[Federal Register Volume 59, Number 155 (Friday, August 12, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-19681]
[[Page Unknown]]
[Federal Register: August 12, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34493; File No. SR-CSE-94-6]
Self-Regulatory Organizations; Cincinnati Stock Exchange, Inc.;
Order Approving Proposed Rule Change to Amend and Extend the Pilot
Program on the Exchange Relating to the Preferencing of Public Orders
by Approved Dealers and Other Proprietary Members
August 5, 1994.
I. Introduction
On June 24, 1994, the Cincinnati Stock Exchange, Incorporated
(``CSE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``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 extend through May 18, 1995,
its pilot program which governs preferenced trading. The Commission
originally approved this pilot on February 7, 1991.\3\ In connection
with this extension of the pilot, the Exchange has proposed certain
changes to its rules.
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\1\15 U.S.C. Sec. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1993).
\3\See Securities Exchange Act Release No. 28866, 56 FR 5854
(Feb. 13, 1991)
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Notice of the filing of this proposal appeared in the Federal
Register on July 1, 1994.\4\ No comment letters were received.\5\ For
the reasons discussed below, the Commission has determined to approve
the proposal on a temporary basis through May 18, 1995.
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\4\See Securities Exchange Act Release No. 34285, 59 FR 33992
(July 1, 1994).
\5\While no comments were received in response to this proposal,
in response to the Boston Stock Exchange's Competing Specialist
program several SROs expressed views regarding the CSR Preferencing
program as structured at that time. Concerns raised included:
reduced incentive to place agency limit orders on the CSE due to
high costs; immediate execution of agency at-the-market and
marketable limit orders on CSE at the Intermarket Trading System
(``ITS'') BBO without an opportunity for price improvement; and the
failure of CSE preferencing dealers to place their limit orders on
the CSE book.
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II. Description
The purpose of the proposed rule change is to amend and extend the
existing pilot program of the Exchange relating to the preferencing of
public agency market and marketable limit orders by approved dealers
and other proprietary members. The Commission originally approved the
pilot in February, 1991,\6\ and subsequently extended the pilot several
times.\7\ The current approval expires August 6, 1994. The Commission's
staff requested that the Exchange seek a limited extension to coincide
with the recently approved Boston Stock Exchange's (``BSE'') competing
specialist pilot program\8\ so that the Commission can consolidate its
future review of the preferencing programs of the various exchanges.\9\
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\6\See supra note 3.
\7\See Securities Exchange Act Release Nos. 29524 (Aug. 5,
1991), 56 FR 38160; 30353 (Feb. 7, 1992), 57 FR 5918; 31011 (Aug. 7,
1992), 57 FR 38704; 32280 (May 7, 1993), 58 FR 28422; and 33975
(April 28, 1994), 59 FR 23243.
\8\See Securities Exchange Act Release No. 34078, 59 FR 27082
(May 25, 1994) (``BSE Approval''). The BSE pilot was approved for
one year expiring May 18, 1995.
\9\The Commission recently approved a CSE proposal implementing
information barrier procedures for Designated Dealers (``DDs''). See
Securities Exchange Act Release No 34449 (July 27, 1994). The term
``Designated Dealer'' means a Proprietary Member who maintains a
minimum net capital amount and who has been approved by the
Securities Committee to perform market functions by entering bids
and offers for Designated Issues into the system. See CSE Rule 11.9
(a)(3). The DD status obligates the dealer to guarantee execution of
all public agency market orders and agency limit orders up to 2,099
shares.
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The CSE preferencing program allows market makers that meet certain
qualifications to interact with their own order flow with respect to
those orders as long as the individual market maker satisfies, among
other things, best execution and other obligations designed to protect
customers.\10\ The rule is intended to provide market makers with the
ability to retain and execute their internal order flow at the national
best bid or offer (``NBBO''), provided the public limit orders on the
book at that price have been executed.\11\
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\10\For a description of the CSE Preferencing program, see
supra, note 3: See also CSE Rule 11.9 (l), (m), and (u). The CSE is
totally automated and utilizes a competing market maker system. Its
members transmit orders, make markets, receive instant executions
and reports through remote terminals or computer interfaces from
around the country. The limit order book is open on the CSE and a
market maker or broker must display his best interest if he or she
wants to trade.
\11\In a 1990 letter, the CSE wrote:
[a]t all times, the CSE market makers and brokers are subject to
being ``hit'' by brokers representing public orders or by
professionals on or off exchange floors. In addition, public orders
are guaranteed executions at the NBBO for up to 2099 shares, and
market makers often display sizes in excess of that number which are
subject to be taken at the literal flick of a switch. No other
exchange trader, whether he be a market maker or specialist, is so
exposed or out on an electronic limb. We believe that the
preferencing rule makes a small dent in this electronic competitive
disadvantage and will encourage well-capitalized market makers to
learn the system and ultimately to provide deeper electronic makers.
See letter from Frederick Moss, Chairman of the Board of
Trustees, CSE, to Richard G. Ketchum, Director, Division of Market
Regulation, Securities and Exchange Commission, dated November 14,
1990.
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The proposal amends CSE rules, effective through May 18, 1995.\12\
As part of a recent analysis of its preferencing program, the Exchange
has reviewed the Division of Market Regulation's (``Division'') five
recommendations in Market 2000: An Examination of Current Equity Market
Developments which are directed toward all market makers in listed
stocks, including third market makers and firms internalizing order
flow.\13\ The Exchange, as a result, proposes to codify the Division's
recommendations by amending or clarifying current CSE Rules.
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\12\In approving the initial pilot, the CSE agreed to several
limitations or requirements, which will continue to apply. These
conditions limit the number of issues (350) in which a preferencing
dealer may be registered; require the Exchange to provide certain
information to the Commission; prohibit preferenced trading for
index arbitrage purposes when ``circuit breakers'' are in effect;
and prohibit the preferencing of any order which the preferencing
dealer has purchased from the customer for a direct cash payment.
\13\See Division of Market Regulation, Securities and Exchange
Commission, Market 2000: An Examination of Current Equity Market
Developments (``Market 2000''), Study III, p. 14 (Jan. 1994).
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First, the Exchange proposes to add interpretive language to CSE
Rule 12.10, the Exchange's ``best execution'' rule requiring members,
as part of their Fiduciary obligation to provide best execution for
their customers' orders. This new obligation requires a member to
expose to the national market system all or a representative portion of
any limit order which is priced either on or between the NBBO, unless
(1) the order is immediately executed, or (2) the customer expressly
requests that the order not be exposed.
Second, the CSE is concerned that dealers should not trade ahead of
customer limit orders. CSE rule 12.6 currently provides that no member
may buy or sell a security for its own account when it holds an
unexecuted customer market or like-priced limit order in that
security.\14\ In order to encourage all members to place public agency
limit orders on the CSE book, the Exchange proposes to amend CSE Rule
11.10(e) to eliminate the transaction charge on public agency limit
orders.
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\14\One way for members to comply with this requirement would be
to place their customer limit orders on the CSE limit order book.
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Third, the CSE is proposing to codify that if a dealer holds a
customer buy order and a customer sell order that can be crossed, the
dealer should cross those orders without interposing itself as dealer.
While the CSE maintains that it historically has interpreted its Rule
12.6 to require the crossing of like-priced customer buy and sell
orders, to remove any doubt, the CSE proposes to make that requirement
explicit.
Fourth, the Exchange proposes to codify that dealers should
establish and adhere to fixed standards for queuing and executing
customer orders. This will facilitate CSE enforcement of standards to
maintain the integrity of its market.
Fifth, consistent with the ITS trade-through and block policies,
dealers will continue to be prohibited from trading at a price outside
the ITS BBO without satisfying the market interest at the price.
Finally, in order to gauge the impact of the preferencing program
on the CSE and on the national market system, the Exchange has agreed
to provide the Commission with quarterly reports similar to those
required of the BSE as part of its competing specialist pilot. These
reports will provide the following information:
(1) A list indicating how many preferencing DDs are on the exchange
and the issues in which they make markets.
(2) The volume of preferenced trades and shares and the percentage
of total CSE trade and share volume that preferenced activity
represents.
(3) The CSE's volume attributable to ITS commitments sent by other
ITS participants and the percentage of such commitments in issues which
have preferencing specialists.
(4) The number of preferenced order effected against the National
Securities Trading System (``NSTS'') limit order book.
(5) The percentage of time that the CSE improves and/or matches the
NBBO, and the percentage of time that the CSE achieves price
improvement for customer orders when the spread is wider than \1/8\th
point.\15\
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\15\Although the BSE is not currently required to provide NBBO
and price improvement data, the CSE is offering to provide this
additional data because it believes that this would be helpful to
the Commission in accurately assessing the contributions of
preferencing to the national market system. The Commission, however,
intends to generate the necessary data to facilitate adequate
comparison of all NBBO data.
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(6) The CSE's share of Consolidated Tape trade reports, as compared
to its share on the date of this extension.
III. Discussion
In its recent order approving the BSE's Competing Specialist
proposal, the Commission articulated views and concerns regarding
exchange proposals that modify traditional auction market priority
rules in favor of certain members over others. The Commission is
concerned about the implications of the preferencing feature and its
effect on quote competition and the risk of market fragmentation
through increased internalization of order flow. The Commission holds
by its views in that order, and is approving the CSE proposal to extend
the expiration date of the CSE perferencing program until May 18, 1995,
the same date that the BSE's Competing Specialist pilot expires. During
this time the CSE will monitor the pilot, collect data, and submit
reports as outlined below.\16\
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\16\The CSE is expected to monitor its pilot and provide the
Commission with a report on its operation detailing how the proposal
has affected the quality of CSE's market, including its effect on
quote competition and market transparency. The Commission expects
the CSE to demonstrate, through periodic reporting requirements
outlined above and other data as the Exchange may wish to generate,
that there are in fact beneficial competitive effects from the
preferencing program. Specifically, the Commission expects the
Exchange to analyze the effects of the program on the quality of
market making by CSE DDs as a result of the enhancements/changes
adopted herein. If, for any reason, the CSE cannot provide such an
analysis, the Commission would have serious reservations about
continuing the preferencing program.
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While the CSE amended the DD program following the BSE approval,
the Commission continues to be concerned about changes in priority
principles, Implicitly, the CSE argues that failure to provide time
priority in a market place whose structure includes multiple market
makers need not be inconsistent with the Act if two primary conditions
are met. First, market makers protect customer limit orders consistent
with the requirements and goals of the Act. This requires that the
Exchange establish and enforce specific practices and standards for its
members participating in the preferencing program to further the goals
of investor protection. Second, the Exchange program contributes
meaningfully to the national market system by narrowing the spread
between the NBBO.
While the CSE continues to alter its priority rules, it has taken
other substantive steps to address the Division's concerns outlined in
Study III of Market 2000 regarding minimum order handling principles to
ensure that customers are treated fairly. The current proposal enhances
customer protection by clarifying CSE Rules regarding best execution
responsibilities, customer priority, and the mandatory crossing of
customer orders whenever possible. Specifically, the CSE proposal not
only requires as part of a members' ``best execution'' responsibilities
the display of all or a representative portion of customer limit orders
that are better than the ITS BBO,\17\ but further requires the display
of those same orders that are at the ITS BBO unless the customer
expressly requests that the order not be exposed or unless the order is
immediately executed.\18\ The Division has stated its belief that this
requirement will result in tighter spreads, provide a more accurate
picture of trading interests, and contribute to improved price
discovery.\19\
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\17\When determining the amount of a limit order to expose, a
broker, as part of its fiduciary duties, is charged with ensuring
the best execution of a customer's order.
\18\This proposed additional requirement also addresses concerns
raised by various SROs in the context of the BSE Competing
Specialist proposal that limit orders on the CSE are immediately
executed at the ITS BBO without the opportunity for price
improvement.
The Commission wishes to clarify that as part of the CSE's
customer priority rule 12.6, a member is obligated to execute a
customer's limit order immediately upon a likepriced proprietary
execution on any other market. Further, if a CSE market maker
determines to route a customer limit order to another firm or
exchange, the limit order will nevertheless be viewed as ``held'' by
the market maker. Thus, the CSE market maker could not trade ahead
of a customer limit order that it forwarded to another firm or
exchange.
\19\See Market 2000, Study IV, p. 6.
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The Exchange also has taken steps to encourage and protect customer
limit orders by eliminating transaction charges on public agency limit
orders and by clarifying that, under its customer priority rule, a
member may hot buy or sell for its own account when it holds an
unexecuted customer market or like-priced limit order in that security.
Moreover, the commitment by CSE in requiring members to expose all of a
representative portion of customer limit orders to the entire ITS
market addresses commentator's allegations that CSE preferencing
dealers do not place their limit orders on the CSE book, but rather
hold the orders ``upstairs'' until the orders become marketable, and
thus disadvantage their customer. Under the current proposal, even if a
limit order is not placed on the CSE book, a member is required, unless
instructed otherwise by a customer, to expose all or part of that limit
order to the market thereby ensuring the customer order is exposed,
eligible for price improvement, and adds to overall transparency of the
marketplace. The CSE has represented that it will enforce specific
practices and standards for its members participating in the
preferencing program and the Commission expects quarterly data from the
Exchange as well as a final report analyzing the effects of the program
on the quality of market making by CSE DDs.
Based on the above, the Commission believes it is appropriate to
allow the CSE to extend, as amended, its preferencing pilot until May
18, 1995. In making this determination, the Commission has carefully
considered the potential benefits from the proposed enhancements, such
as better quotes, as well as the potential adverse effects of the
proposal, such as the possibility of increased internalization of order
flow. The Commission believes that the CSE has incorporated features in
its proposal, consistent with the Division's recommendations in Market
2000, to allow it to implement on a temporary basis, an amended
preferencing program.
The Commission, nevertheless, believes that before the CSE proposal
may be extended beyond May 18, 1995, or approved on a permanent basis,
the CSE must demonstrate that its proposal resulted in added depth and
liquidity to its market and improved quotations.\20\ If this showing
cannot be made, the Commission would not be inclined to extend the
preferencing program. Accordingly, the Commission requests that the CSE
provide the information it has agreed to furnish to the Commission,\21\
on a quarterly basis. Further, we request the Exchange to submit a
report to the Commission, discussing and analyzing the data outlined
above, by January 18, 1995.\22\ The report should discuss data in terms
of the effects of the preferencing pilot on the quality of the CSE
market with respect to depth, liquidity, and quote improvement.\23\
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\20\The BSE will also be required to make such a showing.
\21\See supra Section II.
\22\The BSE report is also due by this date.
\23\As noted in the BSE approval, should any other exchange
attempt to implement a similar system that is acceptable to the
Commission, the pilot period would be limited to the time period
afforded the BSE. As a result all preferencing programs will expire
May 18, 1995. At the end of this period, all systems will be subject
to the same scrutiny regardless of how long they may have been in
operation.
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IV. Conclusion
The Commission finds that temporary approval of the proposed rule
change is consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities exchange,
and, in particular, with the requirements of Section 6(b).\24\ In
particular, the Commission believes the proposal is consistent with
Section 6(b)(5) because it is designed to promote just and equitable
principles of trade and remove impediments to and perfect the
mechanisms of a free and open market and a national market system.
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\24\15 U.S.C. Sec. 78f(b) (1988).
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It is Therefore Ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change be, and it hereby is, approved for an
additional period, ending May 18, 1995.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-19681 Filed 8-11-94; 8:45 am]
BILLING CODE 8010-01-M
