both sides of the trade, the member does

not want the orders to interact with other market interest.

\8\As a general matter, the bid/offer entered at the best price

(i.e., the highest bid or the lowest offer) is entitled to priority

over bids/offers at inferior prices; similarly, the first bid/offer

clearly established at a given price is entitled to priority over

other bids/offers at the same price. See Article XX, rules 15-18 of

the MSE Rules.

\9\Article XX, Rule 22 of the MSE Rules sets forth the minimum

variation permitted for securities traded on the Exchange.

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The Exchange proposes to add a new Interpretation and Policy .01 to

Rule 23. Specifically, the proposed interpretation will require that

the MSE specialist refrain from interfering with a floor-brokered

agency cross,\10\ of 10,000 shares or more,\11\ at a cross price

between the disseminated Exchange market.\12\ Even if the above

requirement precludes specialist participation, once a cross is

executed, the specialist nevertheless will be obligated, as under

current rules, to satisfy all book orders with priority at the cross

price. In contrast, the MSE proposal will allow the specialist to

participate in a block agency cross if he or she has a disseminated bid

or offer at the cross price, regardless of the size thereof.\13\

Finally, the MSE has clarified that a specialist who is willing to

provide one side of the cross with a better price will have the

opportunity to do so.\14\

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\10\For purposes of this proposal, the Exchange has defined the

term ``agency cross'' as a cross where neither the order to buy nor

the order to sell is for the account of any member or member

organization (i.e., including, but not limited to, the member or

member organization executing the cross). Telephone conversation

between David T. Rusoff, Foley & Lardner, and Beth A. Stekler,

Attorney, Division of Market Regulation, SEC, on January 5, 1994.

\11\The proposed interpretation will not apply to crosses of

less than 10,000 shares. According to the Exchange, the current

rules, see supra notes 7-9 and accompanying text, will continue to

govern the execution of, and specialist participation in, crosses

that fall below the MSE's 10,000 share size threshold for block

trades. Telephone conversation between David T. Rusoff, Foley &

Lardner, and Beth A. Stekler, Attorney, Division of Market

Regulation, SEC, on February 18, 1994.

\12\However, the specialist will be allowed to participate if

the member presenting the cross previously solicited his or her

assistance in consummating any part of the transaction.

\13\In particular, the Exchange has indicated that a specialist

who is displaying a bid or offer at the cross price will be allowed

to participate at that price, even in a size greater than his or her

quotation. Telephone conversation between David T. Rusoff, Foley &

Lardner, and Beth A. Stekler, Attorney, Division of Market

Regulation, SEC, on December 20, 1993.

\14\See Amendment No. 2, supra, note 5.

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The MSE states that the purpose of the proposed rule change is to

increase the possibility of immediate execution of agency crosses on

the Exchange when the cross price is between the disseminated MSE

market. The Exchange believes that the proposed rule change is

consistent with section 6(b)(5) of the Act, in that it is designed to

promote just and equitable principles of trade, to remove impediments

to and to perfect the mechanism of a free and open market and a

national market system, and, in general, to protect investors and the

public interest.

III. Comments Received and MSE Response

One comment letter on the proposed rule change, from a MSE

specialist, was received by the Exchange and forwarded to the

Commission.\15\ In his letter, the commentator recommends that the MSE

proposal be disapproved and raises several arguments, as discussed

below, in support of his position.

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\15\See Hill comment letter, supra, note 6.

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First, the commentator states that the MSE's rules have always

provided for the protection of customer orders, no matter how small,

and claims that this proposal represents a significant philosophical

change from that stance. The commentator fears that this will undermine

the Exchange's leverage in arguing for increased protection and

participation of public orders.

The letter also suggests that a new policy is not necessary at this

time. In the commentator's opinion, most instances where crosses are

broken up occur for legitimate reasons, and, while there may be

problems with certain specialists, overall brokers believe that the

current rules are adequate. Moreover, the commentator contends that the

Exchange does not have much to gain, except for ``window dressing

trades,'' from the proposed rule change. To this end, the commentator

states that the Exchange will receive little in the way of additional

transaction fees or CTA revenue.

In addition, the commentator argues that the proposed

interpretation makes no allowance for human slowness and asks what will

happen in busy markets. The commentator notes that a public order which

has come in to the MSE specialist, but has not yet been reflected in

his or her quote, cannot participate in a cross; the letter implies

that this result is contrary to the type of business an exchange (as

opposed to a crossing network) wants to encourage. In addition, the

commentator suggests that the new policy will be susceptible to abuse

because the MSE cannot determine, on an immediate basis, whether a

particular transaction is really an agency cross. His letter predicts

that monitoring ``after the fact'' will have a negative impact on the

Exchange's ability to attract business.

Finally, the commentator expresses concern that this proposal will

reduce the natural tension between specialist and broker that allows

for efficiency in the marketplace. The commentator argues that the

Exchange should be encouraging more orders and less crosses. From his

perspective, liquidity is based on the flow of orders into the price

discovery network, and, accordingly, it is not in the Exchange's

interest to facilitate what he describes as passively priced orders

that trade without interaction.

The MSE responded to the issues raised by the specialist's comment

letter.\16\ In its response, the MSE asserts that the proposed rule

change will not interfere with the execution of public orders on the

specialist's book. According to the Exchange, customer orders will

continue to be protected under its proposal, because the specialist

will be required to fill limit orders at the cross price, even if they

are not displayed due to the specialist's oversight. In the Exchange's

view, this requirement also should encourage specialists to be more

efficient in representing customer orders and to quote their true

market.

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\16\See Amendment No. 1, supra, note 4.

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Second, the MSE disputes the commentator's assessment of the costs

and benefits of the proposed rule change. The MSE believes that its new

policy will encourage more institutional trades to be routed to the

Exchange floor; whether this will result in more revenue is described

as a ``secondary consideration.'' In conclusion, the MSE states that

its proposal will create a more attractive marketplace for

institutional orders, without sacrificing traditional agency auction

market principles.

In addition, the MSE does not agree with the commentator that the

potential for abuse (i.e., by not having an agency order on both sides

of the trade) is a valid argument against adopting the proposed

interpretation in the first place. The Exchange states that many of its

present rules cannot be monitored for compliance on an immediate basis,

and pledges to take appropriate action if it finds that members are

abusing this rule.

Finally, according to the MSE, the proposed rule change will not

reduce the possibility of order interaction on the floor. The Exchange

notes that a specialist who is not displaying his or her market at the

cross price (and who has not previously been solicited for help) will

be the only one who cannot participate in a cross transaction. This

proposal will not affect the requirement that both sides of the cross

be announced publicly and/or the ability of other interest in the crowd

to participate. In fact, the MSE contends that, as a result of this

policy, more orders could be routed to the Exchange floor and could

take part in the auction process.

IV. Discussion

The Commission finds 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 sections 6(b) and P11(a).\17\ In

particular, the Commission believes that the proposed rule change is

consistent with the section 6(b)(5) requirement that the rules of an

exchange be designed to promote just and equitable principles of trade,

to prevent fraudulent and manipulative acts and, in general, to protect

investors and the public interest; and with the section 6(b)(8)

requirement that the rules of an exchange not impose any unnecessary

burden on competition. The Commission also believes that the proposed

rule change does not operate in a manner inconsistent with the

traditional auction market principle of customer priority, as embodied

in section 11(a) of the Act.

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\17\15 U.S.C. 78f(b) (1988).

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After careful review of the comments received as well as the

applicable statutory provisions, the Commission has concluded that the

proposed rule change should further competition among the exchanges, as

well as between exchanges and other markets, and should increase the

opportunities for the efficient execution of cross transactions. In the

past, the Commission has recognized the competition that exists between

the various markets for order flow, and especially for block business.

Several exchanges recently have received Commission approval to amend

their rules, on the grounds that exchange rules may hinder members'

ability to execute a cross transaction without interference and thus

may place an exchange at a competitive disadvantage.\18\

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\18\See, e.g., Securities Exchange Act Release Nos. 27205

(August 31, 1989), 54 FR 37180 (September 7, 1989) (File No. SR-

Phlx-89-17) (approving Philadelphia Stock Exchange (``Phlx'')

proposal to prohibit members from interfering, with either side of

an agency cross or the customer side of a facilitation cross, by

buying or selling for their own account at the cross price; except

that a specialist can participate to the extent of a publicly

disseminated bid or offer at that price, or to better the price);

31343 (October 21, 1992), 57 FR 48645 (October 27, 1992) (File No.

SR-NYSE-90-39) (approving New York Stock Exchange (``NYSE'') ``clean

cross'' proposal to allow members to execute agency crosses of

25,000 shares or more, at a price at or within the prevailing

quotation, without interference, irrespective of any pre-existing

bids or offers at the cross price; however, the cross can be broken

up at a better price); and 33391 (December 28, 1993, 59 FR 336

(January 4, 1994) (File No. SR-PSE-91-11) (approving Pacific Stock

Exchange (``PSE'') proposal to prohibit specialists from

participating for their own account on either side of an agency

cross, or the customer side of a facilitation cross, at a price

within the disseminated PSE market; except that a specialist can

participate to better the price).

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In response to today's competitive market environment, the MSE has

proposed to add a new requirement that a specialist's proprietary bid

or offer must yield to a block agency cross at a cross price between

the prevailing Exchange quotation. The MSE's new policy, however, will

allow a specialist who has a disseminated bid or offer at the cross

price to participate at that price. On balance, the Commission believes

that the proposal will clarify the roles of various market participants

and assure that, under routine circumstances, crosses are executed in a

fair and orderly manner, without disadvantaging public customer orders.

For instance, the Commission has determined that, for a regional

exchange like the MSE, a size threshold of 10,000 shares is not

unreasonable. Similarly, specialists will be protected from yielding

priority if they have exposed themselves to market risk at the cross

price. Accordingly, the Commission finds that the proposed rule change

should improve the MSE's ability to compete for block business and

potentially could enhance the depth and liquidity of the Exchange

market.\19\

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\19\The Commission appreciates all the exchanges' competitive

concerns with respect to the facilitation of cross transactions and,

at the same time, continues to emphasize the importance of adherence

with traditional auction market principles.

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In terms of auction market principles, the Commission believes that

the proposed rule change strikes an appropriate balance between the

competing needs of various customer orders represented for execution on

the MSE and the proprietary trading operations of Exchange members and

member organizations, including specialists. The Commission notes that

the MSE's new policy only applies to crosses between the disseminated

Exchange market. Accordingly, a member effecting a cross transaction at

the prevailing bid or offer will, consistent with current rules, be

required to obtain priority over all existing limit orders at that

price.\20\ In the event that an order on the specialist's book has not

been displayed in the quote but has time priority, the MSE proposal

guarantees that, after an order is effected at its price (pursuant to

rule 23 or otherwise), that limit order will be filled, even if the

specialist is precluded from interfering with the cross on its behalf.

Thus the Commission has concluded that the MSE proposal adheres to the

auction market principles of time and price priority and that this

method for the execution of crosses (and, in particular, the priority

granted to block agency crosses) will not disadvantage existing

orders.\21\ In fact, limit orders on the MSE which coincide with the

cross price could benefit from being assured of receiving an execution

at that price.

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\20\See supra, note 8.

\21\In this regard, the MSE proposal contrasts favorably with

other rule changes approved by the Commission, such as the NYSE's

clean cross proposal, see supra note 18.

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Furthermore, the Commission finds that the MSE proposal does not

restrict the opportunity for customer orders to receive price

improvement. To this end, rule 23 will allow the specialist to

participate in a cross transaction to provide one side with a better

price, notwithstanding any other provisions of this rule.\22\ In

addition, under the proposed rule change, it is still possible for

interest in the trading crowd, including an order for the principal

account of a member, to break up the cross and improve the price.

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\22\See Amendment No. 2, supra, note 5.

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The Commission also believes that the MSE proposal would not grant

priority, parity or precedence to the order of a member in a manner

inconsistent with section 11(a)(1)(G) of the Act or SEC rule 11a1-

1(T)(a)(3) thereunder.\23\ For purposes of this proposed rule change,

the MSE has defined the term ``agency cross'' as a cross where neither

the order to buy nor the order to sell is for the account of a member

or member organization. Because the definition of ``agency cross''

excludes (and, thus, does not grant priority to) an order for the

account of the broker effecting the cross transaction or an associated

person thereof,\24\ the Commission is satisfied that the proposed rule

change complies with section 11(a).

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\23\17 CFR 240.11a1-1(T)(a)(3).

\24\Telephone conversation between David T. Rusoff, Foley &

Lardner, and Beth A. Stekler, Attorney, Division of Market

Regulation, SEC, on March 3, 1994.

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The Commission does not agree with the commentator that this

proposed rule change represents a significant philosophical change from

the MSE's traditional stance of customer protection. As discussed

above, the Exchange will continue to afford time and price protection

to orders on the specialist's book.\25\ In the Commission's opinion,

this proposal contains adequate safeguards to ensure that public

customers are not disadvantaged.

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\25\See supra, notes 20-21 and accompanying text.

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In addition, the Commission finds that the Exchange has advanced a

satisfactory rationale for its new policy. The MSE believes that the

specialist's ability to participate in a cross transaction decreases

the likelihood of the order sending firm receiving an immediate

execution. Conversely, the MSE argues that minimizing such interference

will make the Exchange a more attractive marketplace for institutional

orders (regardless of the effect on Exchange revenues). In the absence

of a finding that this proposal is inconsistent with the Act, which the

Commission cannot make at this time, the Commission is willing, in

these circumstances, to defer to the MSE's judgment about the need for

and the potential gains from the proposed rule change.

The Commission also believes that the means the exchange has chosen

to accomplish its goals are not unreasonable, despite the potential for

abuse identified by the commentator. In reaching that conclusion, the

Commission placed great weight on the MSE's assurances that its current

surveillance methods (especially, the existence of an audit trail) are

capable of determining, in a relatively prompt fashion, whether a

particular transaction was really an agency cross.\26\ The Exchange,

moreover, has pledged to take appropriate action to remedy any

instances of noncompliance. Based on the above, the Commission is

satisfied that existing surveillance procedures will detect, as well as

deter, abuse of the rule. Where appropriate, the Commission expects the

Exchange to take prompt action to discipline members that fail to

comply with the agency cross requirement.

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\26\Telephone conversation between David T. Rusoff, Foley &

Lardner, and Beth A. Stekler, Attorney, Division of Market

Regulation, SEC, on February 24, 1994.

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Finally, the Commission does not believe that the MSE proposal will

significantly reduce order interaction on the floor of the Exchange. As

discussed above, only a MSE specialist who does not have a displayed

bid or offer at the cross price must refrain from participating in a

cross transaction at that price.

The specialist, however, will be allowed to participate at a better

price; and other interest in the trading crowd will not be subject to a

comparable yielding requirement.\27\ In the context of other rule

changes that have been approved by the Commission,\28\ the limited

scope of the yielding requirement and the protection afforded book

orders at the cross price, the Commission does not expect that the MSE

proposal will substantially impair the price discovery network and/or

market liquidity.

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\27\See supra, note 22 and accompanying text.

\28\See supra, note 18.

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The Commission finds good cause for approving Amendment No. 2 prior

to the thirtieth day after the date of publication of notice of filing

thereof. Amendment No. 2 merely delineates the scope of the original

filing and clarifies the intent of certain language used therein.

Finally, the interpretation the MSE proposes to adopt is substantially

similar to the rules of several other exchanges that were published in

the Federal Register for the full comment period and were approved by

the Commission.\29\

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\29\No comments were received in connection with the rule

changes submitted by the Phlx and PSE, which, as discussed above,

see supra note 18, are substantially similar to the interpretation

proposed herein.

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Interested persons are invited to submit written data, views and

arguments concerning Amendment No. 2 to the proposed rule change.

Persons making written submissions should file six copies thereof with

the Secretary, Securities and Exchange Commission, 450 Fifth Street

NW., Washington, DC 20549. Copies of the submission, all subsequent

amendments, all written statements with respect to the proposed rule

change that are filed with the Commission, and all written

communications relating to Amendment No. 2 between the Commission and

any persons, other than those that may be withheld from the public in

accordance with the provisions of 5 U.S.C. 552, will be available for

inspection and copying in the Commission's Public Reference Section,

450 Fifth Street NW., Washington, DC 20549. Copies of such filing will

also be available at the principal office of the Chicago Stock

Exchange, All submissions should refer to File No. SR-MSE-93-05 and

should be submitted by March 30, 1994.

V. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\30\ that the proposed rule change (SR-MSE-93-05), including

Amendments No. 1 and No. 2, is approved.

\30\15 U.S.C. 78s(b)(2) (1988).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\31\

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\31\17 CFR 200.30-3(a) (1991).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-5476 Filed 3-9-94; 8:45 am]

BILLING CODE 8010-01-M