[Federal Register Volume 61, Number 67 (Friday, April 5, 1996)]
[Notices]
[Pages 15322-15330]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-8397]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37046; File No. SR-CSE-95-03]
Self-Regulatory Organizations; The Cincinnati Stock Exchange;
Order Granting Approval to Proposed Rule Change to Adopt Permanently
Rules Regarding the Preferencing of Public Agency Orders
March 29, 1996.
I. Introduction
On March 1, 1995, The Cincinnati Stock Exchange (``CSE'' 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 adopt permanently the Exchange
rules governing preferenced trading. On August 11, 1995, the Exchange
submitted Amendment No. 1 to the proposed rule change to adopt order
handling policies for preferencing dealers.
\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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The proposed rule change was published for comment in Securities
Exchange Act Release No. 35448 (March 7, 1995), 60 FR 13493 (March 13,
1995). Amendment No. 1 was published for comment in Securities Exchange
Act Release No. 36092 (August 11, 1995), 60 FR 42209 (August 15, 1995).
The Commission received 18 comment letters on the proposed rule change,
which are discussed below.\3\ For the reasons discussed below, the
Commission has determined to approve the proposed rule change, as
amended.
\3\ See infra notes 29 to 33, and note 69.
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II. Background
In February 1991, the Commission approved a six month pilot
program, referred to as the CSE's Dealer Preferencing Program
(``DPP''), to modify the Exchange's priority rules to give CSE
Designated Dealers \4\ priority over same-priced professional interest
when interacting with public agency market and marketable limit
orders.\5\ Originally, the DPP contained limitations on preferencing
dealers, including restricting to 60 the number of stocks each
preferencing dealer could trade. Since the inception of the program in
1991, the Commission has approved several extensions of the pilot and
increases in the number of stocks each preferencing dealer could
trade.\6\ Currently, the DPP is approved through March 29, 1996, and
each preferencing dealer is permitted to trade up to 350 issues.
\4\ The term ``Designated Dealer'' is defined by the Exchange as
a member who maintains a minimum net capital amount and who has been
approved by the CSE's Securities Committee to perform market making
functions by entering bids and offers into the Exchange's trading
system. See CSE Rule 11.9(a)(3). In addition, the Designated Dealer
status obligates the dealer to guarantee execution of all public
agency market and marketable limit orders up to 2099 shares. For
issues in which there are more than one Designated Dealer, this
execution guarantee obligation rotates on a daily basis. See CSE
Rule 11.9(c)(iv) and (v).
\5\ See Securities Exchange Act Release No. 28866 (February 7,
1991), 56 FR 5854 (February 13, 1991).
\6\ See Securities Exchange Act Release No. 29524 (August 5,
1991), 56 FR 38160 (August 12, 1991) (extending pilot through
February 7, 1992); Securities Exchange Act Release No. 30353
(February 7, 1992), 57 FR 5918 (February 18, 1992) (increasing
number of stocks to 125 and extending pilot through August 7, 1992);
Securities Exchange Act Release No. 30809 (June 15, 1992), 57 FR
27990 (June 7, 1992) (increasing number of stocks to 250);
Securities Exchange Act Release No. 31011 (August 7, 1992), 57 FR
38704 (August 26, 1992) (extending pilot through May 7, 1993 and
increasing number of stocks to 350); Securities Exchange Act Release
No. 32280 (May 7, 1993), 58 FR 28424 (May 13, 1993) (extending pilot
through May 7, 1994); Securities Exchange Act Release No. 33975
(April 28, 1994), 59 FR 23242 (May 5, 1994) (extending pilot through
August 6, 1994); Securities Exchange Act Release No. 34493 (August
5, 1994), 59 FR 41531 (August 12, 1994) (extending pilot through May
18, 1995); Securities Exchange Act Release No. 35717 (May 15, 1995),
60 FR 26909 (May 19, 1995) (extending pilot through October 2,
1995); and Securities Exchange Act Release No. 36324 (September 29,
1995), 60 FR 52436 (October 6, 1995) (extending pilot through March
29, 1996).
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The CSE initiated the DPP to provide dealers with the ability to
retain and execute their internal order flow at the national best bid
or offer, provided that public limit orders at the same price on the
CSE book were executed first.\7\ In proposing the preferencing program,
the Exchange noted that it had attempted to increase business and
liquidity by developing the National Securities Trading System
(``NSTS''), which electronically interfaces with retail order-delivery
systems of CSE members, and had attempted to increase the number of
issues traded on the Exchange through the creation of the Designated
Dealer category of market makers, which are obligated to guarantee
execution of all public agency orders up to 2,099 shares.\8\ According
to the CSE, however, these efforts had not overcome the lack of
incentive in CSE's multiple market maker environment for firms
affiliated with CSE dealers to direct their retail order flow to the
Exchange. Unlike the specialists affiliated with order flow firms on
the other regional exchanges, who generally faced little or no market
making competition on their floors, the multiple CSE dealers were
subject to losing all or a portion of their public orders to other
[[Page 15323]]
market makers on the Exchange.\9\ Thus, the CSE believed that altering
the priority rules between professional trading interests was necessary
to bring the CSE dealers on par with other regional specialists and
consequently attract retail order flow and enhance liquidity and
efficiency on the Exchange. At the same time, the CSE continued to
protect customer orders on the Exchange's central limit order book by
requiring that such limit orders be satisfied before a dealer could
internalize same-priced customer orders and by ensuring that
internalized orders be executed at no worse than the national best bid
or offer.\10\
\7\ See Securities Exchange Act Release No. 28866, supra note 5.
\8\ T3Id.
\9\ Id.
\10\ Id.
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In approving the initial pilot program, the Commission stated that
the proposal addressed the CSE's legitimate desire to attract
additional business to the Exchange, while at the same time providing
adequate protection for public agency orders placed on the Exchange's
central limit order book.\11\ The Commission noted that the CSE
combines features of both exchange and over-the-counter markets.\12\
\11\ Id.
\12\ Id. To this end, the Commission described the CSE as
``unique among U.S. stock exchanges in that it is totally automated
and utilizes a competing market maker system.''
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During the course of the DPP pilot the Commission has been
considering whether preferencing and the increasing internalization of
order flow, and practices such as payment for order flow, are
consistent with a broker-dealer's duty to seek best execution for
customer orders. Consistent with its consideration of payment for order
flow and best execution, the Commission requested that the CSE start
providing data to show the effects of preferencing on the quality of
order execution and market making on the CSE.\13\ At the same time, the
Commission approved, on a pilot basis, a competing specialist program
on the Boston Stock Exchange (``BSE''), which also raised issues
regarding internalization of order flow.\14\
\13\ See Securities Exchange Act Release No. 34493, supra note
6. Specifically, the Commission requested that the CSE demonstrate
that preferencing added depth and liquidity to the CSE market, and
improved quotations. The Commission stated that if the CSE could not
make such a showing, the Commission would not be inclined to extend
the preferencing program. Accordingly, the CSE submitted several
reports and letters containing data that it believes makes the
required showing. See infra note 36.
\14\ See Securities Exchange Act Release No. 34078 (May 18,
1994), 59 FR 27082 (May 25, 1994). Unlike the CSE program, the BSE
competing specialist program does not alter time priority among
competing specialists quoting at the intermarket best bid or offer.
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In addition, in October 1994, the Commission adopted rules
concerning the disclosure of payment for order flow practices and the
order routing arrangements of broker-dealers receiving payment for
order flow.\15\ The Commission noted that not all market centers expose
market orders to other order flow or provide an opportunity for price
improvement for market orders. While price improvement was not the
exclusive factor for determining whether a broker-dealer was fulfilling
its duty to seek best execution, the Commission believed it important
to the inquiry, particularly when payment was received by the broker-
dealer, or when the broker-dealer internalized orders or routed orders
to affiliates.\16\
\15\ See Securities Exchange Act Release No. 34902 (October 27,
1994), 59 FR 55006 (November 2, 1994).
\16\ The Commission also is currently considering comment
received regarding a series of order handling rules it proposed last
September. See Securities Exchange Act Release No. 36310 (September
29, 1995), 60 FR 52792 (October 10, 1995).
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III. Description
The Exchange requests permanent approval of its DPP. In conjunction
with its permanent approval request, the CSE also seeks approval of
rule changes implementing new order handling policies for the purpose
of increasing order exposure and ensuring the timely execution and
display of limit orders on the CSE.
A. Dealer Preferencing
The preferencing program permits CSE dealers to retain and execute
their internal order flow at the prevailing ITS best bid or offer
(``ITS/BBO''), provided that there are no public agency limit orders on
the Exchange's central limit order book at that price or better. To
this end, the preferencing program permits CSE dealers to internalize
order flow by eliminating time priority between CSE dealers, thereby
enabling preferencing dealers to interact with public market and
marketable limit orders they represent as agent. Specifically, the
preferencing program gives preferencing dealers priority over
professional agency or principal orders entered prior in time when
interacting with a public order it represents as agent.\17\ The dealer
may interact with such orders either by (1) taking the contra-side of
the trade as principal (``paired order trade''), or (2) crossing the
order with another customer order it represents as agent (``agency
cross'').\18\
\17\ See CSE Rule 11.9(u).
\18\ The majority of agency crosses are the result of a limit
order resident in the dealer's proprietary system at the ITS/BBO,
which is matched with an incoming contra-side market order. For
example, if the ITS/BBO is 20 bid--20\1/8\ asked, and a dealer has a
limit order to buy at 20, an incoming market sell order will be
matched with that limit order because the dealer may not trade for
its own account ahead of its own customer limit order. See CSE Rule
12.6(b).
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For example, if dealer A on the CSE is quoting at the ITS/BBO,
dealer B can still internalize its order flow (even if it is not
quoting at the ITS/BBO) so long as dealer B executes the order at the
ITS/BBO (or better) and there is no contra-side public agency order on
the CSE's central limit order book at that price. If there is a public
agency limit order on the CSE's book with priority, however, NSTS will
automatically break the paired order trade and match the incoming
public agency order with the public limit order on the CSE's book.\19\
\19\ If there is a public agency order on the CSE's book, the
system rejects the dealer's principal side of the attempted cross
or, in the case of an attempted public agency cross, rejects the
agency order that is on the same side of the market as the pre-
existing order on the book.
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As noted above, in approving the initial DPP pilot, and subsequent
extensions and expansions, the Commission imposed certain limitations
and requirements on its operation. These conditions currently limit the
number of issues in which a preferencing dealer may be registered to
350; prohibit preferenced trading for index arbitrage purposes when
certain ``circuit breakers'' are in effect; \20\ and prohibit a dealer
from making cash payments for preferenced order flow. In connection
with its request for permanent approval of the DPP, the Exchange
requests that the Commission remove the limitation on the number of
stocks preferencing dealers may trade and the prohibition on cash
payments for order flow.
\20\ Specifically, the index arbitrage restriction permits
preferencing dealers to preference their customer order flow that is
related to index arbitrage only on plus or zero plus ticks when the
Dow Jones Industrial Average (``DJIA'') declines by fifty points or
more from the previous day's closing value. See Securities Exchange
Act Release No. 28866, supra note 5.
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B. Order Handling Policies for Preferencing Dealers
The CSE also seeks approval for three rule changes related to the
handling of customer orders on the Exchange. Generally, these
requirements are designed to increase order exposure and ensure the
timely execution and display of limit orders held by CSE dealers.
First, the Exchange proposes to adopt Interpretation and Policy .01
to CSE Rule 11.9(u) regarding price improvement of certain market
orders. This policy would require that, in greater than minimum
variation markets, a preferencing dealer
[[Page 15324]]
immediately execute market orders routed to him or her for execution on
the CSE at an improved price or expose the orders on the Exchange for a
minimum of thirty seconds to give other market participants an
opportunity to provide an improved price.\21\ A preferencing dealer may
expose a market order by representing the orders at an improved price
in his or her CSE quote, or by placing the order on the CSE's central
limit order book at an improved price.\22\ This requirement, however,
will not be imposed upon members during unusual market conditions or if
such action would not be in the best interest of the customer.\23\
\21\ When exposing a market order on the Exchange for price
improvement, a dealer stops the order to guarantee that the customer
receives the then current best market price in the event that the
order does not receive price improvement. The Commission has
proposed a rule requiring that all market orders receive an
opportunity for price improvement. See Securities Exchange Act
Release No. 36310, supra note 16. The CSE order exposure policy
would be superseded by any final rule adopted by the Commission to
the extent that the Commission's rule imposed greater obligations on
market participants.
\22\ A dealer that represents an order in its CSE quote does not
enter a public agency order into NSTS. Thus, representing an order
in the dealer's quote would not result in the order being
automatically matched with other orders in NSTS, such as with paired
order trades entered by CSE preferencing dealers. However, if the
customer limit order is at a price that is better than the ITS/BBO,
inclusion in the CSE dealer's quote will narrow the market in that
security.
\23\ This provision is intended to apply to unusual market
conditions (e.g., fast moving markets) and situations where it would
be inconsistent with a preferencing dealer's best execution duty to
expose the order. Conversation between David Colker, Executive Vice
President and Chief Operating Officer, CSE, and N. Amy Bilbija, SEC,
on August 14, 1995.
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Second, the Exchange proposes to adopt Interpretation and Policy
.02 to CSE Rule 11.9(u) regarding public agency limit order protection.
Under this policy, a public agency limit order routed to a CSE dealer
for execution on the CSE would be filled if (i) the bid or offer at the
limit price has been exhausted in the primary market; (ii) there has
been a price penetration of the limit order in the primary market; or
(iii) the issue is trading at the limit price on the primary market
unless it can be demonstrated that such order would not have been
executed if it had been transmitteed to the primary market or the
customer and the Designated Dealer agree to a specific volume related
or other criteria for requiring execution of limit orders.\24\ This
policy is designed to ensure that limit orders routed to CSE dealers
for execution on the CSE receive timely executions relative to same-
priced limits orders on the primary markets, and is therefore referred
to as ``primary market print protection.'' \25\
\24\ In unusual trading situations, a Designed Dealer may seek
relief from these requirements from two Trading Practices Committee
members or a designated member of the Exchange staff who would have
the authority to set execution parameters.
\25\ The Commission notes that the Chicago Stock Exchange and
Boston Stock Exchange currently have nearly identical primary market
print protection policies. See CHX Rules, Article XX, Rule 37(a);
and BSE Rules, Chapter II, Section 33, Interpretations and Policies
.01.
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Finally, the Exchange proposes to amend Interpretation and Policy
.01 to CSE Rule 12.10 regarding the handling of public agency limit
orders priced either at or between the ITS/BBO. The policy currently
requires that a CSE dealer display all or a representative portion of
such orders in the national market system unless the order is executed
immediately or the customer requests that it not be displayed.\26\
Under the amended rule, a CSE dealer must display on the CSE all or a
representative portion of public limit orders that he or she represents
as agent for execution on the CSE, unless the order is executed
immediately or the customer requests that it not be displayed.\27\ A
dealer may satisfy this requirement by representing limit orders in his
or her CSE quote, or by placing the agency orders (or a representative
portion) on the CSE's central limit order book.\28\ In addition, if a
representative portion of an order is executed, the CSE dealer must
display all or a representative portion of the remainder of the order
until the order is filled in its entirety.
\26\ The Commission also has proposed a similar limit order
display rule for all markets. Accordingly, the CSE limit order
display policy would be superseded by any final rule adopted by the
Commission to the extent that the Commission's rule imposed greater
obligations on market participants. See Securities Exchange Act
Release No. 36310, supra note 16.
\27\ If the limit order is for 500 shares or fewer, a dealer
must display the entire order. If the limit order is for more than
500 shares, a dealer must display at least 500 shares, but is not
required to display the entire order. Conversation between David
Colker, Executive Vice President and Chief Operating Officer, CSE,
and N. Amy Bilbija, SEC, on August 14, 1995. The Commission notes
that the rule applies to all CSE dealers, not only preferencing
dealers.
\28\ See supra note 22.
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IV. Summary of Comments
The Commission received 18 comment letters from a total of 13
commenters. Eleven of the commenters opposed the DPP and requested that
the Commission disapprove the CSE's request for permanent approval of
the program. The Commission received comment letters from the New York
Stock Exchange (``NYSE''),\29\ Boston Stock Exchange (``BSE''),\30\
American Stock Exchange (``Amex''),\31\ and The Specialist
Association,\32\ as well as from other interested parties.\33\ The
commenters that opposed the continuation of preferencing generally
raised similar concerns regarding the practice of preferencing. As
discussed below, these commenters asserted that preferencing, and the
resulting internalization of order flow (1) decreases order interaction
on the CSE, which negatively affects order execution quality, and (2)
detrimentally affects the quality of the CSE market and the broader
market.\34\ In addition, the NYSE
[[Page 15325]]
commented on the CSE's proposed order handling policies.\35\ The CSE
submitted several letters in response to the comments and provided data
requested by the Commission.\36\
\29\ See letters from James E. Buck, Senior Vice President and
Secretary, NYSE, to Jonathan Katz, Secretary, SEC, dated March 16,
1995 (``NYSE Letter No. 1''); Daniel Park Odell, Assistant
Secretary, NYSE, to Jonathan Katz, Secretary, SEC, dated April 5,
1995 (``NYSE Letter No. 2''); and James E. Buck, Senior Vice
President and Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC,
dated September 5, 1995 (``NYSE Letter No. 3''). In addition, the
NYSE submitted several comment letters regarding prior extensions of
the CSE's preferencing program.
\30\ See letter from John Fitzgerald, Executive Vice President,
BSE, to Howard Kramer, Associate Director, Division of Market
Regulation, SEC, dated March 24, 1995 (``BSE Letter'').
\31\ See letter from James Duffy, Executive Vice President and
General Counsel, Amex, to Jonathan Katz, Secretary, SEC, dated April
20, 1995 (``Amex Letter'')
\32\ See letters from David Humphreville, Executive Director,
The Specialist Association, to Jonathan Katz, Secretary, SEC, dated
April 3, 1995 (``Specialist Association Letter No. 1''); and July
27, 1995 (``Specialist Association Letter No. 2'').
\33\ See letter from The Honorable Thomas J. Bliley, Jr.,
Chairman, Committee on Commerce, U.S. House of Representatives, and
The Honorable Jack Fields, Chairman, Subcommittee on
Telecommunications and Finance, U.S. House of Representatives, to
Arthur Levitt, Jr., Chairman, SEC, dated July 6, 1995 (supporting a
disclosure approach to regulation of broker order routing
practices); letter from The Honorable Alfonse M. D'Amato, Chairman,
Committee on Banking Housing and Urban Affairs, United States
Senate, to Arthur Levitt, Jr., Chairman, SEC, dated July 17, 1995
(opposing preferencing); letter from The Honorable John D. Dingell,
Ranking Member, Committee on Commerce, U.S. House of
Representatives, to Arthur Levitt, Jr., Chairman, SEC, dated June
28, 1995 (``Dingell Letter'') (opposing preferencing); letter from
The Honorable Dan Frisa, U.S. House of Representatives, to Arthur
Levitt, Jr., Chairman, SEC, dated August 9, 1995 (opposing
preferncing); letters from Paula Gavin, Chair, NYSE Individual
Investors Advisory Council, to Arthur Levitt, Jr., Chairman, SEC,
dated July 17, 1995, and October 2, 1995 (opposing preferencing);
letter from Thomas E. O'Hara, Chairman, Board of Trustees, National
Association of Investors Corporation, to Arthur Levitt, Jr.,
Chairman, SEC, dated September 20, 1995 (opposing preferencing);
letter from Wayne F. Haefer, to Arthur Levitt, Jr., Chairman, SEC,
dated September 20, 1995 (opposing preferencing); and letter from
Bruce B. Johnson, for Otten, Johnson, Robinson, Neff & Ragonetti,
P.C., to Arthur Levitt, Jr., Chairman, SEC, dated October 5, 1995
(opposing preferencing).
\34\ The NYSE attempted to evaluate preferencing by constructing
a program, using data from the Consolidated Tape (``CT''),
Consolidated Quotation System (``CQS''), and ITS, to identify paired
order trades (``POTs'') occurring on the CSE. A POT was defined as a
trade printed on the CSE that was not the result of interaction with
the existing CSE quote, e.g., not a trade between two distinct CSE
members. The NYSE included analysis for five consecutive trading
days in March 1995. See NYSE Letter No. 2, supra note 29.
\35\ See NYSE Letter No. 3, supra note 29.
\36\ See letters from David Colker, Executive Vice President and
Chief Operating Officer, CSE, to Arthur Levitt, Jr., Chairman, SEC,
dated January 18, 1995 (``CSE Letter No. 1''); Jonathan Katz,
Secretary, SEC, dated April 26, 1995 (``CSE Letter No. 2''), and
June 14, 1995 (``CSE Letter No. 3''); Brandon Becker, Director,
Division of Market Regulation, SEC, dated June 19, 1995 (``CSE
Letter No. 4''); Richard Lindsey, Director, Division of Market
Regulation, SEC, dated January 31, 1996 (``CSE Letter No. 5'').
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A. Order Execution Quality
Several commenters asserted that the alteration of priority rules
to facilitate internalization discourages interaction between dealers
and among customer orders in the CSE market.\37\ Specifically,
commenters stated that preferencing discourages interdealer competition
on the CSE and, as a result, the CSE functions as a mere facility by
which its members can receive a print for an exchange execution for
internalized trades.\38\ The NYSE asserted that, as a result of
preferencing, there are multiple proprietary trading systems within the
CSE market wherein CSE members can internalize order flow with minimal
probability of that order flow interacting with the orders of other CSE
members.\39\ In response, the CSE indicated that an average of 8,000
trades per month result from interaction between CSE dealers.\40\ In
addition, the CSE believes interdealer activity has been increasing due
to efforts by the Exchange to encourage quote competition among its
dealers.\41\
\37\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra
note 30; Amex Letter, supra note 31; and Specialist Association
Letters Nos. 1 and 2, supra note 32.
\38\ See NYSE Letters Nos. 2 and 3, supra note 29; and
Specialist Association Letter No. 2, supra note 31. The NYSE claimed
that a total of 87.7% of CSE executions were POTs. Further, the NYSE
asserted that in a subset of securities in which there were only
preferencing dealers, 94.2% of all trades were POTs. The NYSE
asserted that only 4.8% of CSE trades could be characterized as
trades between CSE dealers.
\39\ See NYSE Letter No. 2, supra note 29.
\40\ See CSE Letter No. 1, supra note 36.
\41\ Id. In January 1994, the Exchange proposed quoting
parameters that would require dealers to maintain quotation spreads
that are no wider than 125% of the three narrowest ITS quotations.
As a result, in some circumstances, dealers would be required to
maintain quotes that match at least one side of the ITS/BBO. In
addition, the Exchange proposed to prohibit the use of computer-
generated quotations that track the primary market quotation.
Although the rule proposal has not yet been approved by the
Commission, the CSE maintains that many of its dealers began to
comply with these quoting policies voluntarily in January 1994. See
File No. SR-CSE-95-01.
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Commenters asserted that because preferencing provides a
disincentive for interdealer competition, customer orders are denied
the opportunity to interact with other trading interest in the
market.\42\ Several commenters further stated that preferencing
undermines the proper price discovery and market transparency functions
of the agency auction market and makes best execution of customer
orders less likely.\43\ In this regard, commenters asserted that
preferencing makes it more profitable for dealers to internalize orders
by maintaining limit orders on their internal proprietary systems until
they become marketable, rather than placing them on the Exchange's
central limit order book where they would be displayed and have an
opportunity to interact with other customer orders.\44\ In addition,
commenters charged that because orders on the CSE's central limit order
book must be satisfied before a dealer can internalize orders at the
same price, it is to the advantage of dealers that seek to internalize
customer order flow to discourage the placing of limit orders on the
CSE's book.\45\ As a result, the commenters maintained that there are
relatively few, if any, limit orders sent to the CSE's book.\46\
\42\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra
note 30; Amex Letter, supra note 31; and Specialist Association
Letters Nos. 1 and 2, supra note 32. See also comment letters cited
supra note 33 that opposed preferencing
\43\ See Amex Letter, supra note 31; and Specialist Association
Letters No. 1, supra note 32. See also comment letters cited supra
note 33 that oppose preferencing.
\44\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra
note 30; Amex Letter, supra note 31; and Specialist Association
Letters Nos. 1 and 2, supra note 32.
\45\ See NYSE Letter No. 2, supra note 29; BSE Letter, supra
note 30; Amex Letter, supra note 31.
\46\ Id.
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The CSE stated that is has encouraged dealers to place limit orders
on the NSTS book, but that no exchange has the authority to dictate
firm order handling practices by requiring that firms place their limit
orders in the exchange's book.\47\ The NYSE believes, however, that
while the CSE lacks the authority to dictate that its preferencing
dealers enter limit orders on the CSE, the CSE could require firms to
route a mix of order types to CSE preferencing dealers.\48\
\47\ The CSE reported that in the first quarter of 1995, 2104
preferenced orders interacted with pre-existing public agency limit
orders on the CSE's book. See CSE Letter No. 4, supra note 36. The
CSE reported that in the fourth quarter of 1995, 4802 preferenced
orders interacted with agency limit orders on the CSE's book. See
CSE Letter No. 5, supra note 36. As described above, the CSE is
proposing to require dealers to display their limit orders by either
placing the orders on the Exchange's central limit order book, or
representing the orders in their CSE quote.
\48\ The NYSE states as an example that the CSE could require
dealers to route the same ratio of market orders and limit orders to
the CSE. See NYSE Letter No. 2, supra note 29.
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With respect to market order exposure, the CSE maintained that the
rate of price improvement on the Exchange compares favorably to other
exchanges. The CSE asserted that 59% of CSE executions in greater than
minimum variation markets were printed between the ITS/BBO in the
fourth quarter of 1995, and that an additional 4% of the orders
received price improvement after being exposed at prices that narrowed
the ITS/BBO.\49\ The NYSE asserted that the CSE does not compare
favorably to the other exchanges and reported that only approximately
45% of the executions on CSE occur between the ITS/BBO.\50\ Finally,
the NYSE noted that the CSE is the only exchange that does not have
rules requiring members, when trading as principal with an agency
order, to publicly cross the order in the market and quote the agency
order 1/8 better so as to permit other members to improve the
price.\51\
\49\ See CSE Letter No. 5, supra note 36. In addition, the CSE
reported that for the first quarter of 1995, 57% of CSE executions
in greater than minimum variation markets were executed between the
ITS/BBO, and that an additional 3% of the orders received price
improvement after being exposed at prices that narrowed the ITS/BBO.
See CSE Letter No. 4, supra note 36.
\50\ See NYSE Letter No. 2, supra note 29. Based on its own
analysis, the NYSE asserted that during the month of December 1994,
CSE's rate of price improvement was 48.7% in 1/4 point markets, 48%
in 3/8 point markets, and 37.7% in 1/2 point markets. The NYSE also
stated that, contrary to the CSE's contention, price improvement is
possible in minimum variation markets and that 17.6% of NYSE
SuperDot market orders receive price improvement in 1/8 point
markets. Id. The BSE also measures price improvement in minimum
variation markets, and maintains that it provides price improvement
approximately 4% of the time when the ITS/BBO spread is 1/8 point.
See BSE Letter, supra note 30.
\51\ See NYSE Letter No. 2, supra note 29. As described above,
the CSE is proposing to require dealers to either execute market
orders in greater than minimum variation markets between the spread,
or expose the orders for 30 seconds to give other market
participants an opportunity to provide price improvement.
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B. Market Quality
Several commenters asserted that the Commission should not
permanently approve the DPP because the CSE has not demonstrated that
preferencing results in added depth and liquidity to its market, nor
improved quotations.\52\
[[Page 15326]]
The NYSE and BSE asserted that the existence of preferencing dealers in
an issue actually diminishes the quality of the CSE quotes.\53\ In
evaluating whether preferencing dealers add to the quality of the CSE
market, the NYSE believes that preferenced trade activity should not be
considered.\54\ Rather, the NYSE believes that the measure of a
preferencing dealer's contribution to the market is whether it
maintains quotations and handles order flow that interacts with other
CSE members and market participants.\55\ As discussed above, the NYSE
estimated that approximately 88% of CSE trades are executed without
interaction between CSE members.\56\ In addition, the NYSE believes
that ITS inbound activity is an indication of competitive quoting, in
that quotes at the ITS/BBO draw orders to trade on the CSE from other
markets. In this regard, the NYSE asserted that the percentage of CSE
trades in a stock involving orders from other market participants
(i.e., ITS inbound activity) decreased as the number of preferencing
dealers in an issue increased.\57\ Similarly, the BSE argued that the
percentage of ITS inbound activity attributable to preferencing dealers
should be higher in proportion to the number of trades and shares they
execute on the CSE.\58\
\52\ See NYSE Letters Nos. 2 and 3, supra note 29; BSE Letter,
supra note 30; Amex Letter, supra note 31; Specialist Association
Letters Nos. 1 and 2, supra note 32; and Dingell Letter, supra note
33. The commenters note that the Commission requested that the CSE
demonstrate that preferencing added depth and liquidity to its
market, improved quotations, and generally had a beneficial
competitive effect on the national market system. See Securities
Exchange Act Release No. 34493, supra note 6.
\53\ See NYSE Letter No. 2, supra note 29; and BSE Letter, supra
note 30.
\54\ The CSE maintains, however, that the preferencing program
has provided additional depth and liquidity for a substantial amount
of public order flow, and that it is therefore appropriate for the
Commission to include preferenced trade activity in its analysis.
See CSE Letter No. 3, supra note 36.
\55\ See NYSE Letter No. 2, supra note 29. See also BSE Letter,
supra note 30 (asserting that CSE dealers do not trade at their
displayed quotes); and infra note 60.
\56\ See NYSE Letter No. 2, supra note 29. The NYSE maintained
that for stocks in which there were only preferencing dealers, 94%
of the trades were POTs. The NYSE asserted that this data evidenced
that the CSE is being used by its members as a printing mechanism
for their own pre-arranged trades.
\57\ The NYSE reported that, as a percentage of total trades,
ITS inbound trades were 5.8% for stocks with one preferencing
dealer, 3.8% for stocks with two preferencing dealers, and 2.5% for
stocks with three preferencing dealers. In contrast, the NYSE
reported that in stocks with both preferencing and non-preferencing
dealers ITS inbound trades were 7.7% of total trades. The NYSE also
asserted that a single non-preferencing CSE dealer had more ITS
inbound activity than the combined total of the 9 preferencing
dealers during the week studied. See NYSE Letter No. 2, supra note
29.
\58\ See BSE Letter, supra note 30.
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The CSE maintained that preferencing dealers add depth and
liquidity to the market through quotes at the ITS/BBO. In its initial
report, the CSE analyzed its average quote spread, average quote size,
the relation of CSE quotes to the ITS/BBO, total trade activity, ITS
inbound trade activity, and customer order price improvement.\59\ In
every category the CSE reported that its performance either equaled or
exceeded the other regional exchanges.\60\ Several commenters noted
that the CSE's data included all dealers on the CSE and asserted that
inclusion of non-preferencing dealers improved the overall results.\61\
In response, the CSE submitted an analysis that isolated the trading
activity of preferencing dealers in the above categories, and reported
that their performance also equaled or exceeded the other regional
exchanges.\62\ Most recently, the CSE reported that 71% of the CSE's
quotations match at least one side of the ITS/BBO,\63\ and that the CSE
was responsible for generating 6% of all quotes that established a new
ITS/BBO.\64\
\59\ See CSE Letter No. 1, supra note 36.
\60\ See id. The BSE noted that the CSE's data showed that the
BSE's average size for quotes at the ITS/BBO (1,325 shares) far
exceeded that of the CSE (700 shares). While the CSE data also
indicated that the BSE only quotes at the ITS/BBO 5% of the time
compared to approximately 71% for the CSE, the BSE asserts that CSE
dealers do not trade at their quotes and that the size of CSE quotes
is therefore meaningless. See BSE Letter, supra note 30.
\61\ See NYSE Letter No. 2, supra note 29; and BSE Letter, supra
note 30.
\62\ See CSE Letter No. 3, supra note 36. The CSE reported that
for a subset of 237 stocks in which there were only preferencing
dealers (1) the average quotation spread was \1/4\ point, which the
CSE reported was narrower than any other regional exchange, (2) 60%
of their quotes matched one or both sides of the ITS/BBO, while none
of the other exchanges exceeded 30%; and (3) the CSE generated 4% of
all quotes that established a new ITS/BBO, which exceeded the
performance of all other regional exchanges. The CSE also asserted
that it had the highest average quote size (700 shares) of any
regional stock exchange in the 237 stocks. The CSE asserted that the
depth provided by preferencing specialists when their quotes
establish or match the ITS/BBO actually contributed more depth to
the national market than all the other regional exchanges when
viewed in conjunction with the lower rates at which the regional
exchanges quote at the ITS/BBO. The CSE also maintained that
preferencing dealers executed almost half of all ITS inbound
activity in those issues that have at least one preferencing dealer,
and that preferencing dealers' ITS/total trade ratio of 3.5%
compared favorably to the NYSE's ITS/total trade ratio of 2.8%.
\63\ See CSE Letter No. 5, supra note 36 (data from fourth
quarter 1995). The CSE reported that in the first quarter of 1995
73% of the CSE quotes matched at least one side of the ITS/BBO. See
CSE Letter No. 4, supra note 36.
\64\ See CSE Letters No. 4 and 5, supra note 36.
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Several commenters asserted, however, that any liquidity that may
be provided by the CSE is artificial due to the inaccessibility of the
CSE's quotes.\65\ Commenters charged that CSE quotes change too quickly
for other market participants to have a meaningful opportunity to send
ITS orders to the CSE.\66\ Commenters believe that the rapid quote
changes are caused by a combination of multiple dealers in the single
market and the use by some CSE dealers of automated systems that
generate quotations.\67\ The CSE maintained, however, that its
cancellation rate is not increased by computer-generated quotations,
and that 87% of quote changes that result in cancellations are
displayed to other market participants for over one minute.\68\
\65\ See NYSE Letter No. 1, supra note 29; BSE Letter, supra
note 30; Amex Letter, supra note 31; and Specialist Association
Letter No. 1, supra note 32.
\66\ See NYSE Letter Nos. 1 and 2, supra note 29; BSE Letter,
supra note 26 (incorporating by reference letter from John I.
Fitzgerald, Executive Vice President, BSE, to Jonathan G. Katz,
Secretary, SEC, dated April 29, 1994); and Amex Letter, supra note
31.
\67\ Id.
\68\ The CSE analyzed 2,626 CSE ITS cancellations that occurred
on eight randomly chosen trading days between August 4, 1994, and
January 13, 1995. The CSE concluded that, of the total cancellations
analyzed, 4% were caused by erroneous pricing, 9% were the result of
``fishing,'' and 22% were the result of stock having traded prior to
receipt of the ITS commitment. The remaining cancellations were due
to the CSE's quote changing before the commitment to trade was
received by the CSE system. In this regard, the CSE asserts that 87%
of the quotes that changed prior to receipt of ITS commitments to
trade had been displayed for more than one minute, and more than 50%
of these quotes had been displayed for over five minutes. See CSE
Letter No. 2, supra note 36.
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Finally, the Commission received two preliminary drafts of an
academic paper from Indiana University that studies the short term
effects of preferencing on market quality (``IU Study'').\69\ The IU
Study looked for potential shifts in market share, bid/ask spreads, and
liquidity premiums \70\ for 256 securities that the authors believed
were preferenced during the entire pilot (1991-1995). The IU Study's
preliminary results indicated that, while internalization results in
significant volume redistribution, the preferencing program does not
appear to have had an adverse effect on the measures of market
quality.\71\ The IU study noted, however,
[[Page 15327]]
that to the extent that retail brokers internalizing trades reduce (or
even eliminate) commissions, investor welfare is improved.
\69\ See letter from Robert Jennings, Faculty Fellow and
Professor of Finance, Indiana University School of Business, to
Jonathan Katz, Secretary, SEC, dated June 30, 1995; and letter from
Robert Battalio, Assistant Professor, University of Notre Dame, to
Jonathan G. Katz, Secretary, SEC, dated March 6, 1996.
\70\ The liquidity premium measures the closeness of transaction
prices to the mid-point of the quotation spread. Thus, a decrease in
the liquidity premium indicates that transaction prices have moved
closer to the mid-point of the spread.
\71\ Although the IU Study found that spreads and liquidity
premiums decreased, because of the long time intervals involved, the
study noted that it could not rule out a general decreasing trend in
these measures.
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In this regard, the CSE asserted that its efficient electronic
environment, coupled with the ability of member firms to become
specialists in a larger number of desirable stocks than is feasible on
other exchanges, results in cost efficiencies that flow through to
customers.\72\ Some commenters, however, maintained that there is no
evidence to indicate that the purported efficiencies from
internalization are passed along to the CSE dealers' customers.\73\
\72\ See CSE Letter No. 1, supra note 36.
\73\ See NYSE Letter No. 2, supra note 29; and BSE Letter, supra
note 30. The Specialist Association cites to a draft article by
professors Huang and Stoll of the Owen Graduate School of Management
that concludes that internalization and preferencing in the over-
the-counter market limit the incentive of market participants to
narrow spreads, with the result that Nasdaq execution costs are
twice NYSE costs. The Specialist Association concludes that the same
result occurs on the CSE. See Specialist Association Letter 2, supra
note 32 (citing Huang and Stoll, Dealer Auction Markets: A Pencil
Comparison of Execution Costs on NASDAQ and the NYSE (June 6, 1995)
(draft article)).
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C. Order Handling Policies for Preferencing Dealers
As described above, the CSE also proposed policies regarding order
exposure and limit order protection for preferencing dealers. The NYSE
criticized the order exposure portion of the proposed order handling
policies, and stated that these policies will not provide meaningful
benefits to investors or to the market in general. Specifically, the
NYSE maintained that the proposed order exposure requirement will
affect as few as 8% of preferenced orders.\74\ The NYSE further
asserted that, while some customer orders may receive price improvement
as a result of the policy, preferencing dealers will continue to have
an opportunity to trade against the order at the improved price,
negating the opportunity for two customer orders to meet without dealer
intervention. The NYSE also asserted that even if CSE dealers expose
orders for 30 seconds, the short duration of the exposure is unlikely
to provide other market participants sufficient time to trade with
those orders.\75\
\74\ The NYSE states that only approximately 15% of preferenced
trades occur in markets with a quotation spread that is greater than
the minimum variation, and that according to the CSE, dealers
already trade between the ITS/BBO 55% of the time. Thus, NYSE
concludes that the order exposure rule would apply to only 8% of the
order handled by preferencing dealers. See NYSE Letter No. 3, Supra
note 29.
\75\ The NYSE believes that the 30 seconds mandated for order
exposure could lead to an increase in the CSE's ITS cancellation
rate. Id.
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V. Commission Data
As discussed above, the Commission received substantial data from
commenters and the CSE. The various studies result in differing
conclusions regarding the quality of executions achieved on the CSE by
preferencing dealers, as well as the quality of the CSE market. In
response to the differing assertions made by the commenters and the
CSE, the Commission's Office of Economic Analysis (``OEA'') evaluated
CSE quotations and transactions. In considering the CSE trade and
quotation data, the OEA distinguished between the trading activity of
preferencing versus non-preferencing dealers.
During the period considered, preferencing dealers accounted for
more than 90% of trades and two-thirds of share volume on the CSE. The
281 stocks where preferencing dealers accounted for 80% to 99% of total
CSE trades were the most actively traded stocks on the CSE.
The data analyzed by the OEA also showed that CSE preferencing
dealers often matched the NYSE BBO, and that the percentage of time
that the CSE quotes matched those on the NYSE was greatest for those
stocks in which preferencing takes place. Specifically, for the 281
stocks in which preferencing dealers accounted for 80% to 99% of total
CSE trades, the CSE quote on average matched the NYSE best bid
approximately 54% of the time and the NYSE best offer nearly 61% of the
time. When matching at least one side of the ITS/BBO, the CSE's
quotation depth in these 281 stocks averaged over 720 shares. For all
quotes in the 281 stocks, the CSE quotation depth averaged close to 900
shares.
VI. Discussion
The Commission has considered carefully the issues presented by the
CSE's preferencing program, including its potential effects on the
execution of customer orders, competition between markets, and CSE
market quality. In particular, the Commission considered carefully the
commenters' concerns regarding the alteration of time priority, the
lack of order interaction on the CSE, and the impact on public
customers and the quality of the CSE market. Similarly, the Commission
has reviewed the CSE's findings that the DPP has increased the CSE's
market share without affecting the quality of its markets or execution
of customer orders.
The DPP has proven to be a competitive benefit to the CSE. In
addition, after analyzing substantial data provided by the CSE and
commenters, as well as conducting its own data collection and
examination, the Commission believes that the DPP also has improved CSE
quotations, and has added to the depth and liquidity of the CSE market.
In addition, the Commission believes that the DPP, as supplemented by
the adoption of policies related to the handling of customer orders, is
not necessarily inconsistent with best execution of customer orders.
For these reasons, discussed more fully below, the Commission believes
that the proposed rule change, as amended, is consistent with the
requirements of the Act and the rules and regulations thereunder
applicable to a national securities exchange. In particular, the
Commission believes that the proposal is consistent with Section
6(b)(5) of the Act,\76\ which requires, among other things, that the
rules of an exchange be designed to promote just and equitable
principles of trade and to perfect the mechanism of a free and open
market and a national market system and to protect investors and the
public interest. The DPP, as amended, also is consistent with Section
11A of the Act,\77\ which generally promotes, among other things, the
development of a national market system for securities to assure
economically efficient execution of securities transactions and fair
competition among brokers and dealers, among exchange markets and
markets other than exchange markets.
\76\ 15 U.S.C. Sec. 78f(b).
\77\ 15 U.S.C. Sec. 78k-1.
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The Commission supports efforts by exchanges to provide increased
liquidity and competition on their trading floors or trading systems.
Such efforts can enhance market quality and enable exchanges to compete
more effectively for order flow. The CSE's preferencing program was
designed to attract more market making and order flow to the Exchange,
and it is apparent from the data that the DPP has led to a substantial
increase in the CSE's trading volume.\78\ At the same time, the
Commission has been very concerned about the market structure issues
presented by internalization of order flow and its potential effect on
the handling of customer orders and the ability of broker-dealers to
fulfil their duty to seek best execution of customer orders.
Accordingly, in scrutinizing the CSE's preferencing pilot, including
the numerous comment letters, the Commission has considered, among
other things, preferencing's effect on achievement of economically
efficient execution of securities transactions, fair competition among
brokers and dealers
[[Page 15328]]
and among exchange markets, as well as the practicability of brokers
executing investors' orders in the best market.
\78\ See CSE Letters, supra note 36.
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Although preferencing enables CSE dealers to internalize order
flow, the CSE's unique system is not necessarily inconsistent with a
broker-dealer's duty to seek best execution of customer orders.\79\
Dealers preference their customer order flow on the CSE by matching
themselves with a customer order and sending a paired trade priced at
or between the ITS/BBO to NSTS for execution. Upon receiving the paired
order, NSTS replaces the preferencing dealer's side of the trade if
there are any public agency orders at the same price on the CSE's
central limit order book. If there are no such public agency orders,
the paired trade is executed, regardless of dealer quotes resident in
the system. In this manner, the preferencing program protects customer
limit orders entered into NSTS while permitting broker-dealers to
retain their own customer order flow where those orders would have
otherwise been executed by another broker-dealer. Accordingly,
preferencing alters the pre-existing CSE time priority rule that
determines which broker-dealer is entitled to execute a customer order
in favor of the broker-dealer that brought the order flow to the CSE.
\79\ See Securities Exchange Act Release No. 28866, supra note
5. The CSE's NSTS system was designed to centralize the trading
interest of geographically dispersed dealers by consolidating and
disseminating the dealers' quotations, and providing a central limit
order book for orders entered by the multiple dealers. Thus, the
NSTS system provides a central location for CSE dealers to interact
in a manner similar to a traditional exchange trading floor.
Preferencing, however, suspends time priority between professional
trading interest so that the multiple CSE dealers can execute their
own customer orders without interruption by other dealers and is
more akin to trading in the over-the-counter markets.
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Several commenters express concern, however, that the ability of
dealers to maintain and execute their order flow without interruption
from other professionals trading on the CSE provides an incentive for
dealers to delay sending limit orders to the Exchange until they are
marketable,\80\ and that all orders on the CSE are thereby deprived of
the benefits accruing from order interaction. In this regard, the
Exchange is adopting policies for the display and timely execution of
limit orders held by preferencing dealers. Under the policies, a
preferencing dealer will be required to display limit orders he or she
represents as agent priced at or better than the ITS/BBO on the CSE
\81\ and to execute such limit orders in a timely manner relative to
executions on the primary market.\82\
\80\ See supra note 44.
\81\ As described above, see id., CSE dealers may display limit
orders by either representing the orders in their CSE quotes or
placing the orders on the CSE's central limit order book.
\82\ Any preferencing dealer that failed to display limit orders
or provide timely executions as required by these policies would
violate CSE rules and would violate CSE rules and would be subject
to disciplinary action by the Exchange.
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The Commission believes that these limit order policies should
promote order interaction on the CSE through improved quotations and
increased volume on the Exchange's central limit order book, as well as
add to the quality of information displayed to the national market
system. The Commission notes, however, that the limit order display
policy permits a CSE dealer to display orders in his or her quotes,
rather than placing a customer limit order in NSTS where it would have
the opportunity to interact with customer orders from other CSE
dealers. The holding of customer limit orders that are routed to a CSE
dealer for execution on the Exchange outside of the NSTS system raises
concerns regarding whether such order handling practices are consistent
with a CSE dealer's best execution obligations. A CSE dealer that
chooses to represent a customer limit order in his or her dealer quote
instead of on the CSE's central limit order book must ensure that the
customer is not disadvantaged as a result of that decision.
Representing a limit order in his or her quote, rather than placing a
limit order in the NSTS system where it can be matched with customer
orders from other CSE dealers, places an obligation on the CSE dealer
to monitor executions on the CSE to ensure that the limit order
receives an appropriate execution.
While preferencing, and the resulting internalization of order flow
by broker-dealers, may reduce order interaction on the CSE,
preferencing does not inhibit dealers from executing customer orders
between the ITS/BBO spread, nor from executing customer buy orders at
the ITS best bid and sell orders at the ITS best offer. In this regard,
the CSE reported that CSE executions in greater than minimum variation
markets receive price improvement at a rate that is comparable to that
of the NYSE.\83\ Moreover, the CSE is adopting an order handling policy
designed to give market orders an opportunity for price improvement
through exposure on the CSE and to the national market system.\84\
Under this policy, in greater than minimum variation markets,
preferencing dealers will be required to immediately execute market
orders at an improved price, or expose the orders to other market
participants for an opportunity for price improvement.\85\ Accordingly,
these market orders cannot be internalized by a CSE dealer without
first receiving an improved price or the opportunity for price
improvement.
\83\ See CSE Letters Nos. 3, 4, and 5, supra note 36.
\84\ Market orders exposed on the CSE will also be exposed to
the national market system through the CSE's consolidated quote.
\85\ Any preferencing dealer that failed to expose market orders
as required by the policy would violate CSE rules and would be
subject to disciplinary action by the Exchange.
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Although the data indicates that the quality CSE preferencing
dealers' market making is presently comparable to other markets, the
Commission recognizes that this quality relative to other markets may
change over time. The Commission will periodically review the practices
of broker-dealers that internalize order flow through the CSE's
preferencing program. If a deterioration in the performance of
preferencing dealers were evident, the Commission would consider
whether the CSE would need to reinstitute time priority between dealer
quotes on the CSE, or take other actions to improve the quality of
market making on the CSE.
Furthermore, while the CSE's order handling policies and the data
described in this order lead us to conclude that preferencing on the
CSE is not necessarily inconsistent with a broker-dealer's duty to seek
best execution, the Commission recognizes that CSE execution quality
is, nevertheless, in large part dependent on the diligence of CSE
members in handling customer orders. While this is true of all markets,
it is of particular significance in markets where dealers execute
customer orders as principal. It is therefore incumbent on the CSE,
\86\ as well as the Commission in its oversight capacity, to ensure
that CSE members provide best execution of customer orders.
\86\ At a minimum, the Commission would expect the CSE, as with
any self-regulatory organization, to conduct regular, comprehensive
surveillance of the execution quality provided by its members.
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In this regard, the Commission's recent order routing disclosure
requirements \87\ and its proposed order handling rules \88\ signal a
renewed emphasis on the important of price improvement opportunities in
connection with the duty to seek best execution. As the Commission has
noted, while an automated order routing environment is not necessarily
inconsistent with the achievement of best executive, broker-dealers
choosing where to automatically route orders must assess periodically
the quality of
[[Page 15329]]
competing markets to assure that order flow is directed to markets
providing the most advantageous terms for their customers' orders.\89\
Consequently, a broker-dealer may not simply employ default order
routing to an affiliated CSE dealer without undertaking such an
evaluation on an ongoing basis. A broker-dealer sending orders to the
CSE must satisfy itself that its routing decision is consistent with
its best execution obligations, irrespective of the firm's desire to
internalize order flow through an affiliated CSE preferecing dealer. To
reach this conclusion, the broker-dealer must rigorously and regularly
examine the executions likely to be obtained for customer orders in the
different markets trading the security, in addition to any other
relevant considerations in routing customer orders.
\87\ See Securities Exchange Act Release No. 34902, supra note
15.
\88\ See Securities Exchange Act Release No. 36310, supra note
16.
\89\ Id. The Commission also noted that the availability of
sophisticated order handling systems has made it possible for some
broker-dealers and market centers to provide an opportunity for
price improvement for their customer orders. The use of these
efficient routing and execution facilities by firms and exchanges
suggests that price improvement procedures and other best execution
safeguards in an automated environment are increasingly practicable
and are setting new standards for the industry. See also Division of
Market Regulation, SEC, Market 2000: An Examination of Current
Equity Market Developments, (January 1994), at Study V.
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The Commission also has considered carefully the commenters'
concerns regarding the quality of the CSE's market, and whether
preferencing has added depth and liquidity to the CSE market, and
improved quotations.\90\ In this respect, the Commission first
considered data provided by the CSE and commenters. In light of the
conflicting results from the two groups of data, the Commission
collected additional data on its own. Overall the data indicates that
preferencing dealers have added depth and liquidity to the CSE market.
Specifically, data indicated that, for the 281 stocks in which
preferencing dealers accounted for 80% to 99% of total CSE quote on
average matched the NYSE best bid approximately 54% of the time and the
NYSE best offer nearly 61% of the time, with an average depth of over
720 shares. This compares favorably to the data for other regional
exchanges provided by the CSE.\91\ Finally, for the 114 stocks traded
on the CSE for which there are only preferencing dealers, the depth of
CSE quotes matching at least one side of the NYSE BBO nearly 500
shares. This data indicates that preferencing dealers are providing
competitive quotations that add liquidity to the national market.
\90\ See supra note 52 and accompanying text.
\91\ See CSE Letter No. 1, supra note 36.
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Several commenters asserted that CSE quotations at the ITS/BBO do
not add depth and liquidity to the national market because they change
too quickly for other market participants to react. The data regarding
CSE quotations was analyzed by the OEA on a time-weighted basis, so
that, unlike the figures provided by the commenters and the CSE, the
results took into consideration whether the quotes at the NYSE BBO were
short in duration relative to quotes outside of the NYSE BBO. The
resulting figures that CSE dealers match at least one side of the NYSE
BBO between 54% and 61% of the time in the 281 securities, therefore,
indicate that CSE quotes are often maintained at the NYSE BBO.
The Commission believes that the CSE's proposed limit order display
policy could further add to the depth and liquidity of the CSE market.
As discussed above, under the policy, CSE dealers will be required to
display limit orders priced at or better than the ITS/BBO. Whether
represented in the dealer's quote or placed on the Exchange's central
limit order book, these orders will be included in the CSE consolidated
quote and disseminated to the national market system. The Commission
recently recognized that the display of limit orders could produce,
among other benefits, spreads that more fully represent buying and
selling interest in the market and enhance an investor's ability to
monitor execution quality.\92\ This, in turn, should increase
competition among dealers based on their respective quotations.
\92\ See Securities Exchange Act Release No. 36310, supra note
16.
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Finally, the Commission believes it is consistent with the Act for
the CSE to remove the restriction placed on the DPP during the pilot
prohibiting preferencing dealers from making cash payments for order
flow. The Commission believed that a limitation on the inducements for
preferencing order flow was necessary until the Commission had an
opportunity to assess the effects of the DPP pilot. As discussed above,
the Commission has assessed the preferencing pilot and determined that
it is not inconsistent with the Act, nor necessarily, a broker-dealer's
obligation to seek best execution. Moreover, lifting the payment for
order flow restriction on CSE preferencing dealers will place them in
the same position as the CSE's other members. Accordingly, the
Commission believes it is appropriate at this time to remove this
restriction.
The Commission also is approving the DPP without the restriction on
the number of stocks in which a single CSE dealer is permitted to
register. These restrictions were necessary to limit the scope of the
pilot program so that the CSE and Commission could evaluate the effects
of preferencing. The Commission has completed such an evaluation and
finds no reason to continue the restriction.
VII. Conclusion
The Commission believes it is consistent with the Act to approve
the CSE's dealer preferencing program, as amended, on a permanent
basis. In making this determination, the Commission has carefully
evaluated the data provided by the CSE and commenters, as well as data
collected by the Commission. The Commission has concluded that
preferencing, as supplemented by the order handling policies, is not
necessarily inconsistent with the attainment of best execution of
customer orders, the maintenance of fair and orderly markets, or the
protection of investors and the public interest under Section 6(b)(5)
of the Act. In addition, the Commission believes approval of the DPP,
as amended, also is consistent with Section 11A of the Act,
particularly considering the order handling policies being adopted
herein. Moreover, to the extent that preferencing does not have the
effect of increasing order interaction, it fulfills the other national
market system goals of Section 11A(a)(1)(C) of the Act, such as
furthering competition among brokers and dealers, among exchange
markets and markets other than exchange markets.
Nevertheless, Commission approval of the CSE's preferencing program
is not a determination by the Commission that mere default routing by a
firm to its affiliated preferencing dealer is consistent with a firm's
best execution obligations. A broker-dealer associated with a
preferencing dealer must still ensure that its order routing decisions
and the preferencing dealer's order handling practices on the CSE (even
if in technical compliance with the CSE's order handling requirements)
are consistent with the firm's best execution obligations and assess
periodically the quality of competing markets to assure that order flow
is directed to markets providing the most advantageous terms for its
customers' orders.
[[Page 15330]]
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\93\ that the proposed rule change (SR-CSE-95-03), as amended, is
approved.
\93\ 15 U.S.C. 78s(b)(2).
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By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-8397 Filed 4-4-96; 8:45 am]
BILLING CODE 8010-01-M
