96-23210. Order Execution Obligations  

  • [Federal Register Volume 61, Number 178 (Thursday, September 12, 1996)]
    [Rules and Regulations]
    [Pages 48290-48332]
    From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
    [FR Doc No: 96-23210]
    
    
    
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    _______________________________________________________________________
    
    Part III
    
    
    
    
    
    Securities and Exchange Commission
    
    
    
    
    
    _______________________________________________________________________
    
    
    
    17 CFR Part 240
    
    
    
    Order Execution Obligations; Final Rule; Proposed Quote Rule Amendment
    
    Federal Register / Vol. 61, No. 178 / Thursday, September 12, 1996 / 
    Rules and Regulations
    
    [[Page 48290]]
    
    
    
    SECURITIES AND EXCHANGE COMMISSION
    
    17 CFR Part 240
    
    [Release No. 34-37619A; File No. S7-30-95]
    RIN 3235-AG66
    
    
    Order Execution Obligations
    
    AGENCY: Securities and Exchange Commission.
    
    ACTION: Final Rules.
    
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    SUMMARY: The Securities and Exchange Commission (``Commission'') is 
    adopting a new rule requiring the display of customer limit orders and 
    amending a current rule governing publication of quotations to enhance 
    the quality of published quotations for securities and to enhance 
    competition and pricing efficiency in our markets. These rules have 
    been designed to address growing concerns about the handling of 
    customer orders for securities.
        Specifically, the Commission is adopting new Rule 11Ac1-4 
    (``Display Rule'') under the Securities Exchange Act of 1934 
    (``Exchange Act'') to require the display of customer limit orders 
    priced better than a specialist's or over-the-counter (``OTC'') market 
    maker's quote or that add to the size associated with such quote. The 
    Commission also is adopting amendments to Rule 11Ac1-1 (``Quote Rule'') 
    under the Exchange Act to require a market maker to publish quotations 
    for any listed security when it is responsible for more than 1% of the 
    aggregate trading volume for that security and to make publicly 
    available any superior prices that a market maker privately quotes 
    through certain electronic communications networks (``ECNs'') (``ECN 
    amendment''). Finally, the Commission is deferring action on proposed 
    Rule 11Ac1-5 (``Price Improvement Rule'').
    
    Effective Date: January 10, 1997. For specific phase-in dates for the 
    Display Rule, see section III.A.3.d of this Release.
    
    FOR FURTHER INFORMATION CONTACT: Elizabeth Prout Lefler or Gail A. 
    Marshall regarding amendments to the Quote Rule and David Oestreicher 
    regarding the Display Rule at (202) 942-0158, Division of Market 
    Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., 
    Mail Stop 5-1, Washington, D.C. 20549.
    
    SUPPLEMENTARY INFORMATION:
    
    I. Introduction and Summary
    
        On September 29, 1995, the Commission issued a release 1 
    proposing for comment new Rules 11Ac1-4 and 11Ac1-5 and amendments to 
    Rule 11Ac1-1 2 under the Exchange Act.3 As proposed, new Rule 
    11Ac1-4 would require the display of customer limit orders that improve 
    certain OTC market makers' and specialists' quotes or add to the size 
    associated with such quotes. The proposed amendments to the Quote Rule 
    would require OTC market makers and specialists who place priced orders 
    with ECNs to reflect those orders in their published quotes. The 
    proposed Quote Rule amendments also would require OTC market makers and 
    specialists that account for more than 1% of the volume in any listed 
    security to publish their quotations for that security (``Mandatory 
    Quote Rule''). The Price Improvement Rule would have required OTC 
    market makers and specialists to provide their customer market orders 
    an opportunity for price improvement; it also would have included a 
    non-exclusive safe harbor to satisfy the price improvement obligation.
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        \1\ Securities Exchange Act Release No. 36310 (September 29, 
    1995), 60 FR 52792 (October 10, 1995) (``Proposing Release'').
        \2\ 17 CFR 240.11Ac1-1.
        \3\ 15 U.S.C. 78a to 78ll (1988).
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        The Commission received 152 comment letters (from 145 commenters) 
    in response to the Proposing Release.4 Commenters generally 
    supported the Display Rule and the Mandatory Quote Rule, with some 
    commenters suggesting specific modifications or alternatives to the 
    proposed rules. Commenters also supported the objectives of the ECN 
    amendment, but many expressed concerns that diminishing the anonymity 
    of such systems would threaten their viability. Most commenters 
    believed the Price Improvement Rule would be costly to implement and 
    would not be necessary if the other proposals were adopted.
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        \4\ The comment letters and a summary of comments have been 
    placed in Public File No. S7-30-95, which is available for 
    inspection in the Commission's Public Reference Room. The Commission 
    received comments on the proposals from 77 individual investors, ten 
    industry associations, seven exchanges and the National Association 
    of Securities Dealers (``NASD''), eight academics, 41 market 
    participants and the United States Department of Justice. In 
    addition, the Commission met with representatives of broker-dealers, 
    self-regulatory organizations (``SROs''), industry associations, and 
    the U.S. Department of Justice to discuss the proposals. The 
    Commission has conducted its own economic analysis of the likely 
    economic effects of the various proposals.
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        After considering the comments and relevant economic research, and 
    based on the Commission's experience with the development of the 
    national market system (``NMS'') and its knowledge of current market 
    practices, the Commission is adopting the Display Rule and the proposed 
    amendments to the Quote Rule, with certain modifications. The 
    Commission believes that these modifications are consistent with the 
    proposals and responsive to many of the concerns voiced by the 
    commenters.
        The Display Rule adopted today requires OTC market makers and 
    specialists to display the price and full size of customer limit orders 
    when these orders represent buying and selling interest that is at a 
    better price than a specialist's or OTC market maker's public quote. 
    OTC market makers and specialists also must increase the size of the 
    quote for a particular security to reflect a limit order of greater 
    than de minimis size when the limit order is priced equal to the 
    specialist's or OTC market maker's disseminated quote and that quote is 
    equal to the national best bid or offer.
        The Commission has modified the proposed Display Rule in some 
    respects in response to comments. The proposal included an exception to 
    permit a specialist or OTC market maker to deliver a limit order to an 
    exchange or registered national securities association 
    (``association'') sponsored system that complies with the Display Rule. 
    This exception has been expanded to permit delivery to ECNs that 
    display and provide access to these orders. Additionally, with regard 
    to implementation of the rule, the Commission has provided for a phase-
    in over a one year period for non-exchange-traded securities covered by 
    the Display Rule.
        Today, the Commission also is adopting two significant amendments 
    to the Quote Rule. These amendments are designed to ensure that more 
    comprehensive quotation information is made available to the public. 
    The first amendment requires a specialist or OTC market maker to make 
    publicly available the price of any order it places in an ECN if the 
    ECN price is better than the specialist's or OTC market maker's public 
    quotation. The Commission has adopted this amendment as proposed, with 
    an alternative (``ECN display alternative'') that deems OTC market 
    makers and specialists in compliance with the Quote Rule if prices 
    these OTC market makers and specialists enter into an ECN are publicly 
    disseminated and the ECN provides access to other broker-
    
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    dealers to trade at those prices.5 Thus, OTC market makers and 
    specialists may comply directly with the ECN amendment by changing 
    their public quote to reflect their ECN order, or by using an ECN that 
    facilitates their compliance with the rule as described above.
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        \5\ This alternative means of compliance with the ECN amendment 
    is referred to hereinafter as the ``ECN display alternative''.
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        Implementation of the ECN display alternative requires the 
    cooperation of the SROs in order to include the ECN prices in the 
    public quotation system and to provide equivalent access to these 
    quotations. The Commission expects the SROs to work expeditiously with 
    ECNs that wish to avail themselves of this alternative to develop rules 
    or understandings of general applicability. The Commission is prepared 
    to act if necessary to ensure implementation of the ECN display 
    alternative prior to the effective date of the Quote Rule.
        The second amendment to the Quote Rule expands the categories of 
    securities covered by the Mandatory Quote Rule. As amended, the Quote 
    Rule will require that OTC market makers and specialists publish quotes 
    in any listed security if their volume in that security exceeds 1% of 
    the aggregate volume during the most recent calendar quarter. 
    Previously, these requirements applied only to certain listed 
    securities.6
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        \6\ Additional amendments to the Quote Rule adopted today 
    provide that certain Quote Rule provisions that previously applied 
    to market makers that elected to quote a Nasdaq National Market 
    security now also will apply to market makers electing to quote a 
    Nasdaq SmallCap security. See section III.B.d.iii.
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        The Commission is deferring final action on the Price Improvement 
    Rule at this time. The Commission will consider the effect of the new 
    Display Rule and the amendments to the Quote Rule adopted today before 
    determining the appropriate course of action on that proposal.
        In a parallel action, the Commission today is proposing for comment 
    an additional amendment to the Quote Rule. The proposed amendment would 
    require OTC market makers and specialists that account for more than 1% 
    of the volume in any Nasdaq security to publish their quotations for 
    that security.7
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        \7\ See Securities Exchange Act Release No. 37620 (August 28, 
    1996) (``Companion Release'').
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    II. Basis and Purpose of the Display Rule and Quote Rule Amendments
    
        Twenty years ago, Congress directed the Commission--having due 
    regard for the public interest, the protection of investors, and the 
    maintenance of fair and orderly markets--to use the Commission's 
    authority granted under the Exchange Act to facilitate the 
    establishment of a national market system for securities.8 
    Congress further determined that the public interest, investor 
    protection and the maintenance of fair and orderly markets required the 
    NMS to feature:
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        \8\ Pub. L. No. 94-29, 89 Stat. 97 (1975) (``1975 Amendments'').
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        (i) Economically efficient executions;
        (ii) Fair competition among brokers and dealers, among exchange 
    markets, and between exchange markets and markets other than exchange 
    markets;
        (iii) Public availability of quotation and transaction information;
        (iv) An opportunity to obtain best execution; and
        (v) An opportunity to obtain execution without dealer intervention 
    to the extent consistent with economically efficient executions and the 
    opportunity to obtain best execution.9
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        \9\ Exchange Act section 11A(a)(1), 15 U.S.C. 78k-1(a)(1). This 
    Section also recites the Congressional findings that: The securities 
    markets are an important national asset which must be preserved and 
    strengthened; and new data processing and communications techniques 
    create the opportunity for more efficient and effective market 
    operations.
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        The years since the 1975 Amendments have witnessed dramatic 
    developments in the U.S. securities markets. Last sale reporting, which 
    enables investors to determine the current market for a security, has 
    been extended to OTC-traded securities. The Consolidated Quotation 
    System (``CQS''), which allows investors to view in a single source 
    quotes disseminated from dispersed market centers, did not exist in 
    1975. The Intermarket Trading System (``ITS''), which permits 
    investors' orders in certain exchange-listed securities to be routed to 
    the market center displaying the best quotation, has greatly 
    facilitated quote competition. Moreover, technological developments not 
    envisioned twenty years ago have enabled market centers to handle 
    volume levels many times greater than those that led to the ``back 
    office'' crisis of the late 1960s and early 1970s. Taken together, 
    these and other developments have made it possible for investors' 
    orders to be executed much more rapidly and at far lower cost.
        The Commission recognized that U.S. equity markets had undergone 
    significant changes since passage of the 1975 Amendments and were 
    likely to undergo further changes of equal magnitude.10 
    Accordingly, the Commission announced in July 1992 that its Division of 
    Market Regulation (``Division'') would undertake a study of the 
    structure of the U.S. equity markets and of the regulatory environment 
    in which those markets operate.11
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        \10\ See Securities Exchange Act Release No. 30920 (July 14, 
    1992), 57 FR 32587 (July 22, 1992) (``Market 2000 Concept 
    Release'').
        \11\ Id.
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        In January 1994, the Division published a study,12 which 
    reviewed, among other things, market practices and structures that 
    could affect the ability of customers to obtain opportunities for 
    better prices. The Market 2000 Study noted that U.S. equity markets had 
    evolved since 1975 to provide a much wider array of trading venues to 
    meet the diverse needs of investors and made a series of 
    recommendations intended to facilitate the further development of a 
    national market system. As expected, U.S. equity markets have continued 
    to evolve since the Market 2000 Study was published.
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        \12\ Division of Market Regulation, Market 2000: An Examination 
    of Current Equity Market Developments (January 1994) (``Market 2000 
    Study'' or ``Study'').
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        This evolution of the markets is reflected in part by comparing 
    trading volumes and the venues in which orders are executed. In 1976, 
    the New York Stock Exchange (``NYSE'') average daily trading volume was 
    approximately 21.2 million shares.13 By 1995, average daily 
    trading volume exceeded 346 million shares.14 Third market 
    trading, i.e., OTC trading of listed securities, in NYSE-listed issues 
    accounted for 4.57% of consolidated volume in 1976.15 By 1995, 
    third market trading increased to 7.94% of consolidated volume.16 
    In 1987, the NYSE handled almost 74% of trades of NYSE-listed issues 
    reported on the consolidated tape; in 1995, it handled 70.22% of such 
    trades.17
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        \13\ 1982 NYSE Fact Book.
        \14\ 1995 NYSE Annual Report.
        \15\ 1982 NYSE Fact Book.
        \16\ 1995 NYSE Fact Book.
        \17\ Regional exchanges, namely, the Boston Stock Exchange 
    (``BSE''), the Philadelphia Stock Exchange (``Phlx''), the 
    Cincinnati Stock Exchange (``CSE''), the Chicago Stock Exchange 
    (``CHX''), and the Pacific Stock Exchange (``PSE''), have captured a 
    significant share of volume in NYSE-listed issues, particularly with 
    respect to smaller investor orders. In 1995, the regional exchanges 
    accounted for 9.96% of consolidated volume in NYSE-listed issues but 
    accounted for 19.01% of trades of NYSE-listed issues reported on the 
    consolidated tape. Id. They also accounted for approximately 35% of 
    share volume in trades of 100 to 2,099 shares. Shapiro, U.S. Equity 
    Markets: Recent Equity Developments, in Global Equity Markets: 
    Technological, Competitive, and Regulatory Challenges 21 (R. 
    Schwartz ed. 1995). In January 1996, trades of 100-499 shares 
    represented between 65-72% of all trades in NYSE-listed issues on 
    regional exchanges; such trades represented only 37% of all trades 
    on the NYSE. Ross, Shapiro and Smith, Price Improvement of SuperDOT 
    Market Orders on the NYSE (NYSE Working Paper 96-01) (March 11, 1996 
    draft) (prepared for the NYSE Conference for the Search for Best 
    Price) (``Ross, Shapiro and Smith'').
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        Comparable figures for The Nasdaq Stock Market (``Nasdaq'') are 
    even more
    
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    dramatic. In 1975, Nasdaq annual volume was approximately 1.39 billion 
    shares.18 By 1995, Nasdaq annual volume increased to 101.2 billion 
    shares,19 which means that more shares traded hands on three 
    average trading days in 1995 than in all of 1975. In 1993, volume in 
    all proprietary trading systems combined represented 13% of the total 
    volume in Nasdaq/National Market securities; 20 by January 1996, 
    volume on Instinet alone represented approximately 15% of total Nasdaq 
    volume and 20% of total volume for the 250 Nasdaq stocks with the 
    highest median dollar volume.21
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        \18\ 1992 Nasdaq Fact Book.
        \19\ 1995 NASD Annual Report.
        \20\ Market 2000 Study at Appendix IV-2.
        \21\ The Introduction of NAqcess into the Nasdaq Stock Market: 
    Intent and Expectation, NASD Economic Research Staff, June 6, 1996 
    (``NASD Study''), Exhibit D to Securities Exchange Act Release No. 
    37302 (June 11, 1996), 61 FR 31574 (June 20, 1996) (Notice of Filing 
    of Amendment No. 2 to Proposed Rule Change by National Association 
    of Securities Dealers Relating to the NAqcess System and 
    Accompanying Rules of Fair Practice)(``NAqcess Release 2'').
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        The Study addressed the development of certain practices, such as 
    internalization,22 payment for order flow 23 and the non-
    disclosure of certain customer trading interest to all market 
    participants, that raise a variety of market structure and customer 
    order handling concerns. For example, brokers today may quote one price 
    publicly to retail customers, while showing a better price privately to 
    other investors and dealers on an ECN. In addition, the quotes 
    displayed to public investors may not accurately reflect the best price 
    for a security because limit orders, which specify the price at which 
    customers will buy or sell a security, are not uniformly required to be 
    included in the quote.
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        \22\ Internalized orders are customer orders routed by a broker-
    dealer to an affiliated specialist or executed by that broker-dealer 
    as a market maker.
        \23\ The Commission now requires enhanced disclosure of payment 
    for order flow practices on customer confirmations and account 
    statements, as well as upon opening new accounts. Securities 
    Exchange Act Release No. 34902 (October 27, 1994), 59 FR 55006 
    (November 2, 1994) (adopting rules requiring enhanced disclosure of 
    payment for order flow practices on customer confirmations, and 
    account statements, as well as upon opening new accounts) (``Payment 
    for Order Flow Release''). See also Securities Exchange Act Release 
    No. 35473 (March 10, 1995), 60 FR 14366 (March 17, 1995).
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        The Study recommended that the exchanges and the NASD consider 
    taking action to respond appropriately to certain of these 
    developments. Since that time, Nasdaq market makers holding customer 
    limit orders have been prohibited from trading ahead of those 
    orders,24 and some market makers have begun to offer price 
    improvement opportunities in OTC transactions to their retail 
    customers.25 In addition, the NYSE now requires almost all limit 
    orders transmitted through SuperDOT to be displayed to the 
    market.26 Further, Commission rules require enhanced disclosure of 
    payment for order flow practices on customer confirmations and account 
    statements, as well as upon opening new accounts.27
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        \24\ Securities Exchange Act Release No. 34279 (June 29, 1994), 
    59 FR 34883 (July 7, 1994) (``Manning I''); Securities Exchange Act 
    Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 1995) 
    (``Manning II'').
        \25\ See, e.g., Louis, Schwab Debuts New Trading System, San 
    Francisco Chronicle, October 17, 1995, at D1.
        \26\ Securities Exchange Act Release No. 36231 (September 14, 
    1995), 60 FR 48736 (September 20, 1995).
        \27\ See Payment for Order Flow Release supra note 23.
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        Notwithstanding the progress achieved in this period, the 
    Commission believes that further regulatory initiatives are warranted 
    at this time. These changes, as indicated in the Proposing Release, are 
    intended to address current market practices that inhibit opportunities 
    for order interaction and that are inconsistent with Congress's vision 
    of the national market system. These changes also address certain 
    problems in Nasdaq. The Commission recently reported that, among other 
    things: (i) Nasdaq market makers widely followed a pricing convention 
    concerning the increments they used to adjust their displayed quotes; 
    (ii) adherence to the pricing convention was not the result of natural 
    economic forces, often impacted the fairness and accuracy of public 
    quotation information and interfered with the economically efficient 
    execution of customer transactions; (iii) the pricing convention 
    impaired the ability of investors to ascertain the best market for 
    their trades, increased the costs of transactions, and resulted in 
    unfair discrimination among classes of market participants; (iv) 
    numerous market makers collaborated in ways that misled and 
    disadvantaged their customers and other market participants and 
    frequently failed to honor their price quotations; and (v) many market 
    makers have not consistently reported their trades on time or 
    appropriately designated them as late as required by NASD rules.28
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        \28\ Report Pursuant to Section 21(a) of the Securities Exchange 
    Act of 1934 Regarding the NASD, the Nasdaq Market, and Nasdaq Market 
    Makers, Securities Exchange Act Release No. 37542 (August 8, 1996) 
    (``21(a) Report'').
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        The Commission has taken specific regulatory and enforcement 
    actions to address these problems.29 The Display Rule and Quote 
    Rule amendments adopted today should bring about other, significant 
    changes in the operation of Nasdaq, by ensuring the disclosure of 
    customer and market maker buying and selling interest that heretofore 
    has been hidden from many market participants. At the same time, the 
    new rules will benefit investors in the exchange markets by increasing 
    transparency in those markets and improving opportunities for the best 
    execution of customer orders.
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        \29\ See id.
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        The Commission firmly believes that the actions it is taking today 
    are consistent with the regulatory framework for a national market 
    system established by Congress in the 1975 Amendments. Congress 
    envisioned a national market system supported by accurate and reliable 
    public quotation and transaction information, and fair competition 
    among market centers. Congress also believed that linking all markets 
    for qualified securities through communication and data processing 
    facilities would foster efficiency, enhance competition, increase 
    information available to market participants and contribute to the best 
    execution of customer orders.30
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        \30\ See Exchange Act section 11A(a)(1)(D), 15 U.S.C. 78k-
    1(a)(1)(D).
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        The Commission recognizes that investors will lose confidence in 
    the fairness of the markets unless market structures and practices 
    treat all investors fairly. The regulatory initiatives adopted today 
    address current market practices that hinder competition among markets 
    and affect the prices at which customer orders are executed. The 
    Display Rule and Quote Rule amendments enhance transparency and 
    facilitate best execution of customer orders in a manner that preserves 
    maximum flexibility for the markets to design and implement trading and 
    communication systems that are consistent with the objectives of the 
    national market system. These rules contribute to the achievement of 
    the full potential of the national market system as envisioned by 
    Congress. They represent one more step to facilitate the development of 
    an efficient, competitive and transparent national market system in 
    which all market participants can achieve best execution of their 
    orders.
    
    III. Discussion
    
    A. Display of Customer Limit Orders
    
    1. Introduction
        As discussed above, the 1975 Amendments contain an explicit 
    statutory mandate for the establishment of a national market system. 
    Congress considered mandating certain minimum
    
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    components of the national market system, but instead created a 
    statutory scheme granting the Commission broad authority to oversee the 
    implementation, operation and regulation of the national market 
    system.31 At the same time, Congress charged the Commission with 
    the responsibility to assure that the national market system develop 
    and operate in accordance with specific goals and objectives.32 
    The Commission believes that the adoption of a limit order display rule 
    furthers these goals and objectives determined by Congress.
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        \31\ S. Rep. No. 75, 94th Cong., 1st Sess. 8-9 (1975) (``Senate 
    Report'').
        \32\ Id. at 9. Among other things, Congress found it in the 
    public interest and appropriate for the protection of investors and 
    the maintenance of fair and orderly markets to assure an opportunity 
    for investors' orders, in both dealer and auction markets, to be 
    executed without the participation of a dealer, to the extent that 
    this was consistent with economically efficient executions of such 
    orders in the best market. Exchange Act Section 11A(a)(1(c), 15 
    U.S.C. 78k-1(a)(1)(C).
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        Specifically, the display of customer limit orders advances the 
    national market system goal of the public availability of quotation 
    information, as well as fair competition, market efficiency, best 
    execution and disintermediation. The enhanced transparency of such 
    orders increases the likelihood that limit orders will be executed 
    because contra-side market participants will have a more accurate 
    picture of trading interest in a given security. Further, this 
    increased visibility will enable market participants to interact 
    directly with limit orders, rather than rely on the participation of a 
    dealer for execution.
        Moreover, as noted in the Proposing Release, the display of limit 
    orders that are priced better than current quotes addresses at least 
    three regulatory concerns. First, displaying customer limit orders in 
    the quotation can increase quote competition. If the quotes from a 
    market or market maker represent only market maker buying and selling 
    interest in a given security, the market or market maker faces less 
    price competition than if customer buying and selling interest is made 
    public. As a result, the price discovery process may be constrained. 
    Second, the display of limit orders can narrow quotation spreads. 
    Third, because many markets and market makers offer automatic 
    executions of small orders at the best displayed quotes, the display of 
    limit orders that improve the best displayed quotes can result in 
    improved executions for these orders.
        Limit orders currently are handled differently in the various 
    auction and dealer markets. Generally, the rules of most exchanges 
    require that a limit order be displayed in the quotation for a security 
    when it improves the best bid or offer. NYSE specialists, for example, 
    must reflect a customer limit order in their quotations at the limit 
    price when requested to do so.33 In addition, the NYSE's order 
    handling procedures assume that all limit orders routed to a specialist 
    through SuperDOT contain a display request.34 Therefore, except in 
    the unusual and infrequent circumstance where a specialist believes 
    market conditions suggest the likelihood of imminent price improvement, 
    a limit order received by a specialist through SuperDOT should be 
    reflected in the specialist's quote as soon as practicable following 
    receipt of the order.35 According to the NYSE, 93% of all SuperDOT 
    limit orders that improve the best bid or offer displayed are reflected 
    in the specialist's quote within two minutes of receipt, while 98% of 
    such limit orders are reflected within five minutes of receipt.36
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        \33\ See NYSE Rule 79A.10 (when a limit order is presented to 
    the specialist by a floor broker, the floor broker must 
    affirmatively request that the specialist display the limit order; 
    failure to so request leaves the decision whether to display the 
    limit order to the discretion of the specialist); see also NYSE Rule 
    60 (requiring specialists to promptly report, inter alia, the best 
    bid and offer in the trading crowd in each reported security in 
    which the specialist is registered).
        \34\ NYSE Information Memo 93-12 (Mar. 30, 1993).
        \35\ Id.
        \36\ Telephone Conference between Edward A. Kwalwasser, 
    Executive Vice President, NYSE, and Holly H. Smith, Associate 
    Director, Division of Market Regulation, SEC, January 9, 1995.
        Other exchanges also have rules regarding dissemination of bids 
    and offers. However, no uniform standard has been adopted among the 
    exchanges. Generally, the rules either cite, in whole or in part, 
    language from the Quote Rule, or are drafted in such a manner as to 
    allow for broad interpretation with respect to the display of limit 
    orders. See, e.g., BSE Guide, Rules of the Board of Governors, 
    Chapter II, Sec. 7, (CCH) para. 2020; PSE Guide, Rules of the Board 
    of Governors, Rule 5.6(f), (CCH) para. 3979; American Stock Exchange 
    Guide, General and Floor Rules, Rule 115, (CCH) para. 9265; CHX 
    Guide, Article XX, Rule 7, (CCH) para. 1688; Phlx Guide, Rules 105 
    and 229 (CCH) para. 2105 and 2229; Cincinnati Stock Exchange Rules, 
    Rule 11.9.
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        A recent NYSE policy statement requires specialists to display the 
    full size of all orders received through SuperDOT as well as orders 
    received by specialists manually that are subsequently entered into the 
    electronic book.37 When a member requests that less than the full 
    size of the order be shown, the specialist is obligated to show the 
    size requested. Specialists must display as soon as practicable any 
    order that, in relation to current market conditions in a particular 
    security, represents a material change in the supply or demand for that 
    security. This requirement includes increasing the size of a quotation 
    for orders at the same price as the current bid or offer. If the 
    quotation already reflects significant supply or demand, and the 
    specialist receives an order that is de minimis in relation to such 
    supply or demand, the specialist may take a reasonable time (generally 
    not more than two minutes) before updating the size of the 
    quotation.38
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        \37\ See supra note 26.
        \38\ The NYSE provides the following example of when a 
    specialist may take a reasonable time to update the size of the 
    quotation: If the market in XYZ security is 20 (5,000)--20\1/4\ 
    (50,000), and the specialist receives an order to sell 200 shares at 
    20\1/4\, such order would be considered de minimis and the 
    specialist would be permitted to wait a reasonable period of time 
    (but not more than two minutes) before changing the size of the 
    offer to 50,200.
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        Currently in the OTC market, the quote for any security typically 
    represents a dealer's own bid and offer. The rules of the NASD do not 
    require market makers to display customer limit orders, whether or not 
    they better the best bid or offer for the security.39 Generally, 
    customer limit orders in OTC securities either will be routed to a 
    broker-dealer's market making desk or to another market maker for 
    execution if the customer's firm does not make a market in the 
    security. In the past, market makers typically did not execute limit 
    orders until the best bid (for sell orders) or offer (for buy orders) 
    displayed on Nasdaq reached the limit price. This practice has changed, 
    however, in recent years. In June 1994, the Commission approved a rule 
    change filed by the NASD that prohibits broker-dealers from trading 
    ahead of their customers' limit orders.40 This rule was expanded 
    in May 1995, to prohibit broker-dealers from trading ahead of customer 
    limit orders they accept from other brokers.41 The NASD also has 
    filed a proposed rule change that would require, in certain 
    circumstances, the display of customer limit orders for exchange-listed 
    securities traded OTC.42
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        \39\ See NASD Manual, Rule 4613.
        \40\ See Manning I, supra note 24.
        \41\ See Manning II, supra note 24.
        \42\ See Securities Exchange Act Release No. 35471 (March 10, 
    1995), 60 FR 14310 (March 16, 1995). The NASD proposal, applicable 
    to exchange-listed securities traded OTC, generally would require a 
    market maker either to execute immediately a limit order of less 
    than the minimum quotation size priced better than the market 
    maker's quotation, or display the order in its quotation for an 
    amount equal to the minimum quotation size. Market makers would have 
    to display a limit order greater than the minimum quotation size for 
    that security but would not have to display the full size of the 
    order. Any portion of the order not displayed, however, would have 
    to be executed at a price at least as favorable as the displayed 
    price if the displayed portion is executed in its entirety. At the 
    NASD's request, the Commission has postponed final action on the 
    NASD's proposal in order to permit the NASD to evaluate its proposal 
    in light of the Commission's actions on the proposals it is adopting 
    today.
    
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    [[Page 48294]]
    
        The exchanges and the NASD use automated trading systems to route 
    and, in some instances, execute orders up to a predetermined size. Some 
    of these systems accept limit orders. Each system, however, may differ 
    in its handling of limit orders that are not executed immediately upon 
    receipt. For example, the NYSE's SuperDOT system routes limit orders to 
    the specialists' posts where they are handled in accordance with NYSE 
    rules governing specialist representation of such orders. The American 
    Stock Exchange's (``Amex'') PER system routes limit orders in the same 
    manner as SuperDOT and the orders are handled in accordance with Amex 
    rules. The NASD's Small Order Execution System (``SOES'') treats limit 
    orders priced at the current inside market as market orders that are 
    immediately executed.43 All other limit orders reside in a limit 
    order file that can be viewed only by market makers.44 SOES does 
    not provide an opportunity for limit orders to interact with incoming 
    market orders. The Commission has published for comment an NASD 
    proposal to replace SOES with ``NAqcess,'' a system that would include 
    a limit order file designed to display certain customer limit 
    orders.45
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        \43\ Preferenced orders (i.e., orders routed to a specific 
    market maker pursuant to a pre-existing agreement) are executed 
    immediately at the inside quote. Unpreferenced orders are executed 
    against market makers in a security in rotation. SOES, however, does 
    not execute an unpreferenced order against a single market maker 
    more than once every 15 seconds.
        \44\ The current SOES rules have been extended, with certain 
    changes that do not affect the handling of limit orders, through 
    January 31, 1997. Securities Exchange Act Release No. 37502 (July 
    30, 1996), 61 FR 40869 (August 6, 1996).
        \45\ See Securities Exchange Act Release No. 36548 (December 1, 
    1995), 60 FR 60392 (December 8, 1995) (``NAqcess Release 1''); 
    NAqcess Release 2, supra note 21. As proposed, NAqcess would act as 
    an order delivery system with a limited public limit order file.
        Limit orders up to 9,900 shares would be permitted in NAqcess 
    for the top 250 Nasdaq National Market securities, defined by median 
    daily dollar volume, and for 1,000 shares for all other Nasdaq 
    securities. Market makers would be allowed to query the entire limit 
    order file. All other market participants would be limited to 
    viewing the top of the NAqcess limit order file (i.e., the best 
    priced buy and sell limit orders, and the size associated with those 
    orders--the NAqcess inside market). This inside market would be 
    factored into the calculation for the inside quote for each Nasdaq 
    security. Although use of NAqcess would be voluntary, limit orders 
    not entered in NAqcess would be provided with market-wide price 
    protection under the proposal.
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        The disparate treatment of limit orders across markets was raised 
    as an issue in the Market 2000 Study. The Commission received numerous 
    comments concerning whether the optimal degree of pre-trade disclosure 
    of limit orders was being achieved within the U.S. equity markets. Some 
    commentators alleged that specialists and third market dealers 
    sometimes fail to display limit orders priced better than the displayed 
    quotation.46 Questions also were raised about the lack of limit 
    order exposure on Nasdaq. After considering these comments, the 
    Division recommended in the Study that the securities exchanges 
    consider whether to encourage the display of all limit orders in listed 
    stocks priced better than the best intermarket quotes, unless the 
    ultimate customer requests that the order not be displayed. The Market 
    2000 Study also recommended the display of limit orders in Nasdaq 
    stocks when the orders are at prices better than the best Nasdaq 
    quotes, unless the customer requests that the order not be 
    displayed.47
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        \46\ See generally Thomas H. McInish & Robert A. Wood, Hidden 
    Limit Orders on the NYSE, 21 J. Portfolio Mgmt. 19 (No. 3, Spring 
    1995) (``McInish & Wood Study''). The authors asserted that NYSE 
    specialists only display about 50% of limit orders that better 
    existing quotes. In their opinion, this practice represents a 
    serious policy issue because it places both public investors and 
    regional exchanges at a disadvantage. They asserted that hiding 
    limit orders impedes strategic decisions on order placement; results 
    in publicly submitted market orders receiving inferior prices; 
    hampers the monitoring of order executions; reduces the probability 
    of a limit order being executed; results in a delay in reporting 
    limit order executions; interferes with the ability of the regional 
    exchanges to execute public orders; and artificially improves NYSE 
    performance relative to the regional exchanges using a common 
    benchmark. The authors also claimed that NYSE Rule 60 is ambiguous 
    in that the specialists may have some leeway in choosing what to 
    disclose in their quotes.
        In its comment letter to the Market 2000 Study, however, the 
    NYSE asserted that its publicly disseminated best bid or offer 
    includes all firm trading interest announced on the floor as 
    required by the exchange's rules. See Letter from William H. 
    Donaldson, Chairman and Chief Executive Officer, NYSE, to Jonathan 
    G. Katz, Secretary, SEC at 25-26 (November 24, 1992). In addition, 
    the NYSE issued a policy statement that reiterates that specialists 
    have an obligation to reflect in their quotes certain limit orders 
    received manually or via SuperDOT that are not executed on receipt. 
    See supra note 26.
        \47\ Market 2000 Study, at IV-6.
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    2. Discussion
    a. Basis for Adoption of the Rule
        After carefully considering all of the comments as well as economic 
    research regarding the Display Rule, and based on the Commission's 
    experience and knowledge of current market practices and conditions, 
    the Commission believes that adoption of the Display Rule will promote 
    transparency and enhance execution opportunities for customer orders, 
    and encourage liquidity.48
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        \48\ See, e.g., Letter from Thomas F. Ryan, Jr., President and 
    Chief Operating Officer, Amex, to Jonathan G. Katz, Secretary, SEC, 
    dated February 1, 1996 (``Amex Letter''); Letter from David E. Shaw, 
    Ph.D., Chairman, D.E. Shaw & Co., to Jonathan G. Katz, Secretary, 
    SEC, dated January 9, 1996 (``D.E. Shaw Letter'') (rule will promote 
    transparency); Letter from Paul A. Merolla, Vice President, 
    Associate General Counsel, Goldman, Sachs & Co., to Jonathan G. 
    Katz, Secretary, SEC, dated January 26, 1996 (``Goldman Sachs 
    Letter'') (rule would benefit marketplace); Letter from Craig S. 
    Tyle, Vice President and Senior Counsel, Securities and Financial 
    Regulation, Investment Company Institute, to Jonathan G. Katz, 
    Secretary, SEC, dated January 16, 1996 (``ICI Letter'') (increased 
    transparency of customer limit orders in all markets could produce 
    benefits to the markets and investors); Letter from Donald L. 
    Crooks, Managing Director, Lehman Brothers, Inc., to Jonathan G. 
    Katz, Secretary, SEC, dated February 26, 1996 (``Lehman Letter'') 
    (rule promotes transparency and results in improved opportunities 
    for execution of customer orders); Letter from Bernard L. Madoff and 
    Peter B. Madoff, Bernard L. Madoff Investment Securities, to 
    Jonathan G. Katz, Secretary, SEC, dated January 12, 1996 (``Madoff 
    Letter'') (rule will help achieve true price discovery and fairness 
    to investors); Letter from Andrew E. Feldman, Director and Associate 
    General Counsel, Smith Barney Inc., to Jonathan G. Katz, Secretary, 
    SEC, dated January 29, 1996 (``Smith Barney Letter'') (rule will 
    promote transparency and assist in achieving best execution of 
    orders). But see Letter from Charles R. Hood, Senior Vice President 
    and General Counsel, Instinet, to Jonathan G. Katz, Secretary, SEC, 
    dated January 16, 1996 (``Instinet Letter'') (exceptions to rule 
    eliminate potential positive impact on transparency).
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        The Commission stresses, however, that the rule is not meant to 
    displace any SRO rules that provide additional order handling 
    protections to customer limit orders. Instead, the Commission rule 
    represents only a minimum display standard.
        The Commission believes that limit orders are a valuable component 
    of price discovery. The uniform display of such orders will encourage 
    tighter, deeper, and more efficient markets. Limit orders convey buying 
    and selling interest at a given price. The display of limit orders can 
    be expected to narrow the bid-ask spread when this buying and selling 
    interest is priced better than publicly disclosed prices.49 Both 
    large and small orders stand to benefit from the Display Rule's effect 
    on price discovery.50 In fact, the importance of
    
    [[Page 48295]]
    
    limit orders in the trading process was documented in recent 
    studies.51 The author quantified the impact of exposing limit 
    orders on quoted spreads and effective transaction costs. Using NYSE 
    data, he determined that the quote spreads resulting from participation 
    of the limit order book were approximately 4 to 6 cents smaller than 
    the spreads not set by the limit order book. Further, trading costs on 
    the NYSE were approximately 3-4 cents less per share on a ``round 
    trip'' transaction when both the purchase and the sale were executed 
    against the limit order book.52
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        \49\ For example, limit order trading allows investors the 
    opportunity to trade at prices superior to those represented by the 
    prevailing inside bid and offer. See NASD Study, supra note 21.
        \50\ According to SuperDOT trade data analyzed by the 
    Commission's Office of Economic Analysis (``OEA''), customer limit 
    orders account for 50% of all NYSE customer trades originating from 
    orders routed through SuperDOT (``customer trades'') of 100-500 
    shares; 66% of all customer trades of 600-1,000 shares; 71% of all 
    customer trades of 1,100-3,000 shares; and 74% of all customer 
    trades of 3,100-9,900 shares. The Commission believes that these 
    high percentages are based, at least in part, on the fact that limit 
    orders routed through SuperDOT are required to be displayed in the 
    specialist's quote. The Commission believes that these percentages 
    help demonstrate the benefits associated with limit order display 
    for both large and small order sizes. In addition, OEA data shows 
    that NYSE customer limit orders routed through SuperDOT narrow the 
    NYSE quote 22% of the time and match the quote 39% of the time for 
    customer limit orders of 100-1,000 shares; narrow the quote 17% of 
    the time and match the quote 43% of the time for customer limit 
    orders of 1,100-3,000 shares; and narrow the quote 14% of the time 
    and match the quote 46% of the time for customer limit orders of 
    3,100-9,900. OEA data also shows that, when the NYSE bid-ask spread 
    was \1/4\ point or more, customer limit orders routed through 
    SuperDOT narrow the NYSE spread between 41% and 50% of the time, 
    depending on the size of the customer order.
        \51\ See Jason T. Greene, The Impact of Limit Order Executions 
    on Trading Costs in NYSE Stocks (An Empirical Examination), December 
    1995 (``Greene Study''); see also Jason T. Greene, Limit Order 
    Executions and Trading Costs for NYSE Stocks, June 1996 (``Greene 
    Study II'').
        \52\ The Commission further believes that the display 
    requirement will improve price transparency in securities with 
    diverse trading characteristics. Based on SuperDOT trade data, the 
    Commission's OEA has determined that for NYSE securities with an 
    average daily trading value (``ADTV'') of under $100,000, customer 
    limit orders account for 57% of all NYSE customer trades originating 
    from orders routed through SuperDOT (``customer trades'') of 100-500 
    shares; 69% of all customer trades of 600-1,000 shares; 76% of all 
    customer trades of 1,100-3,000 shares; and 83% of all customer 
    trades of 3,100-9,900 shares. Limit orders also are frequently used 
    for securities with higher ADTVs. For example, for NYSE securities 
    with an ADTV of over $5,000,000, customer limit orders account for 
    48% of all NYSE customer trades of 100-500 shares; 68% of all 
    customer trades of 600-1,000 shares; 72% of all customer trades of 
    1,100-3,000 shares; and 73% of all customer trades of 3,100-9,900 
    shares. Moreover, OEA data shows that for NYSE securities with an 
    ADTV of under $100,000, customer limit orders routed through 
    SuperDOT narrow the NYSE quote 30% of the time and match the quote 
    32% of the time. For less liquid securities, therefore, the display 
    of customer limit orders narrows spreads, improves price discovery, 
    and increases market depth. For NYSE securities with an ADTV of 
    $5,000,000 or more, customer limit orders routed through SuperDOT 
    narrow the NYSE quote 18% of the time and match the quote 41% of the 
    time.
        The NASD has suggested that the greater the size of the 
    displayed spread, the greater the use of limit orders. See NASD 
    Study, supra note 21.
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        The uniform display of limit orders also will lead to increased 
    quote-based competition. Market makers will not only be competing 
    amongst themselves, but also against customer limit orders represented 
    in the quote. The Commission believes that this result will reduce the 
    possibility of certain trading behavior on Nasdaq that was recently the 
    subject of a Commission investigation.\53\ As reported in the 21(a) 
    Report, Nasdaq market makers widely adhered to a ``pricing 
    convention,'' whereby Nasdaq market makers maintained artificially 
    inflexible quotations and as a result often traded with the public at 
    prices unduly favorable to such market makers.\54\ In addition, the 
    Commission determined that Nasdaq market makers adhered to a ``size 
    convention'' that deterred Nasdaq market makers from narrowing their 
    quotes to create a new inside market unless the market makers were 
    willing to trade at least 2,000 to 5,000 shares at that price, rather 
    than the minimum quotation size as determined by NASD rules.\55\ This 
    practice prevented the dissemination of improved quotes when a trader 
    sought to trade stock only at a size equal to the minimum quotation 
    size. Thus, the true buying and selling interest in a given security 
    was not reflected in the published quotes.
    ---------------------------------------------------------------------------
    
        \53\ See 21(a) Report, supra note 28. The investigation 
    identified a number of practices in the Nasdaq market that are 
    similar to practices identified in the 1963 Special Study. See SEC, 
    Report of Special Study of Securities Markets (1963). For example, 
    the 1963 Special Study discussed cooperation and information sharing 
    between traders, as well as other non-competitive practices. Id. at 
    pt. 2, 576-577.; See also Competitive Impact Statement of the U.S. 
    Department of Justice Antitrust Division, United States v. Alex. 
    Brown & Sons, et. al., (S.D.N.Y. 1996).
        \54\ As a result of this convention, most Nasdaq stocks were 
    quoted only in increments of \1/4\. Under the convention, stocks 
    with a dealer spread of \3/4\ or more would only be quoted in even-
    eighths (i.e., \1/4\, \1/2\, \3/4\), thereby giving rise to a 
    minimum inside spread of \1/4\. Stocks with dealer spreads less than 
    \3/4\ would be quoted in both even and odd-eighths, thereby allowing 
    a minimum inside spread of \1/8\. The pricing convention 
    significantly limited the flexibility and competitiveness of price 
    quotations in the Nasdaq market.
        \55\ See 21(a) Report, supra note 28.
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        In addition to the Commission's actions, and those of the 
    Department of Justice in connection with its investigation of the 
    Nasdaq market, the Commission believes the requirement to display 
    customer limit orders in market maker quotes would inhibit market 
    makers from engaging in the conduct described above. Moreover, the 
    display of limit orders reduces the potential for certain other conduct 
    described in the 21(a) Report, including market maker collaboration and 
    coordination of trade and quote activities. Market makers will be less 
    able to improperly coordinate such behavior due to the display of 
    competing customer order flow and the resulting transparency of 
    ultimate buying and selling interest. The Commission believes that the 
    display requirement will both foster renewed quote-based competition 
    among market makers and introduce new competition from customer limit 
    orders.
        The Commission also believes that overall market liquidity should 
    be enhanced due to the increased trading volume that is expected to 
    result from the display of limit orders.\56\ As noted previously, 
    customer limit orders account for a significant percentage of total 
    customer orders on the NYSE, where customer limit orders generally are 
    required to be displayed when they represent a better price.\57\ 
    Moreover, previous Commission initiatives designed to enhance 
    transparency have resulted in increased competition and liquidity for 
    the markets.\58\
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        \56\ See Greene Study and Greene Study II, supra note 51 (limit 
    orders affect the quoted spread, provide liquidity to traders that 
    demand immediacy of execution, and may contribute to reduced trading 
    costs); NASD Study, supra note 21 (the liquidity supplied by limit 
    orders reduces trading costs of market participants); OEA Data, 
    supra notes 50 and 52 (limit orders narrow spreads, improve price 
    discovery, and increase market depth).
        \57\ See OEA Data, supra notes 50 and 52.
        \58\ See Market 2000 Study at Study IV. See also discussion at 
    section III.A.b.iii., infra; Simon & Colby The National Market 
    System For Over-The-Counter Stocks (``Simon and Colby''), 55 Geo. 
    Wash. L. Rev. 17 (1986).
    ---------------------------------------------------------------------------
    
        Customers also will be better able to monitor the quality of their 
    executions. Currently, the failure to display limit orders often 
    results in inferior or missed executions for these orders. The 
    Commission has received frequent complaints from customers whose limit 
    orders have not been filled while other executions are reported at 
    prices inferior to their limit order prices. Requiring the display of 
    customer limit orders in specialist and market maker quotes, although 
    not guaranteeing that such limit orders will be executed, will help 
    ensure that other orders are not executed at inferior prices until 
    better priced limit orders are executed. Similarly, customers entering 
    market orders will be able to determine whether their orders are 
    receiving the best price available. Customers also will be in a better 
    position to compare the execution quality provided by different broker-
    dealers.\59\
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        \59\ The Commission notes that if the Display Rule leads some 
    market makers to charge commissions for handling limit orders, 
    Commission rules require disclosure of such charges. See 17 CFR 
    240.10b-10.
    ---------------------------------------------------------------------------
    
        The absence of a uniform limit order display requirement across all 
    markets has contributed to the controversy among market participants 
    regarding the availability of true price improvement
    
    [[Page 48296]]
    
    opportunities. Many claim that ``hidden'' limit orders in exchange 
    markets contribute to distorted price improvement figures for these 
    markets.\60\ This potential distortion also hinders a customer's 
    ability to monitor execution quality. Pursuant to the Display Rule, the 
    vast majority of limit orders will be publicly disclosed, thus enabling 
    a more accurate comparison of price improvement opportunities, and 
    enabling customers and broker-dealers to make more informed order 
    routing decisions.\61\
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        \60\ See James J. Angel, Who Gets Price Improvement on the 
    NYSE?, Working Paper, December 1994. In studying the availability of 
    price improvement on the NYSE, the author noted that over 18% of the 
    market orders that were price improved were filled by SuperDOT limit 
    orders. Based on this percentage, the author estimated the 
    percentage of orders price improved by ``hidden'' limit orders and 
    determined that if such limit orders were represented in the 
    specialist's quote rather than ``hidden,'' spreads would have been 
    narrower and NYSE price improvement statistics would have declined. 
    See also, McInish & Wood Study, supra note 46; Mitchell A. Petersen 
    & David Fialkowski, Posted Versus Effective Spreads: Good Prices or 
    Bad Quotes, 35 J. Fin. Econ. 269 (1994) (the fact that so many 
    orders execute inside the posted spreads indicates that quotes do 
    not represent the true supply and demand of a given security, and 
    may be based, in part, on the failure to display public limit order 
    interest in the quote). Cf. Ross, Shapiro and Smith, supra note 17 
    (although the authors did not examine limit orders in detail, and 
    discounted the effect of ``hidden'' limit orders on their 
    statistics, the authors found that limit orders provide 27% of the 
    price improvement afforded to SuperDOT market order volume).
        \61\ See, e.g., Amex Letter (rule would help eliminate hidden 
    limit orders); Letter from Frederick Moss, Chairman of the Board, 
    CSE, to Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 
    (``CSE Letter'') (elimination of hidden limit orders will eliminate 
    illusion of superior price improvement); Letter from Harold S. 
    Bradley, Vice President and Director of Trading, Investors Research 
    Corporation, to Jonathan G. Katz, Secretary, SEC, dated January 13, 
    1996 (``Investors Research Letter'') (hidden limit orders are not 
    justified).
    ---------------------------------------------------------------------------
    
        Moreover, the Commission believes that the display of limit orders 
    will benefit orders routed to automated execution systems. To the 
    extent these systems execute orders at prices based on the best 
    displayed quotation for a particular security,\62\ customers whose 
    orders are executed through these systems will receive the benefit of 
    prices that more accurately reflect buying and selling interest in the 
    market.
    ---------------------------------------------------------------------------
    
        \62\ Compare discussion of best execution at section III.C.2.
    ---------------------------------------------------------------------------
    
        In sum, the Commission believes the adoption of the Display Rule is 
    an important step in furthering the goals expressed by Congress in the 
    1975 Amendments. The Display Rule will provide enhanced opportunities 
    for public orders to interact with other public orders, consistent with 
    congressional goals.63 In addition, the display requirement will, 
    among other things, narrow quotes, enhance market liquidity, and 
    improve an investor's ability to monitor the quality of its 
    executions.64 This will create a better environment for execution 
    of both limit and market orders without the participation of a dealer. 
    The increased order interaction will result in quicker and more 
    frequent executions of customer limit orders. The Display Rule, 
    therefore, will increase the likelihood that limit orders will be 
    executed, a result that the Commission believes is consistent with the 
    duty of best execution.
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        \63\ See 15 U.S.C. 78k-1(a)(1)(C)(v).
        \64\ The Commission notes that a few commenters are concerned 
    about the potential effects of the Commission's proposals on 
    institutional customers. See Goldman Sachs Letter; Letter from 
    Howard J. Schwartz, Chairman and Chief Executive Officer, and James 
    Hanrahan, Managing Director--Trading, Lynch, Jones & Ryan, Inc., to 
    Jonathan G. Katz, Secretary, SEC, dated February 9, 1996 (``LJR 
    Letter''); Letter from A.B. Krongard, Chairman, SIA Board of 
    Directors, and Bernard L. Madoff and Robert Murphy, Co-Chairmen, 
    Order Execution Committee, Securities Industry Association, to 
    Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 (``SIA 
    Letter''). The Commission believes that the Display Rule will 
    benefit both retail and institutional customers, while preserving 
    the access to the markets that institutional customers have today. 
    For example, an institutional customer's block size limit order 
    would not be subject to the rule unless such customer requests that 
    the order be displayed. Moreover, any customer, whether individual 
    or institutional, can request that its non-block size limit order 
    not be displayed. The Commission also notes that increased quote 
    competition and enhanced transparency should improve the prices at 
    which institutions and market makers begin their negotiations for 
    the execution of institutional orders. See also 21(a) Report, supra 
    note 28.
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    b. Response to Comments 65
        The Commission proposed Rule 11Ac1-4 to establish minimum display 
    requirements for customer limit orders that improve a specialist's or 
    OTC market maker's best bid or offer for a particular security as well 
    as the size of such orders. In addition, the rule requires the display 
    of the size of certain limit orders priced at the national best bid or 
    offer (``NBBO''). Although the rule generally would mandate the display 
    of limit orders, market makers and specialists still would retain some 
    flexibility in handling limit orders accepted for execution.
    ---------------------------------------------------------------------------
    
        \65\ For further discussion of the views of commenters, see the 
    Summary of Comments, supra note 4.
    ---------------------------------------------------------------------------
    
        Specifically, the rule allows an OTC market maker or specialist, 
    immediately upon receipt of a limit order, to: (1) Change its quote and 
    the size associated with its quote to reflect the limit order; (2) 
    execute the limit order; (3) deliver the limit order in an exchange- or 
    association-sponsored system that complies with the requirements of the 
    rule; or (4) send the limit order to another market maker or specialist 
    who complies with the requirements of the rule. The rule would require 
    a specialist or OTC market maker to display a customer limit order when 
    the order was ``held'' by the specialist or OTC market maker. If the 
    specialist or OTC market maker immediately sends the order to a system 
    or to another specialist or OTC market maker that complies with the 
    rule, the specialist or OTC market maker that routed the order would 
    have satisfied its obligation to display the order. These alternatives 
    are intended to allow market makers, specialists, and market centers an 
    opportunity to continue to provide their valuable services while 
    offering customers the best available execution opportunities.
        The Display Rule as adopted maintains these alternatives as 
    proposed. Additionally, to better achieve its aims and to respond to 
    comments, the Commission has made some modifications to the proposed 
    rule. For example, the Commission has decided to permit a specialist or 
    OTC market maker to deliver a limit order to certain ECNs as an 
    alternative to representing the limit order in its quote. This change 
    is an extension of the proposed exception that permits a specialist or 
    OTC market maker to deliver a limit order to an exchange- or 
    association-sponsored system that complies with the Display Rule. 
    Moreover, with regard to implementation of the rule, the Commission is 
    providing for a four-stage phase-in over a one year period for non-
    exchange-traded securities.
        Of the commenters who specifically addressed the proposed Display 
    Rule, an overwhelming majority strongly support the inclusion of 
    customer limit orders in the quote.66 One commenter
    
    [[Page 48297]]
    
    notes that true price discovery and fairness for public investors can 
    only be achieved when limit orders are reflected in the NBBO.67 
    Other commenters, expressing strong support for the proposed rule, 
    believe that market-wide limit order procedures will improve the 
    markets by enhancing overall market transparency 68 and 
    eliminating the advantages derived by some markets from hidden limit 
    orders.69 The Department of Justice states that the proposed rule 
    encourages quote competition, which is likely to reduce spreads,70 
    and allows customer orders to interact with one another.71 In this 
    regard, several commenters recognize that the proposed rule would 
    assist in achieving best execution of customer orders 72 by 
    increasing the opportunities for execution of limit orders, and 
    improving the prices for market orders.73 Another commenter states 
    that the proposed rule is consistent with investor expectations and 
    will act to protect retail customer interests.74
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        \66\ See, e.g., Amex Letter; Letter from Marshall E. Blume, 
    Director, Howard Butcher Professor of Financial Management, The 
    Wharton School of the University of Pennsylvania, to Jonathan G. 
    Katz, Secretary, SEC, dated January 11, 1996 (``Blume Letter''); 
    Letter from George W. Mann, Jr., Senior Vice President and General 
    Counsel, BSE, to Jonathan G. Katz, Secretary, SEC, dated January 26, 
    1996 (``BSE Letter''); Letter from Robert H. Forney, CHX, to 
    Jonathan G. Katz, Secretary, SEC, dated January 23, 1996 (``CHX 
    Letter''); D.E. Shaw Letter; Letter from Antitrust Division, U.S. 
    Department of Justice, to SEC, dated January 26, 1996 (``DOJ 
    Letter''); Letter from Preston Estep, Estep Trading Partners L.P., 
    to Jonathan Katz, Secretary, SEC, dated December 21, 1995 (``Estep 
    Letter''); Goldman Sachs Letter; ICI Letter; Lehman Letter; Madoff 
    Letter; Letter from William A. Lupien, Chairman and Chief Executive 
    Officer, Mitchum, Jones & Templeton, Inc., to Jonathan G. Katz, 
    Secretary, SEC, dated January 8, 1996 (``MJT Letter''); Letter from 
    Joseph R. Hardiman, President, National Association of Securities 
    Dealers, Inc., to Jonathan G. Katz, Secretary, SEC, dated January 
    26, 1996 (``NASD Letter''); Letter from James E. Buck, Senior Vice 
    President and Secretary, NYSE, Inc., to Jonathan G. Katz, Secretary, 
    SEC, dated January 15, 1996 (``NYSE Letter''); Letter from David S. 
    Pottruck, President and Chief Operating Officer, The Charles Schwab 
    Corporation, to Jonathan G. Katz, Secretary, SEC, dated May 7, 1996 
    (``Schwab Letter II''); SIA Letter; Letter from William R. Rothe, 
    Chairman, and John L. Watson III, President, Security Traders 
    Association, to Jonathan G. Katz, Secretary, SEC, dated January 15, 
    1996 (``STA Letter''); Letter from John F. Luikart, President and 
    Chief Executive Officer, Sutro & Co., to Jonathan Katz, Secretary, 
    SEC, dated January 16, 1996 (``Sutro Letter'').
        \67\ Madoff Letter.
        \68\ See, e.g., Amex Letter; CHX Letter; CSE Letter; D.E. Shaw 
    Letter; ICI Letter; Investors Research Letter; Lehman Letter; Smith 
    Barney Letter.
        \69\ See, e.g., Amex Letter (rule would help eliminate hidden 
    limit orders); CSE Letter (elimination of hidden limit orders will 
    eliminate illusion of superior price improvement); Investors 
    Research Letter (hidden limit orders are not justified).
        \70\ DOJ Letter.
        \71\ Id; see also Amex Letter; Lehman Letter.
        \72\ See, e.g., Lehman Letter; Smith Barney Letter.
        \73\ Lehman Letter.
        \74\ D.E. Shaw Letter.
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        Other commenters oppose the proposal. Several commenters in this 
    group have raised the following general concerns regarding the proposed 
    rule.
    i. Distinction Between Markets
        Several commenters argue that the Display Rule does not take into 
    account distinctions between auction and dealer markets. Some of these 
    commenters, discussing the Proposing Release as a whole, argue that the 
    Commission's proposals would ``auctionize'' the dealer market.75 
    One commenter warns that, because auction and dealer markets are 
    fundamentally different, a single set of rules for both auction and 
    dealer markets would reduce quote quality and damage overall market 
    integrity in dealer markets.76 Although the SIA reports that the 
    consensus view of its Ad Hoc Committee on Order Execution is to require 
    a market maker to reflect customer limit orders in the quote, the SIA 
    argues that the adoption of the proposed rule, without suggested 
    modifications, could adversely affect the dealer market so as to weaken 
    competition between dealer and auction markets.77
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        \75\ See, e.g., Letter from R. Steven Wunsch, President, AZX, 
    Inc., to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 
    (``AZX Letter''); Goldman Sachs Letter; Letter from David Rich, Vice 
    President, Jefferies & Company, Inc., to Jonathan G. Katz, 
    Secretary, SEC, dated January 25, 1996 (``Jefferies Letter''); 
    Letter from Robert W. Murphy, President, RPM Specialist Corporation, 
    to Jonathan G. Katz, Secretary, SEC, dated February 26, 1996 (``RPM 
    Letter''); Letter from Robert A. Schwartz, Professor of Finance and 
    Economics, and Yamaichi Faculty Fellow, Leonard N. Stern School of 
    Business, New York University, and Robert A. Wood, Distinguished 
    Professor of Finance, Fogelman College of Business and Economics, 
    University of Memphis, to Jonathan G. Katz, Secretary, SEC, dated 
    January 23, 1996 (``Schwartz & Wood Letter''); SIA Letter.
        \76\ RPM Letter.
        \77\ SIA Letter. Cf. Letter from A.B. Krongard, Chairman, SIA 
    Board of Directors, and Bernard L. Madoff, Chairman, Trading 
    Committee, to Jonathan G. Katz, Secretary, SEC, dated August 1, 1996 
    (``SIA NAqcess Letter'') (the SIA, in its letter to the Commission 
    regarding the NASD's NAqcess proposal, states that the Commission's 
    Order Execution Obligations proposal would narrow quotation spreads, 
    improve transparency, and provide customers with best execution of 
    their orders, consistent with the 1975 Amendments).
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        The Commission believes that the application of the principles 
    underlying the limit order display rule to the dealer market is neither 
    a new nor radical concept. In 1975, Congress envisioned an NMS in which 
    public limit orders in qualified securities would have a central 
    role.78 Congress anticipated that the NMS would make all 
    specialists and market makers aware of public customer limit orders 
    held anywhere in the system, and provide enhanced protection and 
    priority for limit orders in stocks qualified for trading in a national 
    market system.79 The Commission has consistently recognized since 
    1975 that, in order to satisfy this Congressional vision, multiple-
    market display of limit orders was an important component for qualified 
    securities.80 More recently, the Market 2000 Study recommended 
    that the SROs, including the NASD, consider requiring the display of 
    customer limit orders,81 and the NASD, in a proposed rule change 
    filed with the Commission, proposed that CQS market makers display in 
    their quotes certain customer limit orders for exchange-listed 
    securities traded OTC.82 The NASD also has proposed a mechanism 
    for the display and protection of customer limit orders in Nasdaq 
    securities.83
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        \78\ Senate Report, supra note 31.
        \79\ Id. The Senate Report stressed the need to establish a 
    mechanism by which specialists and market makers could be made aware 
    of customer orders within the NMS. The Senate Report was ``satisfied 
    that [the legislation] grant[ed] the Commission complete and 
    effective authority to implement a system for the satisfaction of 
    public limit orders.'' Id. at 18.
        \80\ See Securities Exchange Act Release No. 15671 (March 22, 
    1979), 44 FR 20360 (April 4, 1979) (Development of a National Market 
    System Status Report). See also Securities Exchange Act Release No. 
    18738 (May 13, 1982), 47 FR 22376 (May 24, 1982) (proposing limit 
    order display requirement for Rule 19c-3 securities).
        \81\ Market 2000 Study, at IV-6.
        \82\ See supra note 42.
        \83\ See supra note 45.
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        Although some commenters claim that the Commission is attempting to 
    ``auctionize'' the dealer market, the display requirement is based on 
    transparency and agency concerns, including a broker-dealer's 
    obligation to provide its customers with best execution.84 The 
    display of customer limit orders will act to narrow spreads, improve 
    price discovery, and increase market depth. The enhanced transparency 
    resulting from the Display Rule will increase the likelihood that 
    customer limit orders will be executed, improve the execution prices of 
    market orders, and strengthen an investor's ability to monitor the 
    quality of executions.85 These results further several 
    Congressional goals.
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        \84\ See NASD Study, supra note 21 (enhancements to limit order 
    handling, within the dealer market structure, will create 
    significant benefits for investors). See also Manning II, supra note 
    24 (Commission's extension of limit order protection to Nasdaq does 
    not suggest an intention to ``auctionize'' the dealer market).
        \85\ See Senate Report, supra note 31 at 16-18 (discussing 
    desirability of incorporating certain auction market principles, 
    such as limit order display and protection, for certain qualifying 
    securities in dealer markets).
    ---------------------------------------------------------------------------
    
        In keeping with Congressional intent, the Commission believes the 
    treatment of limit orders should reflect the very real changes in 
    market structure that have taken place since the enactment of the 1975 
    Amendments. These changes include the development of a robust, liquid 
    OTC dealer market that attracts significant investor trading interest, 
    that trades at many multiples of the volume extant in 1975, and that is 
    characterized by the inclusion of thousands of securities that meet the 
    NMS designation.86 In addition, the
    
    [[Page 48298]]
    
    Commission believes that application of the Display Rule should also 
    benefit investors in those securities that do not yet meet the NMS 
    designation.87 As noted earlier, the Commission believes that the 
    increased use of limit orders in these securities will lead to a 
    narrowing of spreads and ameliorate certain anti-competitive practices 
    that have developed in the Nasdaq market.88 The Commission has 
    determined that certain practices on Nasdaq have contributed to 
    artificially wide spreads for OTC securities.89 The display of 
    customer limit orders in all Nasdaq securities will promote accurate 
    pricing and convey the true buying and selling interest in such 
    securities.
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        \86\ To date, approximately 4,000 Nasdaq securities have 
    qualified for the NMS designation. In order to qualify as an NMS 
    security, transaction reports are required to be reported on a real-
    time basis pursuant to an effective transaction reporting plan 
    approved by the Commission. See 17 CFR 240.11Aa2-1 and 11Aa3-1.
        \87\ As discussed below, the Display Rule will apply only to 
    ``covered securities.'' At the present time, the Commission does not 
    believe the rule should be extended to securities for which market 
    makers are not required to quote continuous firm two-sided markets, 
    such as OTC Bulletin Board securities.
        \88\ See supra discussion at section III.A.2.a.
        \89\ 21(a) Report, supra note 28.
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        A few commenters believe that the Display Rule was proposed solely 
    to address problems in the OTC market, and accordingly there is no need 
    for a uniform rule applicable to exchange markets.90 As noted 
    previously, the Commission's intention is to create a minimum standard 
    for the handling of limit orders across all markets, consistent with 
    market transparency, competition, and best execution principles. 
    Currently, the national securities exchanges do not handle limit orders 
    uniformly, and in fact the non-display of retail-size limit orders is 
    permitted under certain circumstances. The rule will ensure that 
    investors benefit from the display of limit orders, no matter where an 
    order is sent for execution.91 A minimum standard also addresses 
    concerns regarding the prevalence of hidden limit orders.92 The 
    Commission believes, therefore, that a market-wide limit order display 
    requirement is most consistent with the duty of best execution and the 
    expectations of investors.
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        \90\ See, e.g., BSE Letter; NYSE Letter; RPM Letter; Letter from 
    David E. Humphreville, Executive Director, The Specialist 
    Association, to Jonathan G. Katz, Secretary, SEC, dated February 2, 
    1996 (``Specialist Assoc. Letter'').
        \91\ See, e.g., Greene Study & Greene Study II, supra note 51.
        \92\ See generally McInish & Wood Study, supra note 46 (hidden 
    limit orders result in, among other things, artificial price 
    improvement statistics and inferior order executions); Traders 
    Accuse Specialists of Holding Back Limit Orders, Investment Dealers' 
    Digest, 8, (February 14, 1994) (some traders have continued to 
    accuse NYSE specialists of hiding limit orders even after the NYSE 
    issued an Information Memo reminding specialists of their duties); 
    Greene Study and Greene Study II, supra note 51 (one explanation for 
    the significantly lower bid-ask spreads in the 1994-95 sample than 
    in the 1990 sample, and the increase in the percentage of 
    transactions at the quoted prices from the 1990 sample to the 1994-
    95 sample, may be that NYSE specialists were more diligent in 
    reflecting the limit order book in their quotes as per Information 
    Memo 93-12); Amex Letter (rule would help eliminate hidden limit 
    orders); CSE Letter (elimination of hidden limit orders will 
    eliminate illusion of superior price improvement); Investors 
    Research Letter (hidden limit orders are not justified).
    ---------------------------------------------------------------------------
    
    ii. Distinction Between Quotes and Orders
        Some commenters maintain that the rule blurs the distinction 
    between quotations and orders.93 One commenter states that limit 
    orders represent only a finite trading interest while quotes represent 
    the ``actual'' market for a security; thus, displaying limit orders 
    would not reflect the ``true'' state of the market and impair the 
    quality of quotation information.94 The commenter suggests that a 
    separate limit order file would be more appropriate in light of these 
    distinctions.95 In this vein, several commenters mention the 
    NASD's proposed NAqcess system,96 suggesting that the Commission 
    postpone implementation of the Display Rule until the Commission has an 
    opportunity to assess the effects of NAqcess.97 A few commenters 
    suggest the implementation of an industry-wide consolidated limit order 
    book as an alternative or a logical outgrowth of the Display 
    Rule.98
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        \93\ See, e.g., Letter from Raymond L. Aronson, Senior Managing 
    Director, Bear, Stearns & Co. Inc., to Jonathan G. Katz, Secretary, 
    SEC, dated February 1, 1996 (``Bear Stearns Letter''); Instinet 
    Letter; Letter from Carol L. Cunniff, Executive Vice President, 
    Ruane, Cunniff & Co., Inc., to Jonathan G. Katz, Secretary, SEC, 
    dated February 23, 1996 (``Ruane Letter''); Letter from Charles R. 
    Schwab, Chairman and Chief Executive Officer, The Charles Schwab 
    Corporation, to Jonathan G. Katz, Secretary, SEC, dated January 25, 
    1996 (``Schwab Letter''). But see Schwab II Letter (supporting the 
    Display Rule).
        \94\ Ruane Letter.
        \95\ Id. See also Bear Stearns Letter (discussion of proposed 
    central limit order file for The Nasdaq Stock Market so as to 
    preserve distinction between dealer quotes and agency or proprietary 
    orders).
        \96\ See supra note 45.
        \97\ See, e.g., Letter from A.B. Krongard, Chief Executive 
    Officer, Alex. Brown & Sons, Inc., to Jonathan G. Katz, Secretary, 
    SEC, dated February 29, 1996 (``Alex. Brown Letter''); Letter from 
    Albert G. Lowenthal, Chairman of the Board, Fahnestock & Co., Inc., 
    to Jonathan G. Katz, Secretary, SEC, dated January 15, 1996 
    (``Fahnestock Letter''); Jefferies Letter; Letter from Gerard S. 
    Citera, Deputy General Counsel, First Vice President, PaineWebber 
    Incorporated, to Jonathan G. Katz, Secretary, SEC, dated February 9, 
    1996 (``PaineWebber Letter''); Schwab Letter; STA Letter; Letter 
    from Charles Snow, Counsel, Securities Traders Association of New 
    York, to Jonathan G. Katz, Secretary, SEC, dated January 30, 1996 
    (``STANY Letter''); see also Letter from C. Robert Paul, III, 
    Associate General Counsel, Dean Witter Reynolds, Inc., to Jonathan 
    G. Katz, Secretary, SEC, dated January 31, 1996 (``Dean Witter 
    Letter''); Goldman Sachs Letter.
        \98\ See, e.g., DOJ Letter; MJT Letter; Schwab Letter; Letter 
    from Junius W. Peake, Monfort Distinguished Professor of Finance, 
    University of Northern Colorado, to Jonathan G. Katz, Secretary, 
    SEC, dated January 15, 1996 (``Peake Letter''); Letter from Jeffrey 
    P. Ricker, CFA, to Jonathan G. Katz, Secretary, SEC, dated January 
    15, 1996 (``Ricker Letter''); Letter from Peter W. Jenkins, 
    Chairman, and Holly A. Stark, Vice Chairman, Institutional 
    Committee, Securities Traders Association, to Jonathan G. Katz, 
    Secretary, SEC, dated January 19, 1996 (``STAIC Letter'').
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        The Commission believes that the display of limit orders is an 
    essential component of accurate price discovery. A quote provides 
    market participants with information regarding a market maker's or 
    specialist's trading interest at a given price. A market maker or 
    specialist could be willing to purchase or sell additional shares above 
    its quoted size.99 Entry of a customer limit order that improves 
    the quote serves a similar purpose. A limit order accurately represents 
    trading interest for a specific volume of a security at the limit 
    price. There are few practical differences between customer limit 
    orders and a market maker's quotation that is firm only for its quoted 
    size. Nonetheless, the proposed rule was not intended to equate 
    customer limit orders with market maker quotes. Instead, the proposed 
    rule was designed to facilitate greater transparency of customer 
    trading interest, with the expectation that orders would have an 
    increased opportunity for best execution without the interaction of a 
    dealer. In the Commission's opinion, these objectives are more 
    difficult to achieve if customer trading interest is not routinely 
    represented in publicly displayed quotes. The Commission notes that the 
    Display Rule provides other means by which a market maker or specialist 
    may comply with the requirements of the rule in the event a specialist 
    or market maker elects not to display customer trading interest in its 
    quote.100
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        \99\ Under Commission rules, the market maker's quote is only 
    required to be firm up to its published size. See 17 CFR 240.11Ac1-
    1(c)(2).
        \100\ For example, a market maker or specialist may deliver a 
    customer limit order immediately upon receipt to another market 
    maker or specialist, or to an ECN or an exchange or association 
    sponsored system pursuant to the rule. Section 240.11Ac1-4(c) (5) 
    and (6).
    ---------------------------------------------------------------------------
    
        Further, the Commission does not agree with the suggestion that the 
    Commission postpone the adoption of the Display Rule until the 
    Commission has had an opportunity to evaluate the NASD's NAqcess 
    proposal.101 Although
    
    [[Page 48299]]
    
    the NASD has argued that limit orders entered into NAqcess, as 
    proposed, would result in greater display of OTC limit order prices, 
    there is no assurance that market makers will enter such orders into 
    NAqcess rather than hold the orders internally.102 Therefore, the 
    Commission believes that the Display Rule is necessary to ensure 
    display of these orders in the OTC market.103 If approved, NAqcess 
    can assist in compliance with the Display Rule to the extent that the 
    system incorporates customer limit orders in the consolidated quote 
    stream, thereby allowing market makers to enter limit orders in NAqcess 
    rather than displaying limit orders in their quotes.104 As noted 
    earlier, the Commission has identified important benefits associated 
    with limit order display. Accordingly, the Commission believes that it 
    is not necessary to observe the effects of NAqcess in order to 
    determine the benefits of the limit order display requirement.
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        \101\ The Commission notes that the proposed NAqcess system is a 
    significant and controversial proposal which has generated 
    approximately 1,100 comment letters. The Commission is in the 
    process of reviewing the comments and has yet to decide what action 
    to take on the proposal.
        \102\ See NAqcess Releases, supra note 45. As noted above, limit 
    orders not entered in NAqcess would be provided with market-wide 
    price protection.
        \103\ In any event, NAqcess will not address at all the issues 
    of disparate limit order handling practices or hidden limit orders 
    in the exchange markets.
        \104\ See Section 240.11Ac1-4(c)(5).
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    iii. Liquidity
        Several commenters assert that application of the Display Rule to 
    Nasdaq securities could reduce liquidity in the Nasdaq market.105 
    These commenters believe that market maker profits may decline due to 
    narrowed spreads or increased compliance costs, with the result that 
    many firms will decide not to make the necessary capital commitment to 
    continue their market making operations. The commenters conclude that 
    as the number of market makers in a security declines, liquidity will 
    be adversely affected, leading to wider spreads. Moreover, some 
    commenters believe that the decrease in liquidity will impair the 
    capital formation process, especially for securities that are not 
    mature enough for auction trading.106
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        \105\ See, e.g., Alex. Brown Letter; Bear Stearns Letter; Dean 
    Witter Letter; Letter from Robert F. Mercandino, Senior Vice 
    President, Dillon, Read & Co., Inc., to Jonathan G. Katz, Secretary, 
    SEC, dated March 15, 1996 (``Dillon Letter''); Jefferies Letter; 
    Lehman Letter; Letter from Robert J. McCann, Managing Director, Co-
    Head, Global Equity Markets, Merrill Lynch, Pierce, Fenner & Smith 
    Incorporated, to Jonathan G. Katz, Secretary, SEC, dated January 26, 
    1996 (``Merrill Letter''); NASD Letter; PaineWebber Letter; Letter 
    from David P. Semak, Vice President Regulation, PSE, to Jonathan G. 
    Katz, Secretary, SEC, dated January 15, 1996 (``PSE Letter''); SIA 
    Letter.
        \106\ See, e.g., NASD Letter; SIA Letter.
    ---------------------------------------------------------------------------
    
        At least one commenter states that the usefulness of limit orders 
    could be diminished by the refusal of some market makers to accept such 
    orders, or by the imposition of high commission costs charged to recoup 
    lost profits on spreads.107 Other commenters believe, however, 
    that it will be difficult for market makers to increase their 
    commissions for limit orders.108 They believe commission charges 
    would not compensate for lost trading profits or prevent the ebb of 
    market liquidity.109
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        \107\ Letter from David K. Whitcomb, Professor of Finance and 
    Economics, Rutgers University Graduate School of Management, to 
    Secretary, SEC, dated January 12, 1996 (``Whitcomb Letter'').
        \108\ See, e.g., Letter from Irving M. Pollack, Alan B. 
    Levenson, and Robert H. Rosenblum, Fulbright & Jaworski L.L.P., on 
    behalf of Herzog, Heine and Geduld, Inc., to Jonathan Katz, 
    Secretary, SEC, dated January 16, 1996 (``HHG Letter''); STA Letter.
        \109\ Id.
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        Other commenters believe the proposed rule will not have a negative 
    impact on market liquidity. One commenter explicitly states that the 
    benefits of the proposed rule would outweigh any potential adverse 
    effects on liquidity.110 Another commenter says that the proposed 
    rule would not result in any significant reduction in market making 
    activity.111 The CSE notes that it has not noticed any negative 
    effects on market liquidity as a result of the implementation of its 
    own limit order display rule.112 Yet another commenter states that 
    although it currently does not trade OTC securities, it expects that 
    many market participants, including the commenter, would begin trading 
    such securities if the proposed rule was adopted, thereby increasing 
    market liquidity.113
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        \110\ Lehman Letter.
        \111\ Letter from Daniel G. Weaver, Ph.D., Assistant Professor 
    of Finance, Marquette University, to Jonathan G. Katz, Secretary, 
    SEC, dated January 10, 1996 (``Weaver Letter'').
        \112\ CSE Letter.
        \113\ The commenter noted further that it does not currently 
    trade OTC securities because it cannot be sure that its order will 
    be represented to the whole market. Estep Letter.
    ---------------------------------------------------------------------------
    
        The display of limit orders is designed, among other objectives, to 
    publicize accurate market interest and increase quote 
    competition.114 The Commission understands that certain costs, 
    including a diminution in market maker profits, are associated with 
    this increased market transparency. For example, a market maker that 
    holds a customer limit order has, in effect, a private ``option'' to 
    execute the order as principal. The longer this ``option'' remains 
    open, the more time the market maker has to determine whether it can 
    profit from executing the order as principal.115 This private 
    market maker ``option,'' however, is potentially detrimental to the 
    execution opportunities for the limit order. The Display Rule will 
    limit this ``option'' and expose the order to market-wide trading 
    interest. Moreover, increased price competition from limit orders may 
    reduce market maker profits through the narrowing of spreads.116 
    As a result, the Display Rule may force less efficient competitors to 
    stop making markets in some of the securities they now quote.
    ---------------------------------------------------------------------------
    
        \114\ See Market 2000 Study, at Study IV.
        \115\ The Commission recognizes that there is also a cost 
    associated with holding that limit order, because a market maker is 
    required to execute that limit order if it has engaged in a 
    transaction for its own account that would have satisfied the limit 
    order. See Manning I & II, supra note 24.
        \116\ See supra notes 53-55 and accompanying text (display of 
    customer limit orders in market maker quotes will act to eliminate 
    certain trading behavior on Nasdaq and foster quote competition).
    ---------------------------------------------------------------------------
    
        Although the rule could lead to a reevaluation by some market 
    makers of the services they wish to provide, after considering the 
    available evidence, and in light of its experience, the Commission does 
    not believe that there will be a significant negative impact on the 
    markets for covered securities. The Commission is not convinced that 
    the loss of some market competitors in securities with many market 
    makers would impair liquidity in these securities.117 The 
    Commission believes that customer orders are the ultimate source of 
    liquidity to the markets, and that adoption of a rule that improves the 
    handling of such orders will have the effect of enhancing market 
    liquidity.118 The Commission believes that a limit order display 
    requirement will encourage new limit orders in securities to be 
    entered, thus providing additional liquidity to the market from 
    customers.119 The potential of limit orders to narrow quotes also 
    may encourage the entry of additional market
    
    [[Page 48300]]
    
    orders.120 The Commission believes that the additional liquidity 
    due to narrower spreads and increased customer orders will outweigh any 
    potential loss of liquidity provided by market makers.
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        \117\ See, e.g., STAIC Letter (limit orders are critical to 
    market liquidity).
        \118\ The Commission does not thereby denigrate the contribution 
    OTC market makers provide in a dealer market. The Commission notes, 
    however, that most market makers provide primarily intra-day 
    liquidity to customers, and generally seek to end the trading day 
    with a limited inventory position in order to minimize inventory 
    risk. Customer limit orders represent buying or selling interest at 
    specified prices for their stated duration, which may be longer than 
    intra-day. Market makers holding customer limit orders rely in part 
    on these limit orders in quoting their own prices to buy and sell 
    securities.
        \119\ See Greene Study & Greene Study II, supra note 51 (limit 
    orders affect the quoted spread and provide liquidity); NASD Study, 
    supra note 21 (limit orders, like market maker quotes, supply 
    liquidity to the markets); OEA Data, supra notes 50 and 52.
        \120\ See NASD Study, supra note 21 (those investors that demand 
    immediate execution, e.g. those entering market orders, will pay 
    less for executions due to the augmented liquidity supplied by limit 
    orders); Greene Study and Greene Study II, supra note 51 (limit 
    orders provide liquidity to traders that demand immediacy of 
    execution and may contribute to reduced trading costs); OEA Data, 
    supra notes 50 and 52 (display of limit orders narrows spreads, 
    improves price discovery, and increases market depth for a variety 
    of securities, including those NYSE securities that are thinly 
    traded).
    ---------------------------------------------------------------------------
    
        As noted above, some commenters expressed concern regarding the 
    effect of the Display Rule on the availability of liquidity to small 
    issuers.121 In response to these comments, the Commission's OEA 
    examined market maker participation in 4,839 Nasdaq issuers over a one 
    month period in 1996. The findings indicate that: (1) the median number 
    of market makers in a security is not appreciably lower for initial 
    public offering (``IPO'') issuers or for securities with the smallest 
    market capitalization; (2) broker-dealers that participated in IPO 
    underwriting syndicates were active participants in aftermarket 
    trading, but were not alone in providing significant market maker 
    liquidity; and (3) in Nasdaq securities with the smallest market 
    capitalization ($2 million or less), the single most active market 
    maker in an issue typically participated in one-third or fewer trades. 
    Thus, there is no convincing evidence that Nasdaq issuers, including 
    IPO issuers, are dependent for liquidity on any one market maker. The 
    pattern of market making activity indicates that significant liquidity 
    is provided by market makers who are not the ``most active'' market 
    makers in a security. Because there does not appear to be high 
    concentration in market making, and because of the Commission's belief 
    that customer order flow is a critical source of market liquidity, the 
    Commission believes that the proposals adopted today will not unduly 
    impact liquidity for small or new issuers.
    ---------------------------------------------------------------------------
    
        \121\ This concern also was raised in the context of the ECN 
    Amendment to the Quote Rule.
    ---------------------------------------------------------------------------
    
        Furthermore, Commission experience has been that enhancements to 
    transparency result in improved liquidity.122 The Commission 
    believes that these improvements are attributable, at least in part, to 
    the impact of transparency on market integrity and investor confidence. 
    In addition, while market maker profits per trade may be reduced as 
    spreads are narrowed, increased volume over time may result in stable 
    profit levels.123
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        \122\ In several instances in the past, commenters have claimed 
    that other Commission initiatives to increase transparency would act 
    to reduce liquidity; others have warned that such initiatives would 
    decrease the competitiveness of the U.S. markets in relation to 
    foreign counterparts. These claims, however, have not been borne 
    out. For example, many industry participants argued that the NASD's 
    adoption of its ``Manning'' rules would severely impact market 
    liquidity. See Market 2000 Study. However, there has been no 
    evidence offered to the Commission of adverse liquidity consequences 
    caused by these limit order protections, and the Commission is not 
    aware of any significant diminution in liquidity. Further, as 
    discussed in the Market 2000 Study, other transparency initiatives, 
    such as the adoption of real-time transaction and quotation 
    reporting, have resulted in increases in the competitiveness and 
    liquidity of both listed and OTC equity markets despite market maker 
    protestations to the contrary prior to adoption of these 
    initiatives. See Id. at Study IV. See also Simon & Colby, supra note 
    58. Even the creation of Nasdaq itself was met with much opposition. 
    The result of this major structural change was far from the 
    predicted ``death knell'' of the OTC market. Rather, OTC market 
    strength and liquidity have flourished since Nasdaq's inception. 
    Based on the Commission's experience with other market structure 
    initiatives, therefore, the Commission believes that improvements in 
    order handling, market transparency, and efficiency will likely 
    improve market liquidity.
        \123\ Although the display requirement may decrease a market 
    maker's per trade profit due to narrowed spreads, the Commission 
    believes that this decrease will be made up for in part by expected 
    increases in trading volume attributable to enhanced liquidity and 
    pricing efficiency. See supra note 24. The Commission believes this 
    potential impact on market maker profits is justified in light of 
    the benefits that will accrue to investors and the markets as a 
    whole. Moreover, even if market makers' profits from trading do 
    decline, market makers may be able to obtain increased revenues from 
    commissions or other fees charged directly to customers. Because 
    these other revenue sources are more transparent to customers than 
    are revenues from market maker trading with customers on a 
    proprietary basis, increased reliance on these other revenue sources 
    will enable customers to make more informed trading decisions.
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        It also may become feasible for market makers to charge customers 
    commissions for handling limit orders, even if that is not the current 
    practice today. As noted earlier, some commenters claim that the 
    Display Rule will have a disparate impact on wholesale Nasdaq market 
    makers in that such market makers would not be able to offset the 
    increased costs associated with limit order display through charges or 
    commissions.124 The Commission believes, however, that the systems 
    costs associated with the Display Rule should not be overly 
    burdensome,125 nor should systems costs or any reduced market 
    maker profitability from declining spreads be more extensive for 
    wholesale market makers than for integrated market makers. Although 
    exchange specialists and integrated firms may find it easier than 
    wholesale firms to charge commissions initially, the Commission notes 
    that wholesale firms are not prohibited from attempting to compensate 
    for handling limit orders, either through negotiated fee arrangements, 
    or reducing any payment made for order flow for limit orders.126
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        \124\ See, e.g., HHG Letter.
        \125\ See Memorandum from Stephen L. Williams, S.L. Williams Co. 
    to Richard R. Lindsey, Director, Division of Market Regulation, SEC 
    (July 29, 1996) (``Williams Study'').
        \126\ The level of these fees, of course, would be determined by 
    competitive forces in the marketplace. Any fees passed on to non-
    broker-dealer customers would have to be disclosed in a clear 
    fashion to the customer, and otherwise comply with applicable law. 
    For example, NASD Rule 2440 states, in part, that if a member acts 
    as agent for a customer in a transaction, the customer shall not be 
    charged more than a fair commission or service charge, taking into 
    consideration all relevant circumstances. See also NASD Regulatory & 
    Compliance Alert Vol. 7, No. 4 (December 1993). At least one 
    commenter argued that because spreads are ascertainable from public 
    quotations and commissions are not, a rule that encourages charging 
    commissions does not satisfy the goal of increased transparency. See 
    Letter from Bruce C. Hackett, Managing Director, Salomon Brothers 
    Inc., to Jonathan G. Katz, Secretary, SEC, dated January 25, 1996 
    (``Salomon Letter''). The Commission notes, however, that Rule 10b-
    10 under the Exchange Act requires customer confirmations to 
    disclose commissions and, for listed and Nasdaq securities, the 
    difference between the reported price and the price to the customer. 
    Based on this disclosure, execution costs could actually become 
    better known to customers if explicit fees are charged. Therefore, 
    the Commission believes that the Display Rule will allow a customer 
    to more easily monitor the execution quality of its limit orders, 
    even if subject to fees for limit order executions. In addition, 
    this situation should foster competition with respect to the amount, 
    if any, firms will charge for the execution of a customer limit 
    order.
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    iv. Discretion
        Several commenters are concerned that the Display Rule would 
    eliminate their discretion to determine the best way in which to 
    execute a customer's order. The commenters also claim that customers 
    rely on the judgment of a market professional in choosing whether to 
    display a limit order.127 For example, the NYSE believes that its 
    current procedures allow broker-dealers to achieve the best prices for 
    their customers.128 Other commenters suggest that if the rule were 
    amended to require the display of representative size, a dealer would 
    retain some discretion on
    
    [[Page 48301]]
    
    how best to execute the order.129 To preserve discretion, at least 
    one commenter argues that the rule should apply only when the customer 
    requests that its order be displayed.130
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        \127\ See, e.g., NYSE Letter; RPM Letter; Specialist Assoc. 
    Letter.
        \128\ See, e.g., NYSE Letter; Specialist Assoc. Letter. 
    According to the NYSE, a customer can choose to benefit from the 
    display of its order or to benefit from relying on the specialist's 
    discretion, depending on whether the order is sent to the post via 
    SuperDOT, or is manually submitted. The NYSE also notes that 
    enabling a specialist to use discretion in the handling of limit 
    orders is important in light of the fact that the NYSE defines a 
    limit order as an order to buy or sell at a specified price, or at a 
    better price, if obtainable after the order is represented in the 
    trading crowd. See NYSE Rule 13.
        \129\ See, e.g., Madoff Letter; NASD Letter; SIA Letter.
        \130\ Jefferies Letter.
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        The Commission believes that the rule appropriately establishes a 
    presumption that limit orders should be displayed, unless such orders 
    are of block size, the customer requests that its order not be 
    displayed, or one of the exceptions to the rule applies. The exception 
    allowing a customer to request that its limit order not be displayed 
    gives the customer ultimate control in determining whether to trust the 
    display of the limit order to the discretion of a market professional, 
    or to display the order either in full, or in part, to other potential 
    market interest.131
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        \131\ See discussion of the exceptions to the Display Rule at 
    section III.A.3.c., infra. See also Sec. 240.11Ac1-4(c)(2); 
    Sec. 240.11Ac1-4(c)(4) (permitting a customer with a block size 
    limit order to request that the order be displayed pursuant to the 
    Display Rule). The Commission does not mean to imply that a 
    specialist or OTC market maker that is not displaying a limit order 
    pursuant to the request of its customer may not change its quotation 
    in that security based on the specialist's or market maker's own 
    trading interest.
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    v. Systems Burdens
        Based on their belief that compliance with the Display Rule would 
    result in a large increase in quotation traffic, a number of commenters 
    maintain that the rule would require major overhauls of the order 
    handling systems used by brokers, market makers and markets. For 
    example, one commenter believes that it would be impossible to comply 
    with the rule without additional automated systems.132 The 
    commenter concludes that the costs associated with new systems and 
    additional staff necessary to monitor a more volatile market would 
    contribute to wider spreads and higher commissions.133 In 
    addition, one SRO claims that quotation traffic must be kept at 
    manageable levels in order to allow entities to continue to manually 
    process limit orders, thus eliminating the need for entities to bear 
    the costs associated with automation of such orders.134 Other 
    commenters also note their concern over the potential operational costs 
    associated with the rule.135 The STA states that an in-depth 
    review is needed to determine the costs for new equipment and 
    technology necessary to comply with the rule.136
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        \132\ PaineWebber Letter.
        \133\ Id.; see also Bear Stearns Letter (noting that the display 
    rule would increase the volatility of quotes and, as a result, 
    market makers would have a difficult time keeping up with the rapid 
    changes in bids, offers, and quote sizes).
        \134\ PSE Letter.
        \135\ See, e.g., Alex. Brown Letter; Bear Stearns Letter; 
    Jefferies Letter.
        \136\ STA Letter.
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        A few commenters are concerned that the increased quotation traffic 
    that may be associated with the rule could pose a threat to the 
    integrity of the central quotation system.137 One commenter 
    suggests that the rule be suspended for the first 30 minutes of 
    trading.138 Another commenter argues that modifying the rule to 
    require only the display of representative size could act to alleviate 
    some of the traffic concerns.139
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        \137\ See, e.g., Letter from Thomas J. Jordan, Financial 
    Information Forum, to Jonathan G. Katz, Secretary, SEC, dated 
    January 12, 1996 (``FIF Letter''); PaineWebber Letter; PSE Letter. 
    This concern was expressed with respect to the proposal that the 
    Commission adopt both the Display Rule and Price Improvement Rule. 
    The fact that the Commission has deferred action on the Price 
    Improvement Rule, as discussed below, should substantially diminish 
    any system capacity concerns. Moreover, the Commission's decision 
    not to require display of de minimis orders also should minimize 
    system capacity concerns.
        \138\ FIF Letter. According to FIF, the heaviest traffic volume 
    usually occurs within the first 30 minutes of trading.
        \139\ PSE Letter. The PSE notes, however, that the rule, even if 
    modified, still may result in an increase in staffing costs. Id.
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        The Commission recognizes that achieving greater transparency for 
    limit orders depends upon the existence of systems that are capable of 
    the smooth and efficient display of trading interest. The Commission 
    believes that the Display Rule will not substantially increase the 
    quotation burden for exchange markets, where systems currently exist 
    for the display of quotes.140 In the OTC market, the Display Rule 
    will result in additional quotation entries for market makers that 
    display customer limit orders in their quotes. The Commission believes, 
    however, that current systems can handle the additional volume, or can 
    be expanded at moderate cost to handle the additional volume.141 
    Further, the Commission notes that the Display Rule contains an 
    exception to the display requirement for limit orders of de minimis 
    size priced at the NBBO when the market maker's or specialist's quote 
    matches the NBBO.142 The Display Rule also allows a specialist or 
    OTC market maker several ways to comply with the rule by routing the 
    order elsewhere without displaying the limit order in its own quote by 
    transmitting a customer limit order to an exchange-or association-
    sponsored system or to a qualifying ECN.
    ---------------------------------------------------------------------------
    
        \140\ For example, SuperDOT data indicates that 57% of all 
    customer trades originating from orders routed through SuperDOT are 
    limit orders. Of these limit orders, 20% narrowed the NYSE quote. 
    See supra note 52. According to the NYSE, 93% of such orders are 
    reflected in the NYSE quote within two minutes of receipt. See supra 
    note 36 and accompanying text (teleconference). See also CSE Letter 
    (costs associated with implementing such a system are minimal, 
    especially in light of the benefits to the public); Paperwork 
    Reduction Act discussion at section VII, infra.
        \141\ The Commission notes that many small to medium broker-
    dealers utilize shared trading systems that enable such broker-
    dealers to streamline their OTC market making and back office 
    responsibilities. Subscribers to such systems benefit by sharing 
    costs associated with the application of improved technologies, 
    rather than creating and updating systems of their own. Therefore, 
    it is assumed that any changes deemed necessary to these shared 
    systems to facilitate efficient compliance with the Display Rule 
    also would be shared by all subscribers.
        In addition, the Commission specifically evaluated the costs 
    associated with implementation of the Display Rule. Based on this 
    evaluation, the Commission concluded that most market makers will 
    not be required to invest substantial amounts of money in systems 
    development in order to comply with the Display Rule as adopted. See 
    Williams Study, supra note 125. See also CSE Letter (costs of 
    implementing a system for display of limit orders are minimal).
        \142\ See, Sec. 240.11Ac1-4(b)(1)(ii). See also Sec. 240.11Ac1-
    4(b)(2)(ii).
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        Additionally, a few commenters believe that the Commission should 
    give more consideration to the Display Rule's impact on automatic 
    execution systems.143 These commenters express concern that a 
    market maker could be exposed to multiple transactions from its own 
    customers in the firm's automatic execution system, which executes 
    orders at the NBBO, even if the NBBO represents a customer limit order 
    as opposed to the price at which a market maker is willing to trade. 
    They claim this result is unfair, especially if the automatic system 
    has a minimum share requirement that exceeds the customer limit order.
    ---------------------------------------------------------------------------
    
        \143\ See, e.g., Dillon Letter; HHG Letter; Merrill Letter; 
    PaineWebber Letter; Schwab Letter.
    ---------------------------------------------------------------------------
    
        The Commission acknowledges the concern of some commenters 
    regarding the rule's interaction with automated execution systems. 
    However, because customer limit orders reflect actual trading interest, 
    it has been the Commission's intention to enhance customer order 
    executions throughout the markets by requiring the display of these 
    customer limit orders.144 Where a limit order represents the best 
    quote, a
    
    [[Page 48302]]
    
    market maker can respond by sending its customer order to the market 
    maker displaying the limit order at the NBBO, thereby attempting to 
    execute the limit order setting that price and removing it as the 
    NBBO.145 Moreover, where the size of a limit order represented in 
    the best quote is smaller than the size eligible for execution in an 
    automated execution system, the Commission believes that it is not 
    inconsistent with best execution principles for market makers and 
    specialists using automated execution systems to take into account the 
    size of the limit order quote in determining the price at which an 
    order, or portions thereof, should be automatically executed. The 
    Commission believes, however, that in such a case the market maker or 
    specialist should provide the customer order an execution at the 
    displayed price at least up to the displayed size of the limit 
    order.146 For example, if customer limit orders compose the NBBO 
    of 10 \1/4\-10 \1/2\ (100  x  300), and a market maker receives a 
    market order to sell 1,000 shares via an automatic execution system, 
    the market maker may automatically execute 100 shares of the order at 
    10 \1/4\, and the remaining portion of the order at the next best bid.
    ---------------------------------------------------------------------------
    
        \144\ The Commission recognizes that SROs may have rules 
    regarding the minimum quotation sizes associated with a specialist's 
    or market maker's quote. The Commission believes that SROs should 
    consider amending such rules and modifying certain systems to allow 
    a specialist or market maker to quote in sizes smaller than the 
    minimum quotation size when such quote represents a customer limit 
    order. With these changes, a specialist or market maker that 
    displays a customer limit order in its quote pursuant to the Display 
    Rule would not be responsible for executing as principal any 
    additional shares at the limit price where the size of the customer 
    limit order is less than the minimum quotation size set by the SRO.
        \145\ The Commission notes that the NASD's NAqcess system, as 
    proposed, would permit market makers to send orders, including 
    proprietary orders, to other market makers through the system. See 
    supra note 45. See also ITS Plan. Moreover, the Commission believes 
    that the NASD should consider modifying its SOES system to allow OTC 
    market makers to route customer orders for execution against limit 
    orders displayed by another market maker in the same security.
        \146\ If the market maker or specialist attempted but was unable 
    to execute the displayed limit order through a reasonable and 
    efficient means, such as sending an order through an automated 
    system for an OTC security, the market maker or specialist would not 
    be expected to give that limit order price to its customer.
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    3. The Operation of the Rule as Adopted 147
        The rule as adopted applies to: (i) every member of an exchange 
    that is registered by that exchange as a specialist or has been 
    authorized by an exchange to perform functions substantially similar to 
    that of a specialist (``specialist''); and (ii) OTC market 
    makers.148 The rule as adopted applies to specialists that trade 
    on the floor of an exchange; 149 third market makers; 150 
    members of a national securities association that are OTC market 
    makers; 151 and specialists that trade an OTC security pursuant to 
    unlisted trading privileges (``UTP'').152 These market makers are 
    required to reflect immediately in their bid or offer the price and the 
    full size of each customer limit order they hold at a price that would 
    improve their bid or offer in the security.153 In addition, all 
    market makers covered by the rule are obligated to reflect in their 
    quotes the full size of a customer limit order that: (1) is priced 
    equal to their bid or offer; (2) is priced equal to the national best 
    bid or offer for the security; and (3) represents more than a de 
    minimis change in relation to the size associated with their bid or 
    offer.154
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        \147\ SRO rules that impose more stringent standards would 
    continue to apply.
        \148\ Although the Commission consolidated certain sections of 
    the proposed rule for clarity, the rule as adopted applies to the 
    same entities identified in the proposed rule.
        \149\ Section 240.11Ac1-4(b)(1).
        \150\ Section 240.11Ac1-4(b)(2).
        \151\ Section 240.11Ac1-4(b)(2).
        \152\ Section 240.11Ac1-4(b)(1).
        \153\ Section 240.11Ac1-4(b)(1)(i) and (b)(2)(i). The Commission 
    wants to clarify that references to a specialist's or OTC market 
    maker's bid or offer include instances where the bid or offer is a 
    proprietary quote, as well as instances where the bid or offer 
    represents a customer limit order. Further, if a market maker is not 
    quoting publicly (e.g., a market maker that does not meet the 1% 
    threshold of the Quote Rule), it still must publish a quotation that 
    displays the limit order, or avail itself of one of the exceptions. 
    Moreover, the Commission notes that some commenters suggest that the 
    rule should require broker-dealers that are not specialists or OTC 
    market makers to immediately transmit limit orders they receive to 
    an entity or system that will display the orders in a manner 
    consistent with the rule. See, e.g., CSE Letter; Madoff Letter; 
    Whitcomb Letter. Also, at least one commenter believes that 
    institutional firms trading in block size should be considered ``OTC 
    market makers'' for purposes of the rule and subject to the display 
    requirement. Amex Letter. See generally infra notes 191-193 and 
    accompanying text. The fact that the Commission has not adopted 
    these suggestions as part of the Display Rule does not relieve 
    broker-dealers which receive such orders from compliance with their 
    obligation to obtain best execution for those orders.
        \154\ Section 240.11Ac1-4(b)(1)(ii) and (b)(2)(ii).
    ---------------------------------------------------------------------------
    
    a. ``Covered Securities'' and ``Customer Limit Orders''
        Rule 11Ac1-4 applies to ``customer limit orders'' in ``covered 
    securities.'' A covered security is defined as any reported security 
    and any other security for which transaction reports, last sale data or 
    quotation information is disseminated through an automated quotation 
    system that is sponsored by a registered securities association. This 
    definition is designed to encompass all exchange-listed securities, 
    Nasdaq National Market securities and Nasdaq SmallCap 
    securities.155
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        \155\ Securities listed on regional exchanges that do not 
    substantially meet NYSE or Amex original listing criteria do not 
    satisfy the definition of ``covered security.'' Such securities are 
    not ``reported securities'' as that term is defined, nor do they 
    meet the other elements of the definition of covered security. OTC 
    Bulletin Board (``OTCBB'') securities also do not satisfy the 
    definition of covered security. The Commission has determined not to 
    extend the display requirement to any of those securities at the 
    present time.
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        The Commission received several comments regarding the application 
    of the rule to Nasdaq securities. Some commenters believe that the rule 
    should not extend to all Nasdaq securities, and that some measure of 
    liquidity should be used to determine which Nasdaq securities should be 
    subject to the rule.156 For example, one commenter suggests 
    limiting the rule's application to the top 250 Nasdaq National Market 
    securities with the highest average daily trading volume over the 
    previous calendar quarter.157 In contrast, another commenter 
    favors the inclusion of Nasdaq SmallCap securities within the 
    definition of ``covered security.'' 158 Further, at least one 
    commenter suggests that the rule apply not only to all Nasdaq 
    securities, but also to OTCBB securities.159
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        \156\ See, e.g., Bear Stearns Letter; Lehman Letter; Merrill 
    Letter; NASD Letter; SIA Letter.
        \157\ SIA Letter.
        \158\ PSE Letter.
        \159\ Ricker Letter.
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        As noted above, the Commission believes that the Display Rule 
    should apply equally to exchange-traded as well as non-exchange-traded 
    securities. In addition, the Commission believes it is appropriate to 
    include all Nasdaq securities within the definition of ``covered 
    security.'' The Commission believes that, regardless of the current 
    trading volume of a particular security, the investors in any security 
    can benefit from the uniform display of customer buying and selling 
    interest if all quotations in that security are required to be firm. As 
    noted previously,160 data analyzed by the Commission shows that 
    limit orders are used frequently for transactions in NYSE securities 
    with ADTVs under $100,000. On average, 63% of customer orders in such 
    securities are limit orders. Of those limit orders, 30% narrowed the 
    NYSE quote and 32% matched the quote. This data indicates that the 
    display requirement may lead to increased customer trading interest in 
    securities that are currently thinly traded.161
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        \160\ See supra notes 50 and 52.
        \161\ As stated previously, because dealers are not required to 
    register as OTC market makers in OTCBB securities and are not 
    required to enter and maintain continuous firm two-sided quotations 
    in OTCBB securities, the Commission does not believe that the 
    Display Rule should be extended to such securities at this time.
    ---------------------------------------------------------------------------
    
        The Commission reiterates that limit order display is not solely an 
    issue of improved transparency. The Display Rule will improve the 
    handling of customer orders across all markets and increase the 
    probability that a customer limit order will be executed. Therefore, 
    the Commission believes that a uniform limit order display requirement 
    is
    
    [[Page 48303]]
    
    closely related to a broker-dealer's ability to obtain best execution 
    for limit orders.
        The Commission recognizes, however, that the rule represents a 
    significant change for the OTC market. The Commission, therefore, has 
    determined to provide a phase-in period for application of the rule to 
    customer limit orders in Nasdaq securities.162 The Commission 
    believes that the phase-in period will allow the Commission to monitor 
    the effects of the rule on the most liquid Nasdaq securities first, 
    while ensuring that customer limit orders in all Nasdaq securities will 
    receive the benefits of the rule within one year of its adoption. This 
    schedule also will provide OTC market makers with time to adjust their 
    systems to comply with the rule's requirements.163
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        \162\ See description of the phase-in at section III.A.3.d., 
    infra.
        \163\ See, e.g., Amex Letter.
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        Under the rule, a customer limit order includes any order to buy or 
    sell a covered security at a specified price not for the account of a 
    broker or dealer. Customer limit orders transmitted from one broker-
    dealer to another for execution are included in the definition. 
    Although some commenters believe that the rule should be extended to 
    orders for the account of a broker or dealer, the Commission does not 
    believe such extension is appropriate at this time. The Commission 
    acknowledges that the display of all limit orders, including those of a 
    broker or dealer, would further enhance transparency.164 Requiring 
    the display of broker-dealer limit orders, however, would be a 
    significant extension of the rule that could change its impact on 
    market maker participation and increase its operational burdens. 
    Therefore, the Commission believes that the effects of the rule should 
    be observed, and additional comment should be solicited, before the 
    rule is expanded.165
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        \164\ The Commission also is sensitive to the fact that 
    providing suitable opportunities for broker-dealers, including 
    options market makers, to lay off risk is an important component of 
    overall market liquidity and efficiency. See Manning II, supra note 
    24.
        \165\ The Commission notes that other actions recently taken by 
    the Commission address certain anti-competitive behavior in the 
    Nasdaq market that heretofore may have negatively impacted the 
    ability of some broker-dealers, including options market makers, to 
    efficiently perform their market making function. See 21(a) Report, 
    supra note 28.
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    b. Size
        As noted above, some commenters expressed concern regarding the 
    requirement that specialists and OTC market makers display the full 
    size of a customer limit order. These commenters suggest that the rule 
    only require the display of representative size.166 They argue 
    that the use of representative size would preserve the ability of a 
    specialist or OTC market maker to exercise some discretion in 
    determining the best execution of the order.167
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        \166\ See, e.g., BSE Letter; CSE Letter; Madoff Letter; NASD 
    Letter; NYSE Letter; PSE Letter; SIA Letter; Specialists Assoc. 
    Letter; see also LJR Letter (questioning whether the display of 
    size, at least with respect to institutional orders, would be 
    consistent with best execution obligations).
        \167\ See, e.g., Madoff Letter; NASD Letter; NYSE Letter; SIA 
    Letter; Specialists Assoc. Letter.
    ---------------------------------------------------------------------------
    
        Other commenters, however, believe that the full size of a customer 
    limit order should be required to be displayed.168 Such commenters 
    argue that the display of full size is an important element in the 
    Commission's effort to improve transparency and, therefore, no dealer 
    discretion should be permitted unless a customer expressly requests 
    that its order not be displayed, or expressly grants discretion, 
    pursuant to the Display Rule.169
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        \168\ See, e.g., Amex Letter; CHX Letter; D.E. Shaw Letter.
        \169\ See, e.g., Amex Letter; CHX Letter; D.E. Shaw Letter; ICI 
    Letter.
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        The Commission continues to believe that the display of full size 
    is important to improved transparency. The display of full size will 
    provide the most accurate picture of the depth of the market at a 
    particular price.170 The Commission believes that size, as well as 
    price, is a factor in attracting order flow and that the display of 
    full size increases the likelihood that a limit order will be executed. 
    The Commission, however, understands that there may be instances where 
    a customer would not want its order displayed, or does not want the 
    full size of its order displayed. The Display Rule, therefore, still 
    contains an exception for a customer that decides to rely on the 
    discretion of a broker-dealer rather than to take advantage of the 
    display requirement for its limit order.171 The Display Rule also 
    permits a customer to state explicitly what portion, if any, the 
    customer wants displayed.172 Furthermore, the Display Rule 
    contains other exceptions to the display requirement that will ease any 
    potential operational burdens associated with the display of full 
    size.173
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        \170\ A few commenters believe that all customer limit orders 
    should be displayed, including the size of those orders that equal 
    the specialist's or OTC market maker's bid or offer, but are not 
    equal to the NBBO. See, e.g., CHX Letter; Letter from Edward J. 
    Johnsen, Vice President and Counsel, Morgan Stanley & Co., to 
    Jonathan G. Katz, Secretary, SEC, dated January 16, 1996 (``Morgan 
    Stanley Letter''); Peake Letter; Weaver Letter. The Commission 
    believes, however, that the burden associated with the commenters' 
    suggestion would outweigh the corresponding benefit to market 
    transparency. Of course, the rule represents a floor, rather than a 
    ceiling. An exchange, association, or broker-dealer may determine to 
    adopt more stringent display requirements. Requiring display of size 
    when the limit order is away from the NBBO and equals the market 
    maker's or specialist's quote would provide some additional market 
    information but also would require market makers not quoting at the 
    NBBO to change their quote size on an ongoing basis. Although some 
    market makers or specialists may choose to do so to be prepared if 
    their quotation becomes the NBBO, on the whole the Commission 
    believes the increased transparency that would result from this 
    updating would not outweigh the burdens imposed by a display 
    requirement.
        \171\ Section 240.11Ac1-4(c)(2).
        \172\ Id.
        \173\ As noted above, a specialist or OTC market maker has the 
    ability to execute a customer limit order upon receipt; transmit the 
    order to another exchange member or OTC market maker that will 
    display the limit order in accordance with the rule; or transmit the 
    order to an exchange or association sponsored system pursuant to the 
    rule. Additionally, a specialist or OTC market maker may transmit an 
    order to an ECN that provides for public display of limit orders and 
    provides access to these orders. Moreover, the rule contains an 
    exception to the display requirement for certain orders of de 
    minimis size.
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        The following example illustrates the application of the Display 
    Rule where a customer limit order improves the price of a specialist's 
    or market maker's quote. Assume that a market maker covered by the rule 
    is quoting 10-10\1/2\ (2,000 x 2,000) when it receives a customer limit 
    order in a covered security to buy 4,000 shares at 10\1/4\. Under the 
    rule, the market maker must change the price and size associated with 
    its quote to 10\1/4\-10\1/2\ (4,000 x 2,000). If this new quote 
    represents the NBBO, the Display Rule would require the market maker to 
    increase the size associated with the quote upon the receipt of 
    additional customer limit orders. For example, if the market maker 
    subsequently accepts another customer limit order to buy 4,000 shares 
    at 10\1/4\, the market maker must change its quote to 10\1/4\-10\1/2\ 
    (8,000 x 2,000).
        The rule as adopted contains a de minimis standard applicable in 
    situations where a customer limit order equals a specialist's or market 
    maker's displayed price and that price is equal to the NBBO. One 
    commenter states that the use of representative size would eliminate 
    the Commission's need to rely on a de minimis standard.174 Another 
    commenter believes that the rationale underlying the de minimis 
    standard demonstrates that the display of size does not benefit public 
    customers.175 Some commenters also believe that the de minimis 
    standard should be clarified or even eliminated.176
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        \174\ CSE Letter.
        \175\ Dean Witter Letter.
        \176\ See, e.g., Amex Letter; CHX Letter; Schwab Letter.
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        The Commission proposed the de minimis standard to strike a balance
    
    [[Page 48304]]
    
    between the benefits of increased transparency and operational burdens 
    that might arise under the display requirement in displaying limit 
    orders irrespective of size. The de minimis standard was intended to 
    reduce the burdens of displaying the smallest of limit orders where the 
    frequent updating of the quote for smaller orders would not result in 
    significant improvements in quotation size. The Commission believes 
    that the size of a customer limit order should be considered de minimis 
    if it is less than or equal to 10% of the displayed size associated 
    with a specialist's or OTC market maker's bid or offer.177
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        \177\ Any SRO may set more stringent display requirements 
    through its own rules.
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        The Commission believes that this de minimis standard will ease 
    potential operational burdens associated with the display of additional 
    size in a specialist's or OTC market maker's quote. The following 
    example illustrates the application of the de minimis standard.
        Assume a market maker's quote is 10-10\1/2\ (1,000 x 1,000), and 
    the NBBO is 10-10\1/4\ when the market maker receives a customer limit 
    order to buy 2,000 shares at 10. Under the rule, the market maker is 
    obligated to change the size of its quote immediately to 10-10\1/2\ 
    (3,000 x 1,000).178 In this case, the 2,000 share order size is 
    more than de minimis in relation to the size associated with the market 
    maker's quote. If the limit order was for 100 shares, however, the 
    market maker would not be required to change its quotation size because 
    the order is de minimis in relation to its quote.179 
    Alternatively, the market maker could voluntarily display the 
    additional 100 shares.
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        \178\ If the original 1,000 shares displayed represents the 
    market maker's proprietary quote and, consistent with Rule 11Ac1-1, 
    the market maker no longer wishes to trade for its own account at 
    10, the market maker may quote at 10-10\1/2\ (2,000 x 1,000).
        \179\ The Commission stresses that all other orders previously 
    considered de minimis and not displayed must be added to the order 
    under consideration for purposes of the de minimis calculation. 
    Therefore, in the case of a 100 share limit order to buy at 10, 
    where the market maker had a previous 100 share limit order to buy 
    at 10 that was not displayed pursuant to the de minimis standard, 
    both orders must be considered together for purposes of making the 
    de minimis calculation. Because 200 shares is more than 10% of the 
    displayed size of 1,000, the market maker must include the 200 
    shares in its quote.
        The Commission notes that if an OTC market maker chooses not to 
    display a de minimis limit order, the NASD's interpretation 
    regarding limit orders would prohibit the market maker from trading 
    ahead of the limit order. See Manning I & II, supra note 24. In 
    addition, the NASD has indicated that market makers must establish 
    and consistently follow policies regarding the priority in which 
    limit orders received from customers, which would include de minimis 
    orders, will be executed. See Special NASD Notice to Members 95-43 
    (June 5, 1995).
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    c. Exceptions
        The rule requires the ``immediate'' display of certain customer 
    limit orders. To satisfy this requirement, a specialist or OTC market 
    maker must display the limit order immediately upon receipt unless 
    there exists an applicable exception to the display requirement. Some 
    commenters have asked for clarification of the ``immediate'' display 
    requirement.180 The Commission is mindful that some measure of 
    time is needed for specialists or market makers to display limit orders 
    in the quote. Assuming that a specialist or OTC market maker does not 
    rely on one of the exceptions to the Display Rule, however, such 
    specialist or OTC market maker must display the order as soon as is 
    practicable after receipt which, under normal market conditions, would 
    require display no later than 30 seconds after receipt.181
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        \180\ See, e.g., Amex Letter; D.E. Shaw Letter; NYSE Letter; PSE 
    Letter.
        \181\ The Commission stresses that specialists and OTC market 
    makers still are under an obligation to protect the customer limit 
    order even during the time the limit order is not displayed. See, 
    e.g., Manning I & II, supra note 24 (prohibiting trading ahead of 
    customer limit orders). It should also be noted that this standard 
    would supersede SRO rules that are less stringent with regard to the 
    time in which limit orders are to be displayed. Those rules that 
    impose more stringent standards may continue to apply.
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        There are seven exceptions to the general requirements of the rule. 
    The first exception applies to any customer limit order that is 
    executed upon receipt of the order.182 If the order is executed 
    upon receipt, then no duty arises under the rule.
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        \182\ Section 240.11Ac1-4(c)(1).
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        The second exception applies to any limit order that is placed by a 
    customer who expressly requests that the order not be 
    displayed.183 This request may take place on an order by order 
    basis, or may be agreed to prospectively. Most commenters that 
    addressed the issue were in favor of the exception.184 The 
    Commission included this exception because there could be instances in 
    which a customer prefers to exclude its order from public display. For 
    example, a customer with a large limit order could wish to let its 
    broker work the order rather than display the entire order. This 
    exception gives the customer the right to decide if the order should be 
    displayed in its entirety, in part, or not at all.185 The 
    Commission notes that under this exception, a customer may leave the 
    decision to display an order to the discretion of a broker-dealer. 
    Therefore, rather than instructing a broker-dealer not to display an 
    order, a customer, consistent with this exception, may instruct the 
    broker-dealer to use its discretion in determining whether to display 
    the order. Although allowing some orders to not be displayed or to be 
    displayed partially in the system reduces transparency, the Commission 
    believes this exception is appropriate to give investors flexibility in 
    deciding how their orders should be handled.
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        \183\ Section 240.11Ac1-4(c)(2).
        \184\ But see, e.g., Madoff Letter; Morgan Stanley Letter.
        \185\ Any portion of a customer limit order that is not 
    displayed pursuant to this exception shall not be included in the 
    calculation for determining whether any other limit order is de 
    minimis. See supra note 179.
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        The exception to the rule requires a customer to expressly request 
    that an order not be displayed.186 A customer request that an 
    order be placed in a particular non-public trading system would not, by 
    itself, be deemed to be a non-display request. The Commission expects 
    that most retail customers will want their limit orders displayed 
    pursuant to the rule. Thus, the Commission has written the rule to 
    require specialists and OTC market makers to assume that retail 
    customers wish to have their orders displayed unless the customer 
    specifically requests that the order not be displayed.
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        \186\ At least one commenter believes that documentation of such 
    customer requests should be required. CHX Letter. Although the 
    Commission does not believe it necessary to mandate a particular 
    method of record keeping, the Commission expects the compliance 
    departments of individual firms to discharge their responsibilities 
    in such a manner as to allow adequate supervision of compliance with 
    the customer's request not to display or to display pursuant to 
    discretionary authority provided by the customer.
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        The exception also permits any customer to negotiate with its 
    broker-dealer an individual agreement regarding the display of its 
    limit orders either on an order-by-order basis or prospectively. 
    Standardized disclaimers or contractual language in broker-dealer new 
    account agreements, however, would not be deemed to be an individual 
    request by a customer that its order or orders not be displayed.
        The third exception applies to odd-lot orders.187 The rule 
    does not require the display of an order for less than a unit of 
    trading as established by the rules of the exchange or association. In 
    the event that a round-lot limit order represented in the quote is 
    partially filled and, as a result, the remainder of the order would 
    then be deemed an odd-lot order, the remainder of the order may be 
    treated as an odd-lot for purposes of this exception. For example, 
    assume a
    
    [[Page 48305]]
    
    market maker is quoting at the NBBO (10\1/4\-10\3/8\ (200 x 1000)) and 
    is representing a 200 share customer limit order to buy when a market 
    order to sell 150 shares is received. Upon execution of 150 shares of 
    the 200 share customer limit order, the market maker is not required to 
    display the remaining 50 shares of the order at 10\1/4\.188
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        \187\ Section 240.11Ac1-4(c)(3).
        \188\ The market maker still will have best execution 
    obligations with respect to the remaining odd-lot portion of the 
    customer limit order.
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        The fourth exception applies to block size orders.189 Orders 
    of at least 10,000 shares or for a quantity of stock having a market 
    value of at least $200,000 need not be displayed in accordance with the 
    rule, unless the customer so requests.190 The Commission 
    recognizes that the display of block size orders would add to market 
    transparency. In practice, however, the handling of block size orders 
    differs from other orders. For example, in the OTC market, market 
    makers often negotiate terms and conditions with respect to the 
    handling of block size orders, and display of block size orders may 
    impact market maker quotations in a security more than would smaller 
    limit orders.191 Further, one of the major objectives in proposing 
    the Display Rule was to improve the handling and execution 
    opportunities afforded to customers that lack the power to negotiate 
    better terms. Because most investors that trade in block size have such 
    power, the Commission has chosen not to mandate the display of block 
    size orders, unless the customer so requests.192 The Commission is 
    satisfied that the current definition strikes an appropriate regulatory 
    balance by requiring a presumption in favor of display for those orders 
    requiring enhanced protection, while not extending the presumption to 
    those orders less likely to need such protection. Of course, the 
    Commission may reevaluate its treatment of block size orders at a later 
    date.
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        \189\ Section 240.11Ac1-4(c)(4).
        \190\ This block definition is consistent with the current 
    definition used in NYSE Rule 127.10. Some commenters, however, 
    suggest that the parameters for such orders be increased or made 
    flexible depending on the liquidity of a particular security. See, 
    e.g., D.E. Shaw Letter; PSE Letter; Schwab Letter. Still others 
    believe that there should be no exception for orders of block size. 
    Instead, these commenters want such orders to be included within the 
    scope of the rule so as to add to market transparency. See, e.g., 
    Amex Letter; ICI Letter; Lehman Letter; Peake Letter; Ricker Letter. 
    One commenter suggests the use of a ``block indicator'' to give a 
    specialist or OTC market maker the option of displaying the full 
    size of the order or using the indicator to identify the quote as 
    representing a block size order. Lehman Letter.
        \191\ See, e.g., Manning II, supra note 24.
        \192\ Customers placing block orders, however, may request that 
    the order be displayed in accordance with the requirements of the 
    rule; a specialist or OTC market maker that accepts the order will 
    be obligated to honor such a request. Section 240.11Ac1-4(c)(4). The 
    Commission expects that adequate procedures will be developed to 
    ensure compliance with a customer request. See supra note 186.
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        As proposed, the fifth exception would have applied to a limit 
    order that is delivered immediately to an exchange or association 
    sponsored system that displays limit orders and complies with the 
    requirements of the rule with respect to that order.193 This 
    exception did not relieve a specialist or OTC market maker from its 
    display obligation for orders it received through exchange or 
    association facilities, unless the facility itself displayed the 
    order.194
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        \193\ Section 240.11Ac1-4(c)(5). A facility would not be deemed 
    to comply with the requirements of the Display Rule if the highest 
    priced buy orders and lowest priced sell orders entered by a 
    specialist or OTC market maker in the facility for a particular 
    security were not included in calculating the best bid and offer for 
    the market and incorporated in the consolidated quote.
        \194\ One commenter argues that the exception permits 
    specialists and OTC market makers to become ``fair weather 
    dealers,'' effectively allowing them to selectively withdraw from 
    the national market system, which creates a misleading picture of 
    liquidity. Madoff Letter. The Commission believes, however, that the 
    exception provides a specialist or OTC market maker with an 
    appropriate amount of discretion in handling a customer limit order 
    while ensuring that orders at the best price are displayed to the 
    marketplace.
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        In the Proposing Release, the Commission requested comment on 
    whether to extend this exception from display to instances where 
    customer limit orders are sent to ECNs or PTSs by a specialist or OTC 
    market maker.195 As discussed below in connection with the 
    amendments to the Quote Rule, the Commission is amending the Quote Rule 
    to require specialists and OTC market makers to include priced orders 
    they enter into ECNs in the bids and offers they communicate to their 
    exchange or association for reflection in their published quotations, 
    when such orders improve their published quotations.196 In 
    recognition of the concerns raised by commenters, the Commission also 
    has included an alternative to the amendment designed to preserve the 
    anonymity of specialists and OTC market makers that is currently 
    provided by certain ECNs, while still publicizing in the public 
    quotation stream better prices entered into ECNs. The ECN display 
    alternative in the Quote Rule is available only if the ECN provides for 
    public dissemination of the price and full size of the orders entered 
    by specialists and OTC market makers to an exchange or association and 
    provides access to other broker-dealers to trade at those prices which 
    is equivalent to that provided in the market where the prices are 
    disseminated.197
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        \195\ See, e.g., Letter from James Lynch, General Counsel, ITG, 
    Inc., to Jonathan G. Katz, Secretary, SEC, dated, January 15, 1996 
    (``POSIT Letter'') (not supporting the extension of the exception); 
    PSE Letter (extension of exception should be contingent on access 
    provided by ECNs); Whitcomb Letter (doubtful that exception could be 
    extended in today's environment); see also Madoff Letter (market 
    makers and specialists should be able to represent a portion of the 
    size of a customer limit order in other markets or ECNs, but the 
    best price and some size should be reflected in their quote).
        \196\ See Sec. 240.11Ac1-1(c)(5)(i)(A); see also Amendments to 
    the Quote Rule discussion at section III.B.2.c.ii., infra.
        \197\ As discussed, the Commission expects the SROs to work 
    expeditiously with ECNs that wish to avail themselves of this 
    alternative, and is prepared to act if necessary to ensure the 
    effectiveness of the ECN display alternative, prior to the effective 
    date of the Quote Rule amendments. See Introduction and Summary, 
    supra; see also Sec. 240.11Ac1-1(c)(5)(ii); Amendments to the Quote 
    Rule discussion at section III.B.2.c.iii., infra.
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        The Commission believes that ECNs that provide their best 
    specialist and market maker prices to the public quotation system and 
    provide ready access to their prices can provide an effective means for 
    specialists and OTC market makers to ensure that customer limit orders 
    are handled in a manner consistent with the Display Rule. In view of 
    the ECN display alternative in the Quote Rule, the Commission believes 
    it is appropriate to extend the exception in the Display Rule to orders 
    entered into ECNs that comply with the Quote Rule alternative.198 
    Accordingly, a specialist or OTC market maker that delivers a customer 
    limit order to an ECN will be deemed to have satisfied its display 
    obligation with regard to that order if the ECN complies with the 
    requirements of the new alternative in the Quote Rule.199 The 
    proposed exception for limit orders entered into exchange or 
    association sponsored systems contemplated that such orders would be 
    transparent and accessible. Therefore, expanding the exception to 
    include the use of ECNs that provide for the requisite transparency and 
    accessibility is consistent with the rule as proposed.
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        \198\ See Amendments to the Quote Rule discussion at section 
    III.B.2.c.i., infra, for a description of the ECN definition; see 
    also Sec. 240.11Ac1-1(a)(8); Sec. 240.11Ac1-4(a)(8).
        \199\ Section 240.11Ac1-4(c)(5). See also, Amendments to the 
    Quote Rule discussion on accessibility at section III.B.2.c.iii., 
    infra. Additionally, a specialist or OTC market maker may be 
    relieved of its display obligation if it delivers the customer limit 
    order to an exchange or association sponsored system that complies 
    with the new alternative in the Quote Rule. Section 240.11Ac1-
    4(c)(5).
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        The Commission notes that this exception to the Display Rule 
    maintains the benefits, including increased transparency, provided to 
    customer limit orders under the rule. The
    
    [[Page 48306]]
    
    exception ensures that customer limit orders will have equivalent 
    public disclosure whether they are sent to an ECN that complies with 
    the alternative or displayed directly in a specialist's or OTC market 
    maker's quote.200
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        \200\ An OTC market maker or specialist choosing to enter 
    customer limit orders for display through an ECN must still evaluate 
    whether the customer order is likely to obtain best execution 
    through display in that ECN. See section III.C.2., infra.
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        The sixth exception applies to a limit order that is delivered to 
    another exchange member or OTC market maker that complies with the 
    display requirements of the rule with respect to that order.201 
    For example, a market maker that receives a limit order subject to the 
    display requirement under the rule may immediately send the order to 
    another market maker in the security if the other market maker will 
    display the order in accordance with this rule.202
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        \201\ Section 240.11Ac1-4(c)(6).
        \202\ One commenter believes that the rule should require a 
    specialist or OTC market maker to obtain assurances that a 
    customer's limit order will be displayed in accordance with the rule 
    before such an order is sent. MJT Letter. But see PSE Letter; 
    Salomon Letter. As noted earlier, the Commission believes that it is 
    best left to a firm's compliance department to decide on the 
    necessary assurances that the order will be displayed in conformance 
    with the rule.
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        The seventh exception applies to ``all-or-none limit orders.'' An 
    ``all-or-none limit order'' is an order accompanied by the customer's 
    instruction that the order is to be executed in its entirety or not at 
    all.203 Although this exception was not included in the proposed 
    rule, the Commission believes that exempting all-or-none limit orders 
    is necessary to avoid operational difficulties regarding partial 
    executions at the public quote.204 In this regard, all-or-none 
    limit orders typically are not displayed in the exchange markets 
    today.205 The Commission believes, therefore, that this exception 
    is consistent with the goals and objectives of the Display Rule.
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        \203\ See, e.g., NYSE Rule 13.
        \204\ For example, if an all or none order to buy 1,000 shares 
    at 10\1/4\ were displayed in the quote and represented the NBBO, a 
    subsequent market order to sell 500 shares could not be matched 
    against the all or none order.
        \205\ See, e.g., NYSE Rule 13.
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        Finally, a new provision has been included that enables the 
    Commission to exempt, conditionally or unconditionally, any 
    transactions that it may determine are not encompassed within the 
    purposes of the Display Rule. The Commission believes that this 
    exemptive authority provides flexibility in applying the Display 
    Rule.206
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        \206\ Section 240.11Ac1-4(d).
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    d. Effective Date and Phase-In
        The Display Rule will become effective on January 10, 1997. As of 
    this date, the Display Rule will apply to exchange-traded securities. 
    Moreover, this date will mark the beginning of the first phase-in for 
    Nasdaq securities. As of this date, the Display Rule will apply to the 
    1,000 Nasdaq securities with the highest average daily trading volume 
    in the previous quarter.
        The second phase-in date will be on March 28, 1997. From this date 
    forward, the Display Rule will apply to the next 1,500 Nasdaq 
    securities with the highest average daily trading volume over the 
    previous quarter.207
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        \207\ Any security already covered by the rule will not be 
    included as part of the calculation of the securities to be included 
    in any subsequent group. Therefore, if a security is included as one 
    of the 1,000 securities in the first group, such security will not 
    be counted as one of the next 1,500 securities in the second group 
    (even if such security's average daily trading volume over the 
    previous calendar quarter would otherwise place it in the second 
    group).
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        The third phase-in date will be on June 30, 1997. From this date 
    forward, the Display Rule will apply to the next 2,000 Nasdaq 
    securities with the highest average daily trading volume over the 
    previous quarter.
        The final phase-in date will be on August 28, 1997. From this date 
    forward, the Display Rule will apply to all remaining Nasdaq 
    securities.
        Although the Commission believes that the Display Rule should apply 
    equally to exchange-traded and non-exchange-traded securities, the 
    Commission understands that the Display Rule will more significantly 
    impact current order handling procedures for Nasdaq securities in light 
    of existing practices in that market. The phase-in period will allow 
    the Commission to monitor the effects of the Display Rule on successive 
    groups of Nasdaq securities while ensuring that all covered securities 
    receive the benefits of the display requirement within one year of the 
    Display Rule's adoption.
    
    B. Amendments to the Quote Rule
    
    1. Background
        Public quotation reporting for equity securities is governed by the 
    Commission's Quote Rule,208 as well as by exchange and NASD rules. 
    These rules require registered exchanges and securities associations to 
    file quotation reporting plans with the Commission that provide for the 
    collection and transmission of quotation information on a real-time 
    basis for securities covered by the Quote Rule.209 Market makers 
    and exchange specialists communicate their quotes to the NASD or to an 
    exchange pursuant to these plans and the NASD and exchanges in turn 
    make this information available to vendors for dissemination to the 
    public.210
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        \208\ 17 CFR 240.11Ac1-1. See also Securities Exchange Act 
    Release No. 14415 (January 26, 1978), 43 FR 4342 (February 1, 1978) 
    (``Quote Rule Adopting Release'').
        \209\ Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1) 
    (dissemination requirements for exchanges and associations).
        \210\ Rule 11Ac1-2, 17 CFR 240.11Ac1-2 (``Vendor Display Rule'') 
    requires vendors of market information to display quotation 
    information in a non-discriminatory manner.
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        The Quote Rule requires the collection and public dissemination of 
    the best bid, best offer, and size for each market quoting any security 
    covered by the Quote Rule, as well as the consolidation of those 
    markets' quotations and public dissemination of the national 
    ``consolidated'' best bid and offer (``NBBO'').211 These 
    quotations must be firm, and a market maker or specialist generally is 
    obligated to execute an order at a price at least as favorable as its 
    published bid or offer up to the size of its published bid or 
    offer.212 Broker-dealers covered by the Quote Rule, including 
    dealers trading listed securities in the OTC market (i.e., third market 
    makers), must supply quotations to their exchange or association for 
    dissemination to quotation vendors.
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        \211\ Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1). Pursuant to 
    the Quote Rule and the Joint Consolidated Quotation Plan (``CQS 
    Plan''), the inside quotations collected and calculated by the 
    exchanges and Nasdaq for exchange-listed securities are consolidated 
    and disseminated to vendors by SIAC, the exclusive processor for 
    consolidated quotations in listed securities. Similarly, Nasdaq is 
    the exclusive processor for quotations in Nasdaq National Market 
    (``Nasdaq NMS'') securities. Nasdaq collects and consolidates inside 
    quotations furnished by OTC market makers and by exchanges pursuant 
    to a Joint Self-Regulatory Organization Plan that provides for 
    exchange trading of Nasdaq securities. Nasdaq then disseminates to 
    vendors the inside bid and offer in Nasdaq NMS securities, and 
    disseminates to various subscribers more specific information 
    concerning the individual market maker and exchange quotes in each 
    Nasdaq security. The terms ``consolidated quote'' and ``publicly 
    available quotation,'' when used with respect to information 
    disseminated by exchanges and Nasdaq via their exclusive processors, 
    refer to the quotes that SIAC or Nasdaq furnishes to vendors for 
    dissemination to the public. The terms ``public quote'' or 
    ``publicly available quote,'' when used with respect to a specialist 
    or market maker, refer to the bid and offer that the specialist or 
    market maker has furnished to its exchange or association for 
    inclusion in the consolidated quote. The term ``public quotation 
    system'' refers to this entire structure through which SROs collect 
    quotations from market participants, and the exclusive processors 
    collect, process, and disseminate those quotations to vendors.
        \212\ Rule 11Ac1-1(c)(1), 17 CFR 240.11Ac1-1(c)(1). This is 
    referred to as the broker-dealer's ``firmness'' requirement.
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        The 1975 Amendments identified the need for a prompt, accurate and 
    reliable
    
    [[Page 48307]]
    
    central quotation reporting system.213 The Quote Rule, in 
    particular, was designed to facilitate the NMS by requiring specialists 
    and market makers publishing quotes to provide these quotes to a 
    central system so they could be made available to the public. Congress 
    considered the public availability of quotation information to be 
    critical to fair and competitive markets because published quotations 
    provide investors, their brokers, and other market participants with 
    essential information about the condition of the market. This 
    information assists investors in making investment decisions and in 
    finding the best market for a security, while making it possible for 
    investors to evaluate the quality of their executions.
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        \213\ Senate Report, supra note 31. Cf. H.R. Rep. No. 229, 94th 
    Cong., 1st Sess. 29 (1975) (``Conference Report'') (noting that the 
    conference committee adopted the Senate's provisions on the NMS with 
    minor revisions).
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        Since the 1975 Amendments and the adoption of the Quote Rule, there 
    have been dramatic changes in the markets and the technologies used by 
    market participants. To ensure that the Quote Rule keeps pace with the 
    evolution of the securities markets and continues to ensure the public 
    availability of accurate, reliable, and comprehensive quotation 
    information, the Commission has determined that certain amendments to 
    the Quote Rule are necessary and appropriate in furtherance of the 
    objectives of the Exchange Act.
        The Commission proposed an amendment to the Quote Rule to require 
    specialists and market makers to reflect in their public quotes any 
    better priced orders they place in certain systems that are not 
    currently integrated into the NMS. In particular, the ECN amendment is 
    intended to incorporate within the public quotes any better priced 
    orders broadly displayed by market makers and specialists through ECNs. 
    This amendment is being adopted with modifications to address concerns 
    raised by some commenters. Specifically, in order to provide 
    specialists and market makers with an alternative method to meet the 
    ECN display requirement, the Commission is adopting an alternative 
    suggested in the proposing release that deems a specialist or market 
    maker in compliance with the ECN amendment if the ECN provides the best 
    prices entered into the ECN by market makers or specialists for each 
    covered security to an exchange or association for inclusion in the 
    public quotation system and provides access to those prices equivalent 
    to the access currently available to other quotes published by the 
    exchange or association. In addition, the Commission is amending the 
    Quote Rule to expand the categories of securities covered by certain 
    existing Quote Rule provisions. The quotation requirements that 
    previously applied to substantial specialists and market makers in only 
    certain exchange-listed securities now will apply to substantial 
    specialists and market makers in all exchange-listed securities. 
    Further, certain Quote Rule provisions that previously applied to 
    market makers electing to quote particular Nasdaq securities now will 
    apply to market makers electing to quote any Nasdaq security. The 
    Commission is adopting these amendments substantially as proposed, 
    along with minor technical amendments to the Quote Rule that are 
    discussed more fully below.
    2. Public Dissemination of Market Maker and Specialist Prices in ECNs
    a. Basis for the ECN Amendment
        Over 20 years ago, the Commission noted that an essential purpose 
    for the establishment of the NMS was ``to make information on prices, 
    volume, and quotes for securities in all markets available to all 
    investors, so that buyers and sellers of securities, wherever located, 
    can make informed investment decisions and not pay more than the lowest 
    price at which someone is willing to sell, or not sell for less than 
    the highest price a buyer is prepared to offer.'' 214 At the time, 
    the lack of consolidated quote information made it difficult to 
    ascertain the different prices that were often available in the various 
    markets for a particular security. This lack of transparency as to the 
    best prices among competing markets was widely recognized as preventing 
    investors and their brokers from ascertaining accurate trading interest 
    for a security and obtaining the best prices for their orders.215 
    To address these concerns, Congress directed the Commission to 
    facilitate the creation of a national market system that would link the 
    various markets trading a security. The price and quotation 
    transparency resulting from the Commission's ensuing NMS initiatives 
    has produced extremely liquid, successful, and, in most cases, 
    competitive markets.
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        \214\ Securities and Exchange Commission, Statement of the 
    Securities and Exchange Commission on the Future Structure of the 
    Securities Markets (February 2, 1972) (``Future Structure 
    Statement'') at 9-10, 37 FR 5286, 5287 (February 4, 1972) (emphasis 
    added). See also Securities and Exchange Commission, Policy 
    Statement of the Securities and Exchange Commission on the Structure 
    of a Central Market System (1973) at 25-28.
        \215\ See Senate Report, supra note 31.
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        As discussed in the Proposing Release, the Commission for many 
    years has been concerned that the development of so-called ``hidden 
    markets,'' in which a market maker or specialist publishes quotations 
    at prices superior to the quotation information it disseminates on a 
    general basis, impedes these NMS objectives.216 Over the course of 
    the last decade, certain trading systems that allow market makers and 
    specialists to widely disseminate significant trading interest to 
    certain market participants without making this trading interest 
    available to the public market at large have become significant markets 
    in their own right. Although offering benefits to some market 
    participants, widespread participation in these hidden markets has 
    reduced the completeness and value of publicly available quotations 
    contrary to the purposes of the NMS. Because these systems are not 
    registered as exchanges or associations, they are currently not 
    required to integrate into the public quote the prices at which their 
    subscribers, including subscribing market makers and specialists, are 
    willing to trade.217 The use of these systems by market makers and 
    specialists to quote prices not incorporated into the NMS has resulted 
    in fragmented and incomplete dissemination of quotation information.
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        \216\ See Proposing Release at 4.
        \217\ Certain ECNs may be registered with the Commission as 
    broker-dealers and indeed perform various brokerage functions. 
    Nevertheless, the Commission recognizes that in providing a 
    mechanism by which system subscribers can (1) broadcast prices to 
    other system subscribers and (2) trade with one another at those 
    prices, these systems also function as securities markets.
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        Certain markets, in particular ECNs that allow subscribers 218 
    to enter priced orders that are widely disseminated to third parties 
    219 and permit such orders to be executed in whole or in part 
    through the system, communicate orders that are closely analogous to 
    quotations. These ECNs, in effect, allow market makers and specialists 
    to display different prices to different market participants.
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        \218\ ECN subscribers may include institutional investors, 
    broker-dealers, and market makers. ECNs provide their services to 
    subscribers for a fee or commission equivalent. Some ECNs (such as 
    SelectNet) have been available only to broker-dealers and not to 
    investors generally.
        \219\ ''Third parties'' in this context refers to subscribers or 
    any other entities (such as customers of subscribers) that receive 
    information from the ECN concerning any priced order entered into 
    the ECN by another subscriber.
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        Although these ECNs can facilitate the execution of their 
    subscribers' orders and allow institutions to participate
    
    [[Page 48308]]
    
    directly in price discovery, the display of better prices privately in 
    ECNs reduces the reliability and completeness of consolidated 
    quotations, the accuracy of which continues to be an essential element 
    of the NMS. These private markets have resulted in fragmented 
    quotations and a reduction in the reliability of public quotations as 
    an accurate indicator of market makers' and specialists' best prices, 
    the identical situation that prompted Congress to adopt the NMS 
    amendments in 1975. The unavailability of full market maker and 
    specialist quotation information prevents investors and their brokers 
    from ascertaining the true trading interest for a security, and 
    obtaining the best price for market orders, and prevents investors from 
    monitoring the efforts of their brokerage firms to obtain best 
    execution for their orders.
        The Commission's analysis of the trading activity in these ECNs has 
    produced clear evidence of the existence of a two-tiered market in 
    which market makers routinely trade at one price with retail customers 
    and at better prices with ECN subscribers.220 For example, 
    analysis of trading activity in the two most significant ECNs in the 
    Nasdaq market, Instinet and SelectNet, reveals that approximately 85% 
    of the bids and offers displayed by market makers in Instinet and 90% 
    of the bids and offers displayed on SelectNet were at better prices 
    than those posted publicly on Nasdaq.221 Furthermore, 
    approximately 77% of the trades executed on Instinet and 60% of the 
    trades executed on SelectNet occurred at prices between the Nasdaq best 
    bid and offer. Market makers participated on at least one side of 
    approximately 90% of the trades in these ECNs. The trading activity in 
    Instinet, which comprised approximately 17% of trades and 15% of the 
    volume in Nasdaq securities, represents a significant portion of the 
    overall market for Nasdaq securities.222
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        \220\ For example, a market maker with a public offer 
    constituting the best public offer of 20\3/4\ might offer to sell 
    shares in an ECN at 20\5/8\. If the market maker did not change its 
    public offer to reflect this improved selling price, public 
    customers buying from the market maker would pay the higher price of 
    20\3/4\ for the security because they do not have access to the 
    market maker's price in the ECN.
        \221\ The Commission's analysis is based on Instinet and 
    SelectNet data for the months April through June 1994. See 21(a) 
    Report at notes 48-52 and accompanying text and Appendix at notes 
    18-28 and accompanying text.
        \222\ More trading volume now occurs on Instinet than on any of 
    the organized U.S. stock markets other than the NYSE and Nasdaq. In 
    1994, trading volume on Instinet totalled approximately 10.8 billion 
    shares with an approximate dollar volume of $282 billion. In 
    comparison, Nasdaq traded approximately 74 billion shares, with an 
    approximate dollar volume of $1,449 billion. Id. at note 50 and 
    accompanying text.
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        The Commission's recent investigation into various trading 
    practices in Nasdaq stocks revealed that the existence of this two-
    tiered market facilitated the maintenance of wide spreads on Nasdaq. As 
    discussed in the 21(a) Report, Nasdaq market makers engaged in a 
    widespread course of conduct that resulted in artificially wide spreads 
    in a large percentage of Nasdaq stocks. The maintenance of wide spreads 
    was made possible at least in part by the fact that ECNs like Instinet 
    and SelectNet did not affect the prices at which market makers traded 
    with the general public, thus allowing market makers to attract trading 
    interest at prices inside the spread without adjusting their Nasdaq 
    quotes. Integrating the better prices market makers quote in ECNs 
    should significantly limit the types of uncompetitive practices 
    identified in the investigation without limiting the usefulness of 
    these systems as efficient alternative mechanisms for negotiating 
    transactions.
        The Commission firmly believes that all investors should have an 
    opportunity to have their orders filled at the best prices made 
    available by market makers. Consistent with Congress's goals for a NMS, 
    these opportunities must be made available to all customers, not just 
    those customers who, due to size or sophistication, may avail 
    themselves of prices in ECNs not currently linked with the public 
    quotation system. The vast majority of investors may not be aware of 
    the better prices widely disseminated by market makers or specialists 
    through ECNs and many do not have the ability to route their orders 
    directly or indirectly to such systems. As a result, many customers, 
    both institutional and retail, do not always obtain the benefit of the 
    better prices entered by a market maker or a specialist into an ECN.
        Brokers frequently use the consolidated quote as the benchmark for 
    automated execution of customer orders and for the starting point in 
    negotiating execution prices with institutional investors.223 
    Consolidated quotations in listed stocks are provided by CQS to 
    vendors, who then provide this information to the public. In approving 
    the CQS as the mechanism to serve this vital function, the Commission 
    stressed that it would expect broker-dealers to take into account 
    pricing information made available through the CQS in fulfilling their 
    best execution obligations.224 Similarly, for OTC securities, 
    Nasdaq disseminates to market makers, vendors, and investors multiple 
    market maker quotations, and a ``best'' bid and offer derived from 
    these quotations. As broker-dealers and markets have developed 
    automated order-routing and order execution systems, they have relied 
    on these consolidated quotes in pricing and executing customer orders 
    routed through their systems.225 Including the prices entered into 
    ECNs by market makers and specialists in the consolidated quotation 
    will help broker-dealers using these automated systems to provide their 
    customers' orders with improved executions, and will improve 
    institutions' ability to ascertain true market prices.
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        \223\ Some commenters argue that the ECN amendment focuses on 
    expanding the availability of these systems to small investors, and 
    ignores the fact that small investors already benefit from these 
    systems in that institutional subscribers in ECNs primarily 
    represent the collective interests of small investors, e.g., through 
    mutual funds and 401(k) plans. See, e.g., CALpers Letter; Dillon 
    Letter; Instinet Letter; LJR Letter; Northern Trust Letter; SIA 
    Letter; STAIC Letter. The objectives of the ECN amendment, however, 
    are not limited to improving market transparency and accessibility 
    for small investors. Comprehensive and transparent information about 
    market conditions is critical to efficient and competitive markets 
    for all investors, whether retail or institutional. Indeed, while 
    large institutional investors often have access to ECNs, the public 
    quotes nevertheless frequently serve as a benchmark for their 
    negotiations with market makers. In any event, while retail 
    investors directly account for a significantly smaller percentage of 
    trading volume than institutional investors, they still account for 
    half of the direct equity investment in U.S. markets. NYSE 1995 Fact 
    Book at 57. The Commission recognizes that direct retail 
    participation provides critical liquidity and therefore limited 
    access and transparency to the best prices available undermines the 
    efficiency of our markets and jeopardizes public confidence in their 
    fairness.
        \224\ See Securities Exchange Act Release No. 15009 (July 28, 
    1978), 43 FR 34851 (declaring the CQS Plan temporarily effective); 
    Securities Exchange Act Release No. 16518 (Jan. 22, 1980), 45 FR 
    6521 (permanently approving the CQS Plan).
        \225\ See discussion of best execution principles, infra section 
    III.C.2.
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        In light of the stated fundamental purposes of the 1975 Amendments 
    and clear evidence of a two-tiered market, the Commission believes it 
    is imperative to amend the Quote Rule to ensure the public 
    dissemination of accurate quotes that represent the best prices that 
    market makers and specialists widely disseminate. Thus, the ECN 
    amendment is intended to integrate into the public quote the prices of 
    market makers and specialists that are now widely disseminated to ECN 
    subscribers but are not available to the rest of the market.226
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        \226\ Several commenters characterize ECNs as ``wholesale'' 
    markets, and argue that the ECN rule would require market makers to 
    trade with retail customers at wholesale prices. See, e.g., Davis 
    Letter; Instinet Letter; LJR Letter; Merrill Letter. The Commission 
    notes that market makers are compensated by the spread between their 
    bid and offer prices, and nothing in the ECN rule prevents market 
    makers from buying at the bid from one customer and selling at the 
    offer to another.
    
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    [[Page 48309]]
    
        Most commenters support the Commission's goal of improving the 
    quality of quotation information made available to the public, although 
    many raise questions, discussed below, about the proposal. In 
    particular, and as discussed below, some commenters expressed concern 
    about the potential impact of the rule on benefits provided to the 
    market as a whole by ECNs. Upon review of the comments received, the 
    Commission has determined that it is appropriate to adopt the proposed 
    ECN amendment. Furthermore, in response to the concerns noted, and to 
    facilitate compliance with the ECN amendment, the Commission has 
    included the ECN display alternative that permits a market maker or 
    specialist to comply with the amendment through an ECN that meets two 
    conditions. First, the ECN into which the market maker or specialist 
    enters its order must ensure that the best prices market makers and 
    specialists have entered therein are communicated to the public 
    quotation system. Second, the ECN must provide brokers and dealers 
    access to orders entered by market makers and specialists into the ECN, 
    so brokers and dealers that do not subscribe to the ECN can trade with 
    those orders. The ECN display alternative therefore allows a market 
    maker or specialist to comply with the ECN amendment directly by 
    changing its quote, or alternatively by using an ECN that meets the 
    above two conditions.
        As discussed above, the Commission expects the SROs to work 
    expeditiously with ECNs that wish to avail themselves of the ECN 
    display alternative to develop rules or understandings of general 
    applicability. The Commission is prepared to act as necessary to ensure 
    implementation of the ECN display alternative prior to the effective 
    date of the Quote Rule.
    b. Response to Comments 227
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        \227\ This section includes a discussion of the principal 
    arguments advanced by the commenters. A more detailed discussion of 
    the comments is provided in the Summary of Comments.
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        The Commission solicited comment on whether the proposed amendment 
    achieves the goals of deterring fragmented markets and promoting 
    improved quotations. The Commission also invited comment on whether 
    there are any feasible alternatives to the rule, and on possible 
    business or economic justifications for permitting market makers and 
    specialists to publish prices in ECNs that differ from their public 
    quotations. The Commission requested comment on the competitive effects 
    of the proposal on existing ECNs, subscribers, and users.228 In 
    addition, the Commission solicited comment on alternatives to the 
    proposal that would minimize any negative effects, yet still achieve 
    the Commission's goals. The Commission specifically asked whether ECNs 
    should, as an alternative, furnish market makers' and specialists' best 
    prices to the applicable exchange or association for further 
    dissemination, and provide access to those prices through some form of 
    linkage.229
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        \228\ The Commission also specifically solicited comment on 
    whether exceptions to the rule would be appropriate, particularly if 
    a customer requests that the market maker refrain from publicly 
    disseminating its order. The Commission also solicited comment on 
    whether market makers should be required to disseminate publicly the 
    full size of orders placed in ECNs. The Commission received only 
    minimal response to these questions, which is discussed in the 
    Summary of Comments.
        \229\ See Proposing Release at 28-29.
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    i. General Comments
        The Commission received numerous comments on the ECN proposal. Many 
    commenters support the proposal as an important initiative designed to 
    further investor protection by improving publicly available quotation 
    information and assuring best execution of customer orders.230 
    Some commenters recognize that a number of brokers and dealers have 
    adopted the practice of placing superior priced orders in ECNs without 
    including these better prices in their public quotes.231 These 
    commenters agree that the Commission should be concerned that some 
    retail investors may have neither knowledge nor access to the best 
    available prices under these circumstances.232 They voice general 
    support for the rule, and recommend one or more mechanisms 233 by 
    which the Commission could ensure that public quotes contain the best 
    prices otherwise widely disseminated by market makers and specialists.
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        \230\ See, e.g., DOJ Letter; Lehman Letter; Madoff Letter; Amex 
    Letter; NASD Letter.
        \231\ See, e.g., Amex Letter; DOJ Letter; Madoff Letter; RPM 
    Letter.
        \232\ See, e.g., Letter from Gerri Detweiler, Policy Director, 
    National Counsel of Individual Investors, to Jonathan G. Katz, 
    Secretary, SEC, dated January 22, 1996 (``NCII Letter''); Goldman 
    Sachs Letter; PaineWebber Letter; SIA Letter; Madoff Letter; Lehman 
    Letter; DOJ Letter.
        \233\ See discussion of alternative approaches, infra at section 
    III.B.2.b.iv.
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    ii. Impact on ECNs, Market Makers and Specialists, and Institutions
        Some commenters express concern that the amendment could negatively 
    impact services provided by ECNs and caution the Commission not to 
    diminish the benefits provided by ECNs to the market as a whole. Some 
    commenters argue that, under the proposal, market makers and 
    specialists that use ECNs would lose the anonymity that these 
    commenters believe is crucial to successfully execute large trades for 
    institutional investors.234 Some commenters anticipate the 
    adoption of the ECN amendment prompting a potential decline in the use 
    of certain ECNs.235 In addition, some commenters contend that this 
    amendment, because of the impact on ECNs and their subscribers, will 
    lead to a loss of liquidity in both ECNs and the public markets 
    236 and to a decline in the variety of available trading options 
    which could be detrimental to all investors.237 Other commenters 
    argue that the proposal would effectively double the risk of a 
    specialist or market maker that enters orders into an ECN because the 
    specialist or market maker could be simultaneously responsible for 
    multiple executions based on its disseminated quote as well as its ECN 
    order.238 Moreover, at least one commenter argues that quotes, 
    bids, offers, and orders have historically had different meanings and 
    that the proposal's treatment of priced orders as quotes confuses the 
    essence of the terms, thereby resulting in inadvertent anti-competitive 
    effects.239 Some commenters also argue that the better prices 
    frequently available in ECNs reflect the lower costs of doing business 
    in those systems, and therefore, it would be inappropriate to require 
    market
    
    [[Page 48310]]
    
    makers and specialists to match their ECN prices in their public 
    quotes.240
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        \234\ See AZX Letter; Instinet Letter; ICI Letter; Investors 
    Research Letter; NASD Letter; Ruane Letter; STAIC Letter; Letter 
    from Edward G. Shufro, Partner, Shufro, Rose & Ehrman, to Jonathan 
    G. Katz, Secretary, SEC (``Shufro Letter''); Sutro Letter.
        \235\ See Goldman Sachs Letter; STA Letter; AZX Letter; Instinet 
    Letter; Schwartz and Wood Letter; Ruane Letter.
        \236\ See DOJ Letter; STA Letter; Alex. Brown Letter; Letter 
    from Jeffrey L. Davis, Economists Incorporated, to Jonathan G. Katz, 
    Secretary, SEC, dated October 25, 1995 (``Davis Letter''); Dillon 
    Letter; Instinet Letter; Merrill Letter. (citing the ``deleterious 
    effects concerning liquidating inventory and replacing necessary 
    capital'' at pp. 7-8); Schwartz and Wood Letter; Letter from Mary 
    Kay Wright, Second Vice President and Senior Equity Trader, The 
    Northern Trust Company, to Jonathan G. Katz, Secretary, SEC, dated 
    February 28, 1996 (``Northern Trust Letter'').
        \237\ See Letter from Anthony R. Gray, Chairman and CIO, STI 
    Capital Management, to Jonathan G. Katz, Secretary, SEC, dated 
    February 12, 1996 (``STI Capital Letter''); Ruane Letter; DOJ 
    Letter; and LJR Letter.
        \238\ See, e.g., Merrill Letter.
        \239\ See Instinet Letter. Instinet also bases much of its 
    arguments on its regulatory identification as a broker-dealer. 
    Instinet argues that the proposal targets its ECN operations for 
    treatment different from other broker-dealers. The Commission notes 
    that Instinet (and similar systems) provides to its customers ECN 
    services that are significantly different from the services provided 
    by other broker-dealers to their customers. Specifically, Instinet, 
    without discretion, publicizes subscriber orders and enables other 
    subscribers to trade with these orders at their stated price.
        \240\ See, e.g., Dillon Letter; HHG Letter; LJR Letter; Merrill 
    Letter; STA Letter; Goldman Sachs Letter.
        There appear to be counter arguments. For example, there is no 
    reason to suppose that adverse selection costs--that is, the risks 
    of trading with an informed trader--are any lower in ECNs, whose 
    subscribers typically can include market makers, other broker-
    dealers, institutional money managers, hedge funds, momentum 
    traders, and options market makers. Second, because traders can more 
    easily mask their identities and thus their trading motives in ECNs 
    than in the primary market, informed traders may prefer to trade in 
    ECNs. These higher information asymmetries would be expected to lead 
    to higher, rather than lower, trading costs. Finally, ECNs often 
    impose transactions charges that may not otherwise be incurred by 
    dealers trading in the primary market.
        Furthermore, it does not appear that the better prices available 
    in ECNs can be explained by differences in the size of orders and 
    transactions given that the average order size and trade size in one 
    ECN (Instinet) is substantially similar to the average size of 
    quotes and trades in the primary market. In any event, the 
    Commission generally would not expect larger size orders to receive 
    better prices in view of the considerable literature suggesting that 
    in equities markets, larger orders tend to get worse prices because 
    of the risk of trading with an informed trader. See, e.g., David 
    Easley and Maureen O'Hara, 19 J. Fin. Econ. 69, (No. 1, September 
    1987).
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        The Commission agrees with commenters that ECNs provide certain 
    valuable benefits to their subscribers. It also recognizes the benefits 
    competing systems bring to the market as a whole, particularly systems 
    that take advantage of new technologies to offer improved trading 
    opportunities. The Commission, therefore, has adopted an alternative 
    method of compliance with the ECN requirement discussed in the 
    proposing release to reduce the amendment's potential impact on 
    existing ECNs and their subscribers, and to maintain incentives and 
    opportunities for new ECNs to enter the marketplace.241 The 
    Commission continues to believe it is important that the best prices of 
    orders entered into these markets by market makers and specialists are 
    properly integrated into the public market so that all market 
    participants can benefit from the price discovery taking place within 
    these markets.
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        \241\ The Commission believes that although the ECN amendment 
    may marginally reduce the incentive of some subscribers to 
    participate in an ECN, on the whole the effect on ECNs should not be 
    so significant as to affect their viability. Moreover, given the 
    availability of the ECN display alternative, which is designed to 
    minimize any potentially detrimental effects of the rule on ECNs, 
    the Commission believes that the benefits of the amendment to 
    investors of publicizing the better prices entered by market makers 
    and specialists outweigh the limited likely costs to ECNs. Many of 
    the comments received that addressed the ECN proposal raised concern 
    about the importance of preserving the anonymity offered by these 
    systems. See, e.g., Alex. Brown Letter; AZX Letter; Dillon Letter; 
    Estep Letter; ICI Letter; Instinet Letter; NASD Letter.
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        In its comment letter, the NASD stated its view that the proposal 
    could discourage market makers' use of ECNs because a market maker 
    placing an order in an ECN at a better price would have to 
    simultaneously change its quote, thereby telegraphing its interest. In 
    proposing a solution to this situation, the NASD specifically referred 
    to the ECN alternative noting ``* * * this problem can be addressed 
    without discouraging market maker use of ECNs through the approach 
    suggested by the Commission as a possible alternative, i.e., by 
    reflecting the better ECN prices in the inside market display, rather 
    than in individual quotes.'' 242
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        \242\ NASD Letter at 14.
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        In response to the concerns raised by the NASD and other 
    commenters, the ECN display alternative is designed to preserve the 
    benefits associated with the anonymity that some ECNs currently offer 
    to subscribing market makers and specialists and their 
    customers.243 This alternative will ensure that the best prices of 
    market makers and specialists are publicly disseminated and that non-
    ECN-subscribing brokers and dealers can trade with the ECN orders 
    represented by those prices. Under the display alternative, the best 
    prices and sizes of orders entered into an ECN by specialists and 
    market makers would be publicly disseminated while the specialists and 
    market makers themselves would remain anonymous. This alternative not 
    only preserves anonymity, but also eliminates the risk that a market 
    maker or specialist could be exposed to multiple executions at the ECN 
    price.244
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        \243\ The Commission recognizes that in certain securities, 
    specific market makers or specialists may be viewed as price leaders 
    for those securities. Therefore, if the market knows that one of 
    those firms has changed its quote, other market makers or 
    specialists are likely to follow that price change and frustrate the 
    first's firms ability to obtain an execution at the improved price. 
    The ability to place an anonymous order in an ECN allows the firm to 
    change its price without triggering corresponding price changes from 
    other market makers or specialists and thereby increases its 
    potential to obtain an execution at the improved price.
        \244\ Certain commenters fear that, as originally proposed, the 
    amendment would have an adverse impact on institutional investors 
    which currently subscribe to ECNs. These commenters appeared to 
    believe that the ECN amendment would seriously harm ECNs, and thus 
    harm institutional users. See, e.g., ICI Letter; Ruane Letter. The 
    Commission does not believe that the amendments will significantly 
    interfere with the operations of ECNs. Moreover, the Commission 
    believes that as adopted, particularly with the addition of the ECN 
    display alternative, ECNs will continue to be able to provide 
    services to institutional investors of similar value to those they 
    provide today. The Commission also believes that the benefits of the 
    amendments, including increased market maker competition and 
    decreased fragmentation, will flow to all investors, institutional 
    as well as retail. See 21(a) Report.
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        The ECN amendment, as proposed, sought to minimize the potential 
    impact on market makers, specialists, and ECNs by requiring a market 
    maker or specialist to display in its public quote only the size 
    required by its exchange or association, rather than the actual size of 
    any order the firm places into an ECN. This part of the amendment is 
    being adopted as proposed for orders for the accounts of market makers 
    and specialists. However, for customers' orders entered into an ECN by 
    a market maker or specialist that are smaller than the quote size 
    required by the market maker's or specialist's exchange or association, 
    the Commission has amended the rule to allow market makers and 
    specialists to display only the customer's order size.245 The 
    requirement to display no more than the required size for market 
    makers' and specialists' own orders should reduce any disincentives to 
    use ECNs that could otherwise result from the ECN amendment, and 
    responds to the concern that disclosure of the full size of the order 
    in the market maker's or specialist's quote could impede its ability to 
    execute the order.246 Moreover, permitting the display of customer 
    orders of less than the minimum quote size should reduce the potential 
    burden on a specialist or market maker of having to publish a public 
    quote for more than the customer's order size when the customer's order 
    is for less than the minimum quotation size required by the 
    specialist's or market maker's exchange or association.
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        \245\ As discussed supra in footnote 144, SROs may wish to allow 
    market makers or specialists to quote in sizes smaller than the 
    minimum quotation increment when the quote represents a customer 
    limit order.
        \246\ The Commission received several comments that support this 
    aspect of the proposal. See, e.g., Lehman Letter; and Smith Barney 
    Letter. These commenters believe that display of full size in a 
    market maker's quote could impair the quality of an execution 
    obtained for a customer because the display in the public quotation 
    system is broader than the display in the ECN.
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        Market makers and specialists who avail themselves of the ECN 
    display alternative will be required to furnish to the public quotation 
    system the full size of the best buy and sell orders they enter into 
    the ECN. The Commission believes that the display of full size by the 
    ECN will help inform the public market of the true trading interest 
    entered by specialists and market makers, without impeding the 
    execution of these orders by disclosing the identity of the specialist 
    or market maker placing the order. Under the ECN display alternative, 
    the market maker or specialist will be able to continue to represent 
    the order on an anonymous basis both in the ECN and in the public
    
    [[Page 48311]]
    
    quote, substantially reducing any negative impact of the amendment on 
    ECN users.
        Where the order entered by the market maker or specialist is on 
    behalf of a customer, the display of full size under the ECN display 
    alternative is consistent with the requirement under the Display Rule, 
    which requires market makers and specialists to display the full size 
    of their customer limit orders. Therefore, the full size of customer 
    limit orders will be displayed whether the specialist or market maker 
    displays the order itself or enters the order into an ECN complying 
    with the ECN display alternative.247
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        \247\ The Commission notes that the exceptions under the Display 
    Rule for limit orders of block size and for limit orders that a 
    customer has asked not to be displayed will not apply to customer 
    limit orders entered by a market maker or specialist into an ECN. If 
    entered into an ECN, these orders must either be reflected in the 
    market maker's or specialist's own quote or displayed via the ECN 
    alternative. As discussed previously, the Commission believes that a 
    customer should have discretion to permit a market maker or 
    specialist to handle its limit order without public display, and 
    large limit orders should not be required to be displayed unless the 
    customer makes a request. However, the Commission does not believe 
    these orders should be withheld from public display if they are 
    being displayed in an ECN. The Commission believes that if these 
    orders, when handled by market makers or specialists, are displayed 
    widely through an ECN to the ECN's subscribers, then they should 
    also be displayed to the public generally. Moreover, limiting 
    display to only one market would be inconsistent with Congress's 
    goal for a NMS in which trading interest in disparate markets would 
    be consolidated and publicly disseminated.
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        The Commission believes that the concerns expressed by some 
    commenters about a potential loss of liquidity resulting from the 
    proposal have been substantially addressed by the alternative adopted 
    today. Because this alternative preserves the anonymity some ECNs 
    afford to the users of their systems, the proposal maintains incentives 
    for subscribers to continue participating in such systems. In fact, a 
    market maker or specialist, who presumably wants its orders executed at 
    prices it is widely displaying through the ECN, should benefit from 
    attracting greater trading interest by having the prices of its orders 
    displayed to the entire market.
        Finally, under the proposal, priced orders of institutions and 
    other non-market makers entered directly into ECNs would not be 
    required to be reflected in the public quote. Some commenters 
    criticized the proposal because it did not require the inclusion of all 
    better priced orders in the public quote. This result, however, is 
    consistent with existing quotation principles. Institutional bids, 
    offers, and orders handled independent of a market maker historically 
    have been outside the scope of the Quote Rule, and the Commission's 
    proposal was not intended to expand the scope of the Quote Rule in this 
    respect.248 Furthermore, the Commission believes that, although 
    institutional investors' direct orders in ECNs provide valuable 
    liquidity, the amendments will substantially strengthen the public 
    quotation system by publishing orders entered by market makers and 
    specialists without creating new requirements for orders not controlled 
    by market makers or specialists.249 Nevertheless, the Commission 
    will continue to monitor closely issues involving the display of prices 
    published by institutions in light of the Quote Rule and its 
    objectives.
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        \248\ The fact that ECNs will continue to contain institutional 
    investors' orders priced better than the public quotes will provide 
    another incentive for market participants to continue to participate 
    in those systems.
        \249\ The Commission notes that, as described in the 
    Commission's 21(a) Report, institutions trading with dealers or 
    others accounted for less than 20% of trades in one ECN (Instinet). 
    See Appendix to the 21(a) Report at A-11.
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    iii. Technology and Innovation
        Some commenters predict that the proposal may have a chilling 
    effect on technological innovation, primarily because the proposal 
    applies only to ECNs and not to all available communication 
    technologies that may be used for disseminating interest to buy and 
    sell a particular number of shares at a specified price.250 Some 
    commenters argue that the proposal is anti-competitive and otherwise 
    antithetical to the purposes of the Exchange Act because it will deter 
    future technological advances in automated trading environments by 
    favoring less automated trading methods (e.g., telephone 
    transactions).251
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        \250\ See DOJ Letter; SIA Letter; Instinet Letter; Schwab 
    Letter; STI Capital Letter; Sutro Letter.
        \251\ See, e.g., Instinet letter.
    ---------------------------------------------------------------------------
    
        The Commission is cognizant of the importance of the continued 
    development of innovative trading systems and services. New 
    technologies have expanded the ways in which investors' buying and 
    selling interest can be brought together and have fostered additional 
    competition in the securities markets. The Commission believes that 
    this competition should be encouraged. Nonetheless, to promote 
    competition, efficiency, and transparency in the securities markets, 
    and insure the integrity of publicly available information, the 
    Commission believes it is appropriate to set minimum standards that 
    apply to the entry of the functional equivalent of quotations by market 
    makers and specialists in trading systems.252 Indeed, consistent 
    with the Commission's experience with previous NMS initiatives,253 
    these minimum standards will permit and foster the development of new 
    technologies that improve the public availability of trading 
    information, while discouraging practices that are inconsistent with 
    the purposes of the 1975 Amendments. The Commission believes that the 
    Quote Rule as amended will not unduly diminish the beneficial services 
    provided by existing ECNs, nor will it stifle the development of new 
    trading technologies or new ECNs.
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        \252\ The Commission notes that the focus of the proposal is not 
    on any particular system or systems but, rather, on the types of 
    orders that are the fundamental equivalent of quotations, and the 
    fragmented market that results when the prices of these orders are 
    not integrated into publicly available quotations.
        \253\ See Simon and Colby, supra note 58. The Commission also 
    notes the growth in technologies over the past twenty years, 
    including broker-dealer and exchange automated execution systems, 
    that clearly rely on, and were facilitated by, successful operation 
    of NMS and joint industry initiatives such as the Quote Rule, CTA, 
    and the ITS Plan.
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    iv. Alternative Approaches
        In the Proposing Release, the Commission suggested alternatives to 
    the proposal, and solicited comment on these alternatives. The 
    Commission also invited commenters to suggest possible alternatives. 
    The Commission specifically asked whether it should require ECNs to 
    furnish prices to the applicable exchange or association for public 
    dissemination and to provide some access, such as a linkage, to the 
    prices in the ECN.254 A number of commenters supported this 
    approach.
    ---------------------------------------------------------------------------
    
        \254\ See Proposing Release and e.g., NASD Letter.
    ---------------------------------------------------------------------------
    
        The NASD recommended, as an alternative to the proposed rule, that 
    the better ECN price be reflected in the inside market, rather than in 
    individual quotes. Under the alternative described by the NASD, an ECN 
    would report its best market maker or specialist inside prices to the 
    SRO that is the primary market in the security. The NASD also 
    recognizes that more assured access to orders in the ECNs would be 
    necessary under this option.255 Similarly, one commenter agreed 
    that the inside market available to the public should reflect the best 
    bid and offer prices whether in a market maker's quote or in a market 
    maker's order on an ECN. The Commenter suggested that this could be 
    accomplished by requiring quotations in ECNs to be made part of the 
    public quotation and by separately identifying the ECN into which the 
    order is entered rather than the market maker that
    
    [[Page 48312]]
    
    placed the order.256 Finally, certain commenters state that 
    expanding ITS to include orders entered into ECNs would be a better 
    alternative to the proposal.257
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        \255\ See NASD Letter.
        \256\ Morgan Stanley Letter. See also, PaineWebber Letter 
    (recommending that priced orders in ECNs be included in the NBBO).
        \257\ See, e.g., STAIC Letter; ICI Letter.
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        The Commission believes that the ECN display alternative adopted 
    today is consistent with these suggested alternatives and will minimize 
    many of the asserted negative effects of the rule. The adopted 
    provision provides an alternative to an ECN that disseminates 
    specialists' and market makers' best prices to the public quotation 
    system. Thus, the amendment enables a market maker or specialist to 
    comply with the Quote Rule either directly by sending to its exchange 
    or association the prices of orders it places into ECNs that improve 
    the market maker's or specialist's public quote, or indirectly by using 
    an ECN that transmits the best prices entered therein by market makers 
    and specialists for publication in the public quotation system.
        The ECN display alternative is consistent with the alternative 
    recommended by the NASD because the adopted provision enables the 
    specialists' or market makers' best prices in ECNs to be consolidated 
    with the exchange's or association's best prices for dissemination 
    within the consolidated quotes. In addition, the adopted amendment 
    requires the ECNs to provide an equivalent means of access to those 
    best prices.
        The Commission recognizes that this alternative may reduce the 
    content of information that is publicly available because under the ECN 
    display alternative, the identity of the market maker or specialist 
    that entered the better priced order in the ECN will be 
    withheld.258 The Commission believes this result is justified 
    because the inside prices and full sizes of orders entered by market 
    makers and specialists will be in the public quotation system to inform 
    the entire market of these prices and ECNs will provide equivalent 
    access to those prices. Moreover, the Commission believes the benefits 
    of facilitating the use of ECNs, by permitting the continued anonymity 
    of market makers and specialists, more than offset the reduced 
    information available on the identity of a particular market maker or 
    specialist.
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        \258\ The Commission also notes that under the alternative, a 
    specialist or market maker that puts an order into an ECN that is 
    priced better than that specialist's or market maker's public quote, 
    but is not the best priced quote from any specialist or market maker 
    in the ECN, will not have its better priced order reflected in the 
    public quote. The prices will be displayed, however, if the better 
    price in the ECN is executed or withdrawn and the lower specialist's 
    or market maker's priced quote then becomes the best priced quote.
    ---------------------------------------------------------------------------
    
        As an alternative to the ECN amendment, certain commenters 
    suggested that enforcement of best execution principles would be 
    sufficient to protect public investors.259 As discussed in more 
    detail in section III.C.2., the Commission does not believe this is a 
    practical alternative because ECNs do not provide broker-dealers with 
    automated links and thus may not be reasonably available for the 
    handling of retail orders on an automated basis. Furthermore, investors 
    and their brokers cannot efficiently ascertain if they have received 
    the best prices for their orders if publicly available prices do not 
    reflect the best prices at which specialists and market makers are 
    willing to trade. Under these circumstances, providing customers the 
    best executions available can be achieved most effectively by ensuring 
    that the consolidated quotes systematically include the better prices 
    that market makers and specialists have entered into an ECN.
    ---------------------------------------------------------------------------
    
        \259\ See, e.g., Instinet Letter.
    ---------------------------------------------------------------------------
    
        Finally, certain commenters argue that, as an alternative to 
    adopting the ECN proposal, the Commission should defer any action until 
    further study is completed on the use of ECNs because the Proposing 
    Release provides insufficient data regarding whether customers 
    currently get the best available price, or market maker and specialist 
    use of ECNs results in harm to customers.260 The Commission has 
    determined to go forward with the amendments now because of compelling 
    concerns presented by two-tiered markets. Many of the commenters to the 
    proposed rules also recognize these concerns. Furthermore, as part of 
    its recently concluded Nasdaq investigation, the Commission has 
    conducted an extensive analysis since the proposals were published that 
    supports the Commission's proposal and clearly evidences the existence 
    of a ``two-tiered'' market in which customer orders are executed at 
    publicly available prices inferior to prices contemporaneously 
    available in existing ECNs.261 Moreover, Commission data shows 
    that the pricing opportunities available in at least two ECNs (Instinet 
    and SelectNet) are not limited to block trades, but extend to smaller 
    orders executed in the system.262 The Commission believes, 
    therefore, that further study is not necessary to address a structural 
    disparity in market information that disadvantages investors who lack 
    access to ECNs.
    ---------------------------------------------------------------------------
    
        \260\ See, e.g., Instinet Letter, asserting that the Commission 
    should obtain and study data on this matter and that, absent such 
    data, adoption of the proposed amendment is unwarranted.
        \261\ As discussed previously, the Commission believes the data 
    it has reviewed supports the need for prompt adoption of the ECN 
    amendment to the Quote Rule. See supra notes 222 and 223, and 
    accompanying text. Given the strong evidence that investors would 
    benefit from public dissemination of the hidden prices that are 
    broadly disseminated to subscribers in these systems, the Commission 
    believes that it is appropriate to adopt the amendments to the Quote 
    Rule.
        \262\ As noted above, the Appendix to the 21(a) Report states 
    that average trade size for Nasdaq NMS securities on Instinet was 
    approximately 1,600 shares for the period studied, while the average 
    trade size generally in the securities was approximately 1,900 
    shares. See Appendix to the 21(a) Report at A-8.
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    c. Operation of the Rule Amendment
    i. Definition of the Term ``Electronic Communications Network''
        The proposed amendment did not specifically define the term 
    ``electronic communications network.'' The Commission did state, 
    however, that priced orders that market makers and specialists enter 
    into certain ECNs are bids and offers for the purposes of the Quote 
    Rule.263 The proposal applied to systems that widely disseminate 
    priced orders to third parties and permit such orders to be executed 
    against in whole or in part. The Commission further explained that the 
    term ``electronic communications network'' was intended to include 
    continuous auction trading systems, but was not intended to include 
    crossing systems or broker-dealer internal order routing systems.
    ---------------------------------------------------------------------------
    
        \263\ As a result, relevant provisions of the Quote Rule, such 
    as the obligation on exchanges and associations to disseminate 
    quotes, and the firmness requirement placed on a market maker or 
    specialist who furnishes the quotes, become operative with respect 
    to a security when a market maker or specialist enters an order for 
    that security into an ECN. See section III.B.2.c.v., infra.
    ---------------------------------------------------------------------------
    
        Several commenters suggested the need for a definition of the term 
    ``electronic communications network.'' 264 The Commission agrees 
    that it is appropriate to define the term in the Quote Rule and has 
    decided to adopt a definition that reflects the fundamental 
    characteristics of an ECN as discussed in the Proposing Release.
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        \264\ See Goldman Sachs Letter; Instinet Letter; Schwab Letter. 
    In addition, one commenter argues that ECNs should include SRO stock 
    crossing systems and all non-market-maker broker-dealers. NYSE 
    Letter.
    ---------------------------------------------------------------------------
    
        As discussed earlier, the objective of the ECN amendment is to 
    incorporate within the consolidated public quote firm prices quoted by 
    market makers and specialists in securities markets that widely 
    disseminate those prices but are not registered as exchanges or 
    associations and thus are not integrated
    
    [[Page 48313]]
    
    into the NMS. Therefore, the Commission has defined the term ``ECN'' as 
    an electronic system that widely disseminates to third parties 265 
    orders entered therein by a market maker or specialist, and permits 
    such orders to be executed against in whole or in part. The definition 
    specifically excludes any system that crosses multiple orders at one or 
    more specified times at a single price set by the system and that does 
    not allow orders to be crossed or executed against directly by 
    participants outside of such times. This exclusion is consistent with 
    statements made in the Proposing Release that it was not the 
    Commission's intention to cover crossing systems because these systems 
    do not communicate to multiple market participants the prices at which 
    system subscribers are willing to trade. Rather, the excluded crossing 
    systems themselves establish an internal trading price for subscribers 
    on an episodic basis.266
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        \265\ The Commission intends the term ``third parties'' to refer 
    to subscribers to the ECN, other than the ECN and the market maker 
    or specialist that is entering its priced order into the ECN. The 
    ECN also may disseminate to others, including non-subscribers.
        \266\ The Commission notes that broker-dealers that publish 
    quotes through a vendor are already covered by the rule.
    ---------------------------------------------------------------------------
    
        The ECN definition also excludes any system operated by, or on 
    behalf of, a market maker or specialist that executes customer orders 
    primarily for its own account as principal, other than as riskless 
    principal. This exclusion is intended to ensure that, as discussed in 
    the Proposing Release, internal broker-dealer order routing systems in 
    which the market maker trades primarily with customer orders on a 
    principal basis are not ECNs within the scope of the amendment. The 
    exclusion would not except from the ECN definition systems that involve 
    multiple market makers or specialists competing as principal in a 
    security or that cross multiple market maker and customer orders.
        Furthermore, the Commission believes the definition should be read 
    broadly to include systems that match orders internally and deliver the 
    matched order to some other market for execution. Thus, the term 
    ``permits such orders to be executed against'' should not be read to 
    exclude systems where a narrow technical reading of ``executed'' is the 
    only reason that the system would not fall within the ECN definition. 
    For example, if a system puts buy orders and sell orders together for 
    execution, completes all necessary elements of the trade, and then 
    sends the matched pair to an exchange or association merely to print 
    the terms of the trade on the Consolidated Tape, the system would be an 
    ECN.
    ii. ``Priced Orders'' in ECNs
        Under this definition, the Commission intends to include in the 
    public quotation system firm prices for securities entered by market 
    makers or specialists, whether such firm prices are labeled as 
    ``quotes'' or ``orders.'' The Commission believes that priced orders 
    entered by market makers or specialists into ECNs where the orders are 
    widely disseminated and executable are the functional equivalent of 
    market maker or specialist quotations, and like quotations, play a key 
    role in the price discovery process. The Commission thus believes that 
    these ``quotation-equivalents'' should be made part of the public 
    quote.
        Although some commenters argue that priced orders entered into ECNs 
    are more closely parallel to prices communicated over the telephone to 
    other market makers than to market quotes, the Commission recognizes a 
    fundamental distinction between limited communication of price in 
    bilateral telephone negotiations and broad exposure of firm prices to 
    multiple participants in a market.267 Accordingly, prices 
    communicated by telephone are excluded because these prices generally 
    are not widely disseminated to other parties for execution. The rule 
    also would not cover indications of interest that do not constitute 
    firm prices.
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        \267\ The Commission recognizes that market makers and 
    specialists may be willing to trade with certain customers at 
    better, negotiated prices, such as when market makers negotiate with 
    customers over the telephone. In contrast, however, the prices 
    quoted by market makers and specialists in ECNs are widely 
    disseminated to market participants. In adopting the ECN amendment, 
    the Commission is reaffirming the NMS principle that prices 
    advertised in one market must be integrated into the national 
    market--that is, the consolidated public quote.
    ---------------------------------------------------------------------------
    
        In this connection, the Commission intended the term ``priced 
    order,'' which is deemed under the ECN amendment to be a bid or offer, 
    to encompass commitments to buy or sell a security at a particular 
    price for a particular number of shares. The Commission also does not 
    intend the term ``priced orders'' to include interest to buy or sell a 
    security where price or the number of shares is not specified to system 
    subscribers, unless the price or size is otherwise understood as part 
    of the system's operation.268 The ECN amendment would, however, 
    include priced orders entered into an ECN by a market maker or 
    specialist that are visible only to some system subscribers if these 
    orders can be executed against in the ECN. The ECN amendment is 
    intended to require the public display of priced orders entered into 
    ECNs by market makers and specialists where these priced orders are 
    similar to quotations. Accordingly, the Commission does not intend the 
    ECN amendment to apply to a priced order that is entered into an ECN by 
    a market maker or specialist merely in order to execute against an 
    existing order visible in the ECN, and not entered to elicit other 
    buying or selling interest. If, however, the order entered by the 
    market maker or specialist does not in fact execute immediately in full 
    against an existing order but rather is itself disseminated as an open 
    order in the ECN, the market maker or specialist must comply with the 
    requirements of the ECN amendment with respect to the order.
    ---------------------------------------------------------------------------
    
        \268\ The definition of an ECN specifically excludes any system 
    that crosses multiple orders at one or more specified times at a 
    single price set by the ECN (by algorithm or by any derivative 
    pricing mechanism) and does not allow orders to be crossed or 
    executed against directly by subscribers outside of such times. See 
    11Ac1-1(a)(8).
    ---------------------------------------------------------------------------
    
        In order to ensure that customers consistently receive the benefit 
    of better prices entered into ECNs, a market maker or specialist 
    entering an all-or-none or minimum size order for its own account into 
    an ECN would be required to include this price in its public quote, or 
    disseminate the price via the ECN display alternative, and thereby 
    publicly display the order for the full number of shares for execution 
    in whole or in part. Although the execution of an all-or-none order is 
    typically conditioned on execution of the entire size of the order, the 
    Commission believes that allowing market makers to avoid public display 
    of an unconditional quote when using this type of order could seriously 
    undermine the purposes of the rule.269 The rule will permit, 
    however, a market maker or specialist to enter an all-or-none customer 
    order into an ECN without requiring public display of the quote for 
    that order where the customer specifically requests that the order be 
    executed on an all-or-none basis. This latter provision accommodates 
    the desire of some customers to trade only at a specific size 
    associated with a specific price.
    ---------------------------------------------------------------------------
    
        \269\ All-or-none and minimum size orders are rarely used by 
    market makers and specialists in ECNs and are prohibited from being 
    included in the public quotes by the registered exchanges and 
    Nasdaq.
    ---------------------------------------------------------------------------
    
    iii. ECN Display Alternative
        Pursuant to the amendment as adopted, a priced order entered by a 
    market maker or specialist into an ECN that widely disseminates the 
    order is deemed to be a bid or offer for the
    
    [[Page 48314]]
    
    purposes of the market maker's or specialist's quotation reporting 
    obligations under the Quote Rule. As a result, specialists and market 
    makers are required to include such orders in the bids and offers they 
    communicate to their exchange or association for inclusion in the 
    published quotations made available by the exchange or 
    association.270
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        \270\ An OTC market maker that places priced orders for 
    execution into any ECN will in effect be making an election to 
    communicate quotations to its association bids, offers and quotation 
    sizes in the security. See 11Ac1-1(a)(25)(ii)(B).
    ---------------------------------------------------------------------------
    
        As discussed above, in response to the concerns of some commenters, 
    the adopted amendment includes an alternative to the specialist or 
    market maker itself revising its public quotation to reflect its better 
    priced order entered in an ECN. This alternative allows the ECN to act 
    as an intermediary in communicating to the public quotation system the 
    best price and size of orders for each security that have been entered 
    into the ECN by a specialist or market maker. To communicate the 
    quotations publicly, the ECN must submit the best price entered by a 
    specialist or market maker to an exchange or association, or to a 
    securities information processor acting on behalf of one or more 
    exchanges or associations.
        The alternative reduces the impact of the amendment on specialists 
    and market makers because they have a choice regarding how to comply 
    with their obligation. This alternative also reduces the impact of the 
    amendment on ECNs by offering these systems an opportunity to provide 
    additional services to their subscribers, and creating an opportunity 
    to generate additional order flow from non-subscribers. At the same 
    time, more accurate prices are provided through public quotation 
    systems than are currently available.
        Under this alternative, consistent with the goals of the initial 
    proposal, the ECN must comply with two conditions. First, the ECN must 
    provide the best prices and sizes that market makers or specialists 
    have entered in the ECN to the public quotation system for inclusion in 
    the consolidated quotation. The market maker or specialist responsible 
    for the price does not have to be identified.271 The ECN must, 
    however, at a minimum, publicly identify itself as the originating 
    system for these prices. Accordingly, if a market maker puts an order 
    that improves the NBBO into an ECN and the ECN disseminates that price 
    to the public quotation system, the disseminated price must either be 
    identified as originating from the market maker or from the ECN.
    ---------------------------------------------------------------------------
    
        \271\ An ECN that does not offer the option of anonymity to its 
    subscribers could choose to include the identity of the market maker 
    or specialist with the prices furnished to the SRO for public 
    dissemination. As discussed below, the ECN also must provide access 
    to these prices.
    ---------------------------------------------------------------------------
    
        Second, the ECN must provide non-subscriber brokers and dealers 
    with a means of access to those prices entered in the ECN by market 
    makers and specialists. This access must be equivalent to the access 
    that would have been available for the relevant security if these 
    prices had been published in the market makers' or specialists' 
    quotation.272 The extent and form of this access will depend on 
    the form(s) of access available in the market to which the ECN supplies 
    the bids and offers for public dissemination.273
    ---------------------------------------------------------------------------
    
        \272\ For access to be ``equivalent'', the ECN must enable non-
    subscribing broker-dealers to execute against the ECN's published 
    best price to the same extent as would be possible had that best 
    price been reflected in the public quote of a specialist or market 
    maker. The ECN, however, may impose charges for access to its 
    system, similar to the communications and systems charges imposed by 
    various markets, if not structured to discourage access by non-
    subscriber broker-dealers.
        \273\ The extent and form of the access will not necessarily be 
    the same as the access available in the market to which the 
    specialist or market maker would otherwise supply its bid and 
    offers.
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        For example, market makers in Nasdaq NMS and SmallCap securities 
    typically can be reached through the telephone and through the NASD's 
    Small Order Execution System. Therefore, an ECN that chooses, pursuant 
    to the alternative, to act as an intermediary for its market maker and 
    specialist subscribers for Nasdaq NMS and Smallcap securities would 
    have to be prepared to receive and execute telephone orders from 
    broker-dealers against those market makers' and specialists' orders 
    entered in the ECN. The ECN will have to execute these orders promptly 
    at the prices the market makers and specialists have entered into the 
    ECN. In addition, because a market maker with the best price in a 
    Nasdaq NMS security is subject to SOES executions, this equivalent 
    access condition would require the ECN to provide broker-dealers who 
    use SOES with equivalent automated access to the best priced market 
    maker orders in the ECN. This could be accomplished either through an 
    electronic linkage to SOES or by other means agreed upon with the NASD. 
    For example, the ECN could supply the NASD with an identifier for the 
    market maker who entered the best priced order, which the NASD could 
    use in assigning SOES executions to that market maker.274
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        \274\ As discussed supra section II., the NASD has proposed a 
    new facility, NAqcess, which, as part of its proposed services, 
    would widely disseminate priced orders for execution in whole or in 
    part. Supra note 45. As proposed, Naqcess would publish its best 
    prices in the Nasdaq quotation system stream and would be accessible 
    to all NASD members for order entry and execution against those 
    orders. Thus, NAqcess, as proposed, would appear to make prices 
    entered by market makers into NAqcess available, and provide 
    equivalent access under the alternative. Therefore, a market maker 
    that entered its best priced order into NAqcess would comply with 
    the requirements of the ECN amendment without reflecting the order 
    in the market maker's own quote. Moreover, a market maker that 
    entered an order into another ECN at a price better than its quote 
    could satisfy the requirements of the ECN amendment by entering an 
    order reflecting this price into NAqcess, even if the other ECN does 
    not directly provide the price to the public quotation system, 
    because this use of NAqcess, as proposed, would meet the 
    requirements of the amendment. Similarly, an ECN availing itself of 
    the ECN display alternative could provide prices directly to 
    NAqcess. The ECN and the NASD also could develop mechanisms to 
    ensure public anonymity of market makers that use ECNs, while 
    providing to the NASD the identity of the market makers that are at 
    the inside quote solely for the purpose of direct order-routing 
    between NAqcess and the market maker.
    ---------------------------------------------------------------------------
    
        Similarly, in exchange-listed securities, the degree of access that 
    the ECN must offer would depend on the current access that the market 
    receiving the information from the ECN offers to broker-dealers in the 
    relevant type of security. If the ECN communicates prices for exchange-
    listed securities to an exchange, the specialist or market maker orders 
    in the ECN must be accessible to broker-dealers in the same manner as 
    quotes on that exchange. This access would include any automated 
    execution features offered to broker-dealers by the exchange. The ECN 
    must provide to the exchange, or to the exchange specialist in each 
    security, access to the market maker or specialist orders in the ECN. 
    Such access must provide broker-dealers with the ability to enter and 
    obtain executions for their orders at least as promptly as that 
    exchange offers to its own members through its order-routing and 
    execution systems. Because the ITS Plan applies to exchange-trading of 
    listed securities, orders received from other markets through ITS must 
    have the same ability to trade with ECN orders whose prices are 
    displayed through the exchange as they have with the exchange's own 
    quotations. For instance, if the exchange specialist typically receives 
    incoming ITS commitments and executes them manually, the ECN must at a 
    minimum enable the incoming ITS commitment to be manually entered into 
    the ECN for execution.
        If the ECN instead provides orders in exchange-listed securities to 
    the NASD for inclusion in the public quotation system, the orders must 
    be as accessible to broker-dealers as the quotes published by third 
    market makers in
    
    [[Page 48315]]
    
    exchange-listed securities. At a minimum, these prices must be included 
    as part of the third market quotation display and identified as 
    originating from a named market maker or from a named ECN. For non-Rule 
    19c-3 securities, broker-dealers must be able to contact the ECN by 
    telephone and have an order promptly entered into the ECN for 
    execution. For Rule 19c-3 securities, the ECN also must be accessible 
    through the ITS/CAES linkage, operated by the NASD, in the same manner 
    as other third market maker quotes in those securities.275
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        \275\ As discussed below concerning expansion of the ITS/CAES 
    linkage, currently non-Rule 19c-3 securities may not be traded via 
    the ITS/CAES linkage.
    ---------------------------------------------------------------------------
    
        Under the ECN display alternative, the ECN must furnish to an 
    exchange or association the full size associated with the best priced 
    orders placed in the ECN by market makers and specialists to buy and to 
    sell a security. This full size requirement under the alternative is 
    intended to give the public information about the depth of the market 
    at the ECN prices, while maintaining the anonymity of market makers and 
    specialists. For example, if an ECN is furnishing quotation information 
    to Nasdaq under this alternative, and a market maker enters a 4,000-
    share order into the ECN at a price that is better than other market 
    maker or specialist prices for that security in the ECN, the ECN will 
    be required to provide Nasdaq that price and size of 4,000 shares as a 
    quotation for public dissemination. If 2,500 shares of this order is 
    executed, the ECN must display the remaining 1,500 shares. If two 
    market makers enter 4,000-share orders for a security at the same 
    price, which is the best price in the ECN for that security, the ECN is 
    required to show all 8,000 shares publicly. In contrast, if a market 
    maker enters a 100-share order for a Nasdaq security at the best price 
    in the ECN for that security, the alternative requires the ECN to 
    furnish the price for only 100 shares, even though NASD rules require 
    Nasdaq market makers to display no less than 1000, 500, or 200 shares 
    in Nasdaq, depending on the characteristics of that security.
        The Commission recognizes that the means of providing equivalent 
    access will vary for different markets, and that ECNs operating under 
    the ECN display alternative that currently do not provide access to 
    their systems to non-subscribers will have to develop methods to 
    provide this access. Meeting this requirement may be achieved in a 
    variety of ways, including a linkage between ECNs and one or more of 
    the SROs. The Commission believes an SRO that accepts the prices 
    provided by an ECN for publication should be authorized to impose 
    reasonable rules related to the public dissemination of those prices 
    upon market makers and specialists who avail themselves of this 
    alternative. The rules an SRO imposes in this regard, however, may not 
    establish standards for the dissemination of these prices that are more 
    burdensome for market makers and specialists using ECNs than the SRO 
    rules that apply to quotations delivered directly to the SRO by 
    specialists and market makers.
        The Commission looks forward to working closely with all market 
    participants to effect the necessary market developments to ensure that 
    this alternative method of compliance with the Quote Rule is made 
    possible. In order to ensure prompt implementation of the necessary 
    changes before the effective date of the rule amendments, the 
    Commission requests each SRO, individually or jointly as signatories to 
    the CQS Plan, to notify the Commission in writing by October 28, 1996 
    regarding its willingness and its plan to afford ECNs the opportunity 
    to communicate, for inclusion in the public quotation system, the 
    prices of market makers and specialists.
        In order to implement the changes to the Quote Rule under new 
    subsection (c)(5), the prices sent to an ECN by market makers and 
    specialists will have to be displayed in the public quotations 
    disseminated by SROs, and order routing or access linkages will have to 
    be in place. After hearing from the SROs, the Commission will determine 
    whether it will be necessary to use its authority under Section 
    11A(a)(3)(B) of the Exchange Act to require the SROs to act jointly to 
    provide means to accomplish these objectives.
    iv. Minimum Price Variations
        In the Proposing Release the Commission recognized that there may 
    be different minimum price variations in any given security between the 
    SROs providing a market for the security and ECNs through which the 
    security is also traded. Currently most exchange-listed securities tend 
    to be quoted and traded with a minimum price variation of \1/8\ point 
    or \1/16\ point.276 Nasdaq securities can be publicly reported in 
    variations as low as \1/64\, and can be quoted in minimum variations as 
    low as \1/32\, depending on the price at which the security 
    trades.277 Some ECNs allow priced orders in variations as low as 
    \1/256\; other systems provide for orders priced in decimals as small 
    as one cent.
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        \276\ NYSE Rule 62 provides that bids or offers in stocks 
    selling above one dollar per share may not be made at a variation of 
    less than one-eighth of a dollar or twelve and a half cents; Amex 
    Rule 127 allows for one-sixteenth spreads for stocks priced under 
    ten dollars, and one-eighth spreads for stocks priced ten dollars 
    and over.
        \277\ The NASD does not have a minimum variation policy for 
    Nasdaq stocks. Nasdaq, however, is designed to process quotes and 
    trades in particular minimum variations.
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        Most commenters did not address the issue of ECN minimum price 
    variations. Some commenters that did address the issue, however, 
    recommended that the ECN quote be rounded for public dissemination 
    either downward from or upward to better prices in increments of \1/16\ 
    or smaller.278 Other commenters recommended rounding in 
    decimals,279 while still others strongly opposed the use of 
    decimals.280 One commenter asserted that non-standard increments 
    (i.e., increments not approved by the primary market for the relevant 
    security) should be prohibited in non-primary markets.281 To 
    address situations where the priced order in an ECN is at a non-
    standard increment, the Commission has determined that it is 
    appropriate to interpret the ECN amendment to allow market makers and 
    specialists to comply with the amendment (either individually or 
    through the ECN) by rounding up or down to the nearest fraction 
    accepted by the market disseminating the quote provided by the 
    ECN.282 The Commission believes, however, that rounding is 
    appropriate only if the rounded public quotes are accompanied by an 
    identifier that marks the quote as rounded.283 Market makers, 
    specialists, and ECNs will be permitted to round the prices of ECN buy 
    orders
    
    [[Page 48316]]
    
    down to the nearest quote increment, and round the prices of ECN sell 
    orders up to the nearest increment. For example, under this 
    interpretation, if a market maker or specialist enters a priced buy 
    order into an ECN at 10\5/16\ and the market receiving the price from 
    the ECN for dissemination has a minimum quote increment of \1/8\, a bid 
    of 10\1/4\ will be displayed in the public market and identified as a 
    rounded price. This result reflects an SRO rule that prohibits 
    dissemination of quotes in \1/16\ variations. If the market maker or 
    specialist already is bidding publicly at 10\1/4\ when it enters the 
    10\5/16\ buy order in an ECN, the market maker or specialist publishing 
    a quote must reflect the ECN order by identifying its 10\1/4\ bid as 
    rounded.
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        \278\ See, e.g., NASD Letter; Lehman Letter; Instinet Letter.
        \279\ See, e.g., Letter from Leslie M. Marx, Assistant Professor 
    of Economics and Management, and Eugene Kandel, William E. Simon 
    Graduate School of Business Administration, University of Rochester, 
    to Commissioner Steven Wallman, SEC, dated November 27, 1995 (``Marx 
    and Kandel Letter''), concluding that the markets should move toward 
    decimal pricing.
        \280\ See CHX Letter.
        \281\ See Madoff Letter.
        \282\ The Commission believes this alternative is preferable to 
    imposing particular trading increments on the markets. At the same 
    time, however, this alternative will provide the markets with an 
    incentive to voluntarily move towards finer trading increments.
        \283\ In order to facilitate compliance with the rule, it will 
    be necessary for SROs to provide a means for rounded prices to 
    include a ``rounded'' identifier that makes clear that a better 
    price is available in the ECN. The Commission notes that SROs, and 
    the public quotation system, may not currently have such a field 
    available for identifying quotations as rounded. The Commission, 
    therefore, requests that the SROs work jointly to modify the public 
    quotation system to ensure that specialists, market makers, and ECNs 
    that are disseminating rounded prices have the ability to 
    distinguish those rounded quotes.
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        In addition, market makers and specialists entering orders into 
    ECNs that are reflected at rounded prices in the public quote will be 
    expected to give their customers an execution at the superior non-
    rounded price. Thus, the market maker or specialist quoting a rounded 
    price of 10\1/4\ to reflect a 10\5/16\ buy order must give a customer 
    sell order an execution at 10\5/16\ up to the published size. 
    Similarly, an ECN providing market maker or specialist prices pursuant 
    to the rounding alternative must execute an incoming order at the non-
    rounded price. The Commission recognizes that it may not be feasible 
    for market makers or specialists that have not entered the rounded 
    order into an ECN to determine, in an efficient manner, the actual 
    price of the better order in the ECN. This may particularly be true 
    with respect to market makers or specialists operating automated 
    execution systems. The Commission believes that it is appropriate in 
    such instances for such market makers and specialists that did not 
    enter the rounded order to execute orders at the displayed rounded 
    price.284
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        \284\ See also, section III.C.2. for a discussion of best 
    execution, infra.
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        The Commission recognizes that this interpretation will allow 
    prices in ECNs that are denominated in non-standard quotation 
    increments not to be fully displayed, but believes this interpretation 
    is appropriate to accommodate ECN prices in the existing public 
    quotation system without imposing uniform trading increments.285 
    The rounding identifier will inform investors that a better price is 
    behind the rounded quote. Thus, even though the actual price cannot be 
    readily displayed, investors will be aware of, and will be able to 
    obtain, the better price in the ECN or from the market maker or 
    specialist.
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        \285\ If primary markets in the future allow narrower quotation 
    increments, these ECN prices between the existing quotation 
    increments could be more accurately displayed in the public quote.
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    v. Effect on the Voluntary Aspect of the Quote Rule
        If an OTC market maker uses an ECN that does not rely on the 
    alternative of communicating that market maker's best prices to the 
    public quotation system, then the market maker must publish in its own 
    quote that better priced order entered into the ECN. Once a market 
    maker publishes a quote through its association to reflect a priced 
    order it entered into an ECN, pursuant to Rule 11Ac-1(c)(5)(i)(A), it 
    will be deemed to have elected to publish quotations in that 
    security,286 and will therefore be subject to the quotation 
    provisions of the Quote Rule. Moreover, pursuant to certain existing 
    SRO rules,287 withdrawal of that quotation after the ECN order has 
    been executed or withdrawn prevents the market maker from immediately 
    reinstating quotes in that security.288 As a practical matter, 
    once electing to quote, a withdrawal then precludes the market maker 
    from continuing to enter priced orders for the security in an ECN 
    because of the SRO prohibition on re-entering quotes after withdrawal.
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        \286\ 17 CFR 240.11Ac1-1(b)(5), as amended. See also, 17 CFR 
    240.11Ac1-1(a)(25), 17 CFR 240.11Ac1-1(c)(4)(ii), and 11Ac1-
    1(c)(5)(ii), as amended, acting jointly to ensure that OTC market 
    makers publish quotations pursuant to the Quote Rule in securities 
    they trade via ECNs.
        \287\ See NASD Manual, Marketplace Rules, Rule 4600 et. seq., 
    Nasdaq Market Maker Requirements (requiring members to maintain 
    continuous two-sided quotations in the Nasdaq securities for which 
    they are registered as market makers). See also, ITS Plan, Section 
    6(A)(i)(B), Furnishing Quotations (requiring each ITS Participant to 
    furnish the current bid-asked quotation emanating from its floor or, 
    in the case of the NASD, the best bid and offer emanating from ITS/
    CAES market makers in eligible securities). Unexcused withdrawal of 
    quotations violates these NASD rules and ITS provisions.
        \288\ This will be true even if the market maker traded less 
    than 1% of the share volume in the security in the previous quarter 
    because the 1% threshold of the Quote Rule for mandatory quotes 
    would not exempt the market maker from disseminating quotes once the 
    market maker has ``elected'' to quote the security by using the ECN.
    ---------------------------------------------------------------------------
    
        The Commission solicited comment on this aspect of the ECN 
    proposal. Although most commenters were silent concerning this issue, 
    certain comments indicate confusion as to the effect on market makers 
    who currently use ECNs but who do not voluntarily quote under the 
    existing Quote Rule.289 The Commission, therefore, reiterates that 
    the combined operation of the ECN amendment and SRO rules may require a 
    market maker or specialist who enters an order into an ECN that does 
    not rely on the ECN display alternative, and publishes a quote 
    reflecting that price, to continue to publish quotes in the public 
    market regardless of the number of shares traded by the market maker or 
    specialist in the security during the previous quarter.
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        \289\ See, e.g., Madoff Letter; Instinet Letter. In its comment 
    letter, Instinet notes that some market makers that make a 
    continuous market in a security, but do not normally publish 
    quotations in that security, will now be required to disseminate 
    quotations for that security if the market maker places a priced 
    order for that security on an ECN. The Commission recognizes this 
    result, but notes the ECN display alternative of allowing such 
    market makers to continue to place orders in a security into an ECN 
    without having to directly publish quotes in that security.
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        In determining whether a market participant will be required to 
    publish quotes after entering orders in an ECN, the Commission notes 
    that, with respect to any given security, the quote rule requirements 
    only apply if the market participant falls within the definition of the 
    term ``OTC market maker'' for that security. To be an OTC market maker, 
    the participant must hold itself out as willing both to buy and sell on 
    a regular or continuous basis.290
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        \290\ Rule 11Ac1-1(a)(8), as amended.
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        The ``OTC market maker'' definition is not intended to capture 
    subscribers who enter orders into ECNs on one side of the market to 
    limit or offset their risk, such as options market makers who use ECNs 
    to hedge their positions in the securities underlying the options they 
    trade. They would not be required to publish public quotes in a 
    security simply because they had entered an order for the security into 
    an ECN, unless they regularly or continuously hold themselves out as 
    willing to buy and sell the security. An entity that holds itself out 
    via contract, marketing, or other communications with its customers, as 
    being willing both to buy and sell a specific security on a regular or 
    continuous basis would be an ``OTC market maker'' for the security. 
    This latter market maker's entry of a superior priced order into an ECN 
    for a security that itself does not publish quotes would compel the 
    market maker to publish a quote and potentially, depending on SRO 
    rules, trigger on-going quotation obligations.
    vi. Exemptive Relief
        Finally, the Commission is amending Section (d) of the Quote Rule 
    concerning exemptive relief. Under that section, the Commission 
    previously could exempt from the provisions of the Quote Rule, either 
    conditionally or on specified terms and conditions, any responsible 
    broker or dealer (which now will include a specialist or market
    
    [[Page 48317]]
    
    maker under the ECN amendment), exchange, or association if the 
    Commission determined that such an exemption was consistent with the 
    public interest, the protection of investors and the removal of 
    impediments to and perfection of an NMS. The Commission is adding a 
    provision allowing it to exempt an ECN from the definition in the rule. 
    The Commission did not solicit comment on expanding its authority to 
    grant exemptive relief in this manner. The Commission believes, 
    however, that the added exemptive authority is appropriate because it 
    provides flexibility in applying the ECN amendment.
    3. Amendments to the Quote Rule Concerning Definitions
    a. Introduction
        In the Proposing Release the Commission proposed to expand the 
    Quote Rule's existing requirements to include quotation information 
    from broker-dealers that, while internalizing order flow, hold 
    themselves out as willing to buy and sell on a regular or continuous 
    basis. This expansion of the Quote Rule would be accomplished by 
    amending the definition of OTC market maker. The Proposing Release also 
    recommended that quotation requirements be imposed on substantial 
    broker-dealers in non-Rule 19c-3 securities by amending the definition 
    of subject security, and on broker-dealers in Nasdaq SmallCap 
    securities by amending the definition of covered security.291 In 
    putting forward this proposal, the Commission noted that some dealers 
    quote on a selective basis, choosing not to display quotes for 
    securities that they actively trade because these securities are 
    subject only to the voluntary quote provisions of the Quote Rule.
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        \291\ OTC market makers and specialists are not required by the 
    Quote Rule to provide continuous two-sided quotations for any Nasdaq 
    security. As amended, an OTC market maker or specialist may make an 
    election, pursuant to paragraph (b)(5)(i) of the Quote Rule, to 
    collect, process, and make available quotations for Nasdaq NMS or 
    Nasdaq SmallCap securities. The Commission is soliciting comment on 
    a proposed amendment which would require continuous two-sided 
    quotations from OTC market makers and specialists responsible for 
    more than 1% of the aggregate transaction volume for a Nasdaq 
    security. See Companion Release.
    ---------------------------------------------------------------------------
    
        The amendments adopted by the Commission today are substantially 
    the same as those proposed.292 The Commission believes these 
    amendments will benefit investors by improving price discovery and 
    liquidity, and increasing competition between OTC market makers and 
    specialists. The Commission further believes that these amendments are 
    in keeping with Congress's directive that the Commission use its 
    rulemaking authority to remove impediments to competition.
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        \292\ The only substantive difference between the amendments as 
    adopted today and as proposed is the definition of the term ``OTC 
    market maker.'' The definition as proposed read ``* * * sell to a 
    customer * * *'' but has been modified to read ``* * * sell to its 
    customers * * *.'' Rule 11Ac1-1(a)(13), 17 CFR 240.11Ac1-1(a)(13). 
    See infra note 308.
        In addition to the amendments discussed in detail herein, the 
    Commission is making technical, non-substantive amendments to the 
    Quote Rule. The terms ``association'', ``revised bid or offer'', and 
    ``revised quotation size'' will be separately defined in the rule. 
    The definition of ``exchange-traded security'' has been revised to 
    exclude OTC securities traded on an exchange pursuant to unlisted 
    trading privileges. The definition of ``plan processor'' has been 
    amended to reflect the appropriate cross-reference. The definition 
    of ``principal market'' has been removed from the Quote Rule because 
    it is no longer applicable. In addition, the definitions have been 
    arranged in alphabetical order.
        Paragraph (b)(1)(i) of the rule has been reorganized to 
    separately set forth the exclusions in subparagraphs (A) and (B). 
    Paragraph (b)(1)(iii) has been eliminated and the substance of the 
    provision has been incorporated into paragraphs (b)(1)(i) and 
    (b)(1)(ii).
        The Commission is also amending the definition of the term 
    ``reported security'' as it appears in Rule 11A3-1(a)(4). The 
    amendment alters the form but not the meaning of the term or its 
    application. The amendment will make the term consistent with the 
    definition of ``reported security'' in the Quote Rule.
        The amendments to Rule 11Ac1-1(a) are being adopted 
    prospectively. Outstanding Quote Rule interpretations and no-action 
    letters continue to be operative, to the extent that the positions 
    taken therein are not materially in conflict with the amendments 
    adopted today. Persons seeking clarification regarding the status of 
    outstanding no-action letters should contact the Office of Market 
    Supervision, Division of Market Regulation, Securities and Exchange 
    Commission.
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    b. Basis for Amendments to Rule 11Ac1-1(a)
    i. Amendment to 11Ac1-1(a)(25) (Definition of a ``Subject Security'')
        The Commission is amending the Quote Rule's definition of subject 
    security to require continuous two-sided quotations from OTC market 
    makers and exchanges that are responsible for more than 1% of the 
    volume in a non-Rule 19c-3 security. The Commission believes that this 
    amendment removes an impediment to competition that exists under the 
    current rule. Broker-dealers that held themselves out as willing to buy 
    and sell non-Rule 19c-3 securities on a regular or continuous basis 
    were not previously required to disseminate quotation information 
    unless they transacted the largest percentage of the aggregate trading 
    volume in a particular security. Consequently, regardless of the volume 
    transacted by other exchanges or OTC market makers, the primary market, 
    which was the market responsible for transacting the largest percentage 
    of the aggregate trading volume, was the only market participant 
    required to disseminate quotations in these securities.293
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        \293\ An OTC market maker or specialist, although not the 
    principal market for a listed security, could elect to disseminate 
    quotes for the security. Under the amended 11Ac1-1(a)(25) an OTC 
    market maker or specialist may still elect to disseminate quotations 
    if it is responsible for 1% or less of the volume in that security.
    ---------------------------------------------------------------------------
    
        As noted in the Proposing Release, third market trading in non-Rule 
    19c-3 securities has increased considerably since the Quote Rule was 
    last amended.294 Third market trading in Rule 19c-3 securities now 
    accounts for a greater number of stocks and a more substantial 
    percentage of U.S. trading volume than it did when the Commission 
    initially established disparate regulatory treatment under the Quote 
    Rule for Rule 19c-3 securities and non-Rule 19c-3 securities.295 
    In view of the growth of third market trading volume, the Commission 
    believes that requiring all broker-dealers trading more than 1% of the 
    volume in a listed security to publish quotations will provide more 
    accurate and comprehensive quotation information for non-Rule 19c-3 
    securities.
    ---------------------------------------------------------------------------
    
        \294\ Third market maker trading interest is more concentrated 
    in non-Rule 19c-3 securities, as evidenced by the fact that the 
    percentage of third market quotes in non-Rule 19c-3 securities (36%) 
    is greater than that for Rule 19c-3 securities (28%). See 
    Fragmentation vs. Consolidation of Securities Trading: Evidence of 
    the Operation of Rule 19c-3, Office of Economic Analysis, SEC, at 5 
    (March 29, 1995) (``Fragmentation vs. Consolidation'').
        \295\ Third market trading volume has grown, at least in part, 
    because the universe of securities subject to Rule 19c-3 has 
    increased considerably. For example, nearly 60% of the stocks listed 
    on the NYSE are subject to Rule 19c-3, accounting for approximately 
    48% of the total NYSE volume. See Fragmentation vs. Consolidation at 
    4-5.
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        The Commission believes that disparate regulatory requirements for 
    Rule 19c-3 and non-Rule 19c-3 securities can no longer be justified by 
    differences in the trading of the two types of securities. Moreover, 
    the Commission finds that differences in regulatory treatment have 
    impaired transparency. Because of the growth of third market trading in 
    non-Rule 19c-3 securities, the absence of quotes revealing the 
    substantial third market makers in a security and the prices they are 
    prepared to publicly quote results in the consolidated quotations in 
    the security being incomplete.296 The Commission therefore 
    believes that significant dealers in non-Rule 19c-3 securities should 
    become subject to the same standards required for trading
    
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    Rule 19c-3 securities.297 As a result of this amendment, market 
    participants will have more complete information about significant OTC 
    market makers and specialists in a security and the prices at which 
    they are willing to trade. The majority of commenters who addressed the 
    amendment to Rule 11Ac1-1(a)(25) endorse the Commission's proposal to 
    end the disparity between Rule 19c-3 securities and non-Rule 19c-3 
    securities, noting that there is no basis for continuing to draw a 
    regulatory distinction between Rule 19c-3 and non-Rule 19c-3 
    securities, and that the extension of the Quote Rule will provide 
    meaningful information about significant market makers in listed 
    securities.298 One commenter asserts that requiring quotations 
    from all significant OTC market makers will succeed in improving the 
    quality of the NMS for all listed securities while at the same time 
    leveling the playing field for all market makers.299
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        \296\ See, e.g., supra note 294.
        \297\ OTC market makers that trade a significant volume in non-
    Rule 19c-3 securities have not been subject to the same requirements 
    as third market makers that meet the 1% threshold for Rule 19c-3 
    securities. For example, an OTC market maker meeting the 1% 
    threshold is required to quote in a Rule 19c-3 security and 
    therefore must register as a CQS market maker with the NASD. NASD 
    Manual, Rule 6320. CQS market makers are subject to the NASD's CQS 
    market maker rules, which include firm and continuous two-sided 
    quote obligations and mandatory participation in the ITS through 
    Nasdaq's Computer Assisted Execution System. NASD Manual, Rules 6320 
    and 6330.
        \298\ See, e.g., Amex Letter; Blume Letter; BSE Letter; CHX 
    Letter; CSE Letter; NASD Letter; PSE Letter; Alex. Brown Letter; 
    Schwab Letter; D.E. Shaw Letter; Dean Witter Letter; Lehman Letter; 
    Madoff Letter; Merrill Letter; PaineWebber Letter; Salomon Letter; 
    Smith Barney Letter; STA Letter.
        There were some commenters who did not support the extension of 
    the Quote Rule's requirements to non-Rule 19c-3 securities. See, 
    e.g., NYSE Letter; and Specialists Assoc. Letter, which note that 
    the Commission, rather than expanding the Quote Rule to include non-
    Rule 19c-3 securities, should re-examine the validity of Rule 19c-3. 
    See, e.g., Letter from Alexander H. Slivka, Executive Vice-
    President, National Securities Corporation, to Jonathan G. Katz, 
    Secretary, SEC, dated October 25, 1995 (``NSC Letter''); Fahnestock 
    Letter; Letter from Samuel Lieberman, President, Rothschild 
    Lieberman Ltd., to Jonathan G. Katz, Secretary, SEC (``Rothschild 
    Letter''); Letter from Mark T. DeFelice, Vice President, Roosevelt & 
    Cross, Inc., to Jonathan G. Katz, SEC, dated January 24, 1996 
    (``Roosevelt Letter''), which note that the extension of the 
    quotation requirements to include non-Rule 19c-3, will have an 
    impact on small firms. See infra note 307.
        \299\ Madoff Letter.
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        Nevertheless, many commenters suggest modifications to the 1% 
    volume threshold. Some commenters suggest that Nasdaq, on behalf of all 
    third market makers, should be viewed as one market participant, and 
    that once its volume exceeds 1% for a listed security, all OTC market 
    makers in that security should be required to maintain continuous two-
    sided quotations.300 Other commenters believe that the Commission 
    should adopt a ``continuousness of execution'' standard rather than a 
    rigid 1% volume threshold.301 This suggestion would require a 
    dealer to quote if it executes orders on a regular or continuous basis, 
    even if it accounts for less than 1% of the volume, while excluding 
    from quotation requirements a dealer that executes a few large trades 
    that account for more than 1% of the volume. The NYSE suggests an 
    additional threshold, to be used in the alternative with the 1% of 
    volume threshold.302 This alternative would have the effect of 
    requiring public quotations from market makers who, while not 
    accounting for more than 1% of the aggregate transaction volume, have 
    an active retail business in small-sized trades.
    ---------------------------------------------------------------------------
    
        \300\ See PSE Letter; Specialists Assoc. Letter.
        A comparable alternative is to require quotations from all OTC 
    market makers who account for more than 1% of the Nasdaq-reported 
    volume in a security. See Investors Research Letter.
        In the same vein, two commenters suggest that once an OTC market 
    maker or specialist displays a quotation in a listed security, it 
    should be subject to the requirements of the rule. See BSE Letter; 
    CSE Letter.
        The NYSE and CSE suggest further application of the rule to 
    include brokers and their private trading systems. See NYSE Letter; 
    CSE Letter.
        \301\ See CHX Letter; Fahnestock Letter; Jefferies Letter; 
    Salomon Brothers Letter; STA Letter. See also Rothschild Letter.
        \302\ NYSE Letter. See also RPM Letter; Specialists Assoc. 
    Letter.
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        The Commission believes that extending the 1% threshold based on 
    quarterly aggregate trading volume to non-Rule 19c-3 securities is a 
    reasonable method to improve the scope of quotation information to 
    include significant OTC market makers and specialists. This 1% 
    threshold, currently in effect for Rule 19c-3 securities, has proved 
    effective in supplying comprehensive quotation information to the 
    market at large. Moreover, based on the increase in third market 
    trading volume for these securities, the Commission does not believe 
    this standard is unduly burdensome on OTC market makers or 
    specialists.303 Rather, the Commission believes this threshold 
    strikes a balance between requiring the dissemination of all quotation 
    interest and accommodating those specialists and OTC market makers that 
    are small entities. The Commission believes that OTC market makers and 
    specialists that account for 1% or less of the aggregate volume are not 
    active enough to justify the additional expense of providing continuous 
    quotation display.304
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        \303\ The Commission seeks to avoid imposing burdens on market 
    participants that are not necessary to achieve the Quote Rule's 
    objective of reliable public quotations from all significant markets 
    in a security. The Commission notes that the 1% threshold for 
    quotations in Rule 19c-3 securities has not impaired trading in 
    these securities. Since the Quote Rule was amended, OTC market 
    makers' volume in Rule 19c-3 securities has increased. See 
    Fragmentation vs. Consolidation at 4-5. The Commission has no reason 
    to believe that imposing mandatory quotations on specialists and OTC 
    market makers that are responsible for more than 1% of the volume in 
    a non-Rule 19c-3 security will affect market making in these 
    securities.
        \304\ A few commenters expressed concern that the amendment to 
    the Quote Rule would have a detrimental impact on small firms. See 
    Fahnestock Letter; NSC Letter; Roosevelt Letter; Rothschild Letter. 
    The Commission believes the requirement that a dealer must transact 
    greater than 1% of the volume in a security before quotations are 
    mandated prevents the rule from becoming unnecessarily burdensome on 
    small firms. For example, a firm would not have to publish 
    continuous two-sided quotations in AT&T unless it transacted more 
    than 1% of the aggregate transaction volume, which the Commission 
    considers more than modest volume.
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        Similarly, the Commission believes that applying the 1% threshold 
    to the total over-the-counter volume in a listed security would extend 
    the quotation requirements to inactive market makers. The Commission 
    questions whether the added quotation information would justify the 
    added burden.305 The Commission also believes that reliance on 
    something other than a numerical standard in this circumstance would 
    lead to confusion in the marketplace. Accordingly, the Commission 
    believes the ``greater than 1% aggregate trading volume'' threshold for 
    mandatory quotations continues to be appropriate.
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        \305\ In a related release issued today, the Commission is 
    proposing an amendment that would require continuous two-sided 
    quotations from OTC market makers and specialists provided that the 
    OTC market maker or specialist is responsible for more than 1% of 
    the aggregate transaction volume for a security included on the 
    Nasdaq Stock Market. See Companion Release for a detailed discussion 
    on the proposed amendment to the Quote Rule.
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    ii. Amendment to 11Ac1-1(a)(13) (Definition of an ``OTC Market Maker'')
        Amended Rule 11Ac1-1(a)(13) 306 revises the definition of 
    ``OTC market maker'' to include any dealer who holds itself out as 
    willing to buy from and sell to its customers, or otherwise, a covered 
    security for its own account on a regular or continuous basis otherwise 
    than on an exchange in amounts of less than block size.307 
    Accordingly, dealers that internalize customer order flow in particular 
    stocks, by holding themselves out to customers as willing to buy and 
    sell on an ongoing basis, would fall within the definition even though 
    they may not hold themselves out to all other market participants. In 
    addition, dealers
    
    [[Page 48319]]
    
    that hold themselves out to particular firms as willing to receive 
    customer order flow, and execute those orders on a regular or 
    continuous basis, also would fall within the definition of an OTC 
    market maker.
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        \306\ 17 CFR 240.11Ac1-1(a)(13).
        \307\ The definition, as proposed, read ``* * * sell to a 
    customer * * * '' but has been modified to read ``* * * sell to its 
    customers * * *. ''
    ---------------------------------------------------------------------------
    
        This change was in response to the requests of commenters for 
    consistency in the definition of OTC market maker between proposed Rule 
    11Ac1-1(a)(13) and proposed Rule 11Ac1-4(a)(9).See, e.g., NASD Letter. 
    Additionally, the Commission stated in the Proposing Release that 
    ``[a]s in the past, broker-dealers will not be considered to be holding 
    themselves out as regularly or continuously willing to buy or sell a 
    security if they occasionally execute a trade as principal to 
    accommodate a customer's request.'' Proposing Release at 24. The 
    Commission believes the new language more accurately reflects that 
    premise.
        Most commenters addressing this issue assert that it is appropriate 
    to include in the definition of OTC market maker those dealers who 
    internalize customer order flow because they believe that dealers that 
    hold themselves out to their customers as willing to buy and sell 
    securities on a continuous basis should be required to publish 
    quotations.308 One commenter asserts that the amendment will 
    broaden the definition of who should be required to provide 
    transparency and liquidity to the NMS to include dealers that transact 
    business with other firms' order flow and with their own customers, 
    thus ensuring a minimum level of quotation commitment from those NMS 
    participants vying for public order flow.309 Some commenters, 
    however, advocate that more than internalization of order flow should 
    be required before a dealer is deemed an OTC market maker. These 
    commenters suggest the Commission adopt some form of a ``holding itself 
    out'' standard, so that the rule would capture the quotations of 
    professional liquidity providers but not dealers that occasionally 
    accommodate a customer's request.310 Other commenters, deeming the 
    definition too inclusive, suggest the Commission add an exception for 
    broker-dealers that act solely as agents.311
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        \308\ See Amex Letter; BSE Letter; CHX Letter; CSE Letter; D.E. 
    Shaw Letter; Madoff Letter; NYSE Letter; PSE Letter; RPM Letter; SIA 
    Letter; STA Letter.
        \309\ Madoff Letter.
        \310\ See NASD Letter; Jefferies Letter; SIA Letter; PaineWebber 
    Letter; STA Letter. It should be noted that the amended definition 
    includes a requirement that the broker-dealer hold itself out to, at 
    a minimum, its customers on a regular and continuous basis in order 
    to be an OTC market maker.
        \311\ See Fahnestock Letter; Salomon Brothers Letter; Rothschild 
    Letter; Investors Research Letter.
    ---------------------------------------------------------------------------
    
        One commenter believes that excluding firms that transact primarily 
    block size orders and therefore account for significant volume is 
    inconsistent with the Commission's goals for increased 
    transparency.312 However, several commenters note that block size 
    orders are excluded from the existing definition of OTC market maker 
    and argue strongly that it is consistent with the purposes of the rule 
    to continue to exclude them.313
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        \312\ Amex Letter.
        \313\ See Fahnestock Letter; Dillon Letter; Goldman Sachs 
    Letter; Merrill Letter; Salomon Brothers Letter.
    ---------------------------------------------------------------------------
    
        The Commission believes that adoption of the amendment is warranted 
    to ensure the availability of quotation information that accurately 
    reflects the interests of all significant market participants. 
    Increased transparency is fundamental to the fairness and efficiency of 
    the securities markets. As noted in the Market 2000 Study, enhanced 
    transparency helps link various market segments.314 Currently, a 
    dealer can receive order flow from internalization or pre-existing 
    order routing arrangements but avoid publishing quotations, even when 
    it accounts for more than 1% of the volume in a non-Rule 19c-3 
    security, because it is not currently deemed to be an OTC market 
    maker.315 Allowing significant market makers that deal actively in 
    securities without publicizing their activity or making available their 
    prices undermines the NMS goal of transparency. The Commission believes 
    that those dealers should be classified under the rule as market makers 
    and be required to publicize their quotations so that investors may 
    know of, and trade on similar terms with, those market makers.
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        \314\ See Market 2000 Study at III-7.
        \315\ Although NASD rules require dealers who are registered as 
    CQS market makers to provide quotations, registration is not 
    mandated. A dealer in reported securities may elect to disseminate 
    quotations by registering as a NASD market maker and 
    ``communicating'' its best bids and offers to the association by 
    entering two-sided quotations in the Nasdaq System. See NASD Manual, 
    Rule 4611.
    ---------------------------------------------------------------------------
    
        The Commission has considered commenters' suggestions regarding 
    alternative definitions. In fact, in response to the suggestions of 
    some commenters, the Commission has modified the proposed amendment to 
    make clear that more than an isolated transaction is necessary before a 
    dealer is designated an OTC market maker.
        The Commission, in regard to orders of block size, has determined 
    to continue to exclude dealers that hold themselves out as only willing 
    to deal in orders equal to or greater than 10,000 shares. Orders of 
    block size are generally negotiated with the dealer and exposed upon 
    execution. Block positioners usually do not maintain prices at which 
    they are willing to buy and sell a particular security; rather, they 
    make known their role of assisting in the purchase and sale of large 
    positions in securities at some price. Consequently, these dealers do 
    not function as typical dealers that maintain a regular or continuous 
    price quote. The Commission has concluded that requiring quotations 
    from these dealers would not provide useful price information and 
    therefore a dealer that acts solely as a block positioner should remain 
    excluded from the definition.
    iii. Amendment to 11Ac1-1(a)(6) (Definition of a ``Covered Security'')
        As amended, Rule 11Ac1-1(a)(6) 316 defines ``covered 
    security'' to include any security for which a transaction report, last 
    sale data or quotation information is disseminated through an automated 
    quotation system as described in Section 3(a)(51)(A)(ii) of the 
    Exchange Act.317 This amendment would extend the Quote Rule 
    provisions to OTC market makers and exchange specialists quoting in 
    Nasdaq SmallCap securities.
    ---------------------------------------------------------------------------
    
        \316\ Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1(a)(6).
        \317\ 15 U.S.C. 78c(a)(51)(A)(ii).
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        The Proposing Release noted that the Quote Rule presently does not 
    reflect certain developments in the Nasdaq market, including the large 
    number of securities included on the Nasdaq SmallCap market. Only one 
    commenter addressed this amendment. That commenter, MJT, expressed 
    strong support for the proposal, noting that it is both fair and 
    equitable to apply the Quote Rule to Nasdaq SmallCap 
    securities.318 The Commission believes it is appropriate to extend 
    coverage of the Quote Rule to these securities in recognition of the 
    development of a liquid trading market and increased investor demand 
    for these securities. NASD rules concerning quotations already require 
    firm quotations for both Nasdaq SmallCap securities and Nasdaq/National 
    Market securities.319 Thus, the amendment simply extends coverage 
    of the Quote Rule requirements to the same range of securities as
    
    [[Page 48320]]
    
    existing NASD firm quote requirements.320
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        \318\ MJT Letter.
        \319\ See NASD Manual, Rule 4613.
        \320\ Section 11A(c)(1) of the Exchange Act grants the 
    Commission the authority to prescribe, among other matters, rules 
    and regulations to assure accurate and reliable quotations ``with 
    respect to any security other than an exempted security.'' The 
    Commission believes that extending the requirements of the Quote 
    Rule to Nasdaq SmallCap securities will further these interests. No 
    new costs should be imposed on market participants because the NASD 
    rules concerning quotations already treat Nasdaq/National Market and 
    SmallCap securities similarly.
    ---------------------------------------------------------------------------
    
    c. Response to Other Specific Requests for Comments
        In addition to the Quote Rule amendments discussed above, the 
    Proposing Release solicited comment on whether: (1) revisions are 
    necessary to an NASD rule that restricts certain computer generated 
    quotations; 321 and (2) whether the ITS linkage should be expanded 
    to allow NASD CAES members access to the linkage in non-Rule 19c-3 
    securities.
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        \321\ NASD Manual, Rule 6330. The NASD, however, provides an 
    automated quotation update capability (``auto-refresh'') as part of 
    the Small Order Execution System which market makers may elect to 
    use. Specifically, the quote of a market maker using auto-refresh 
    will be automatically updated when the market maker exhausts its 
    exposure limit in the NASD's Small Order Execution System.
    ---------------------------------------------------------------------------
    
    i. Automatic Generation of Quotations
        Requiring active third market makers in non-Rule 19c-3 securities 
    to quote also raises the issue of whether NASD members should continue 
    to be prohibited from using computer systems to generate quotations 
    automatically.322 Currently, exchange specialists may use 
    automated mechanisms to track the NBBO in a security if they maintain a 
    quotation size of no more than 100 shares.323 OTC market makers, 
    however, are prohibited by NASD requirements from using automated 
    quotation tracking systems.
    ---------------------------------------------------------------------------
    
        \322\ See supra note 288, concerning the impact of the ECN 
    amendment to the 1% rule.
        \323\ The 100-share limitation follows the ITS Plan requirement 
    that no ITS Participant may use an automated computer tracking 
    system to generate quotes for more than 100 shares in any security 
    the Participant trades through the ITS system.
    ---------------------------------------------------------------------------
    
        The Commission requested comment on whether computer generated 
    quotations should be permitted if active third market makers are 
    required to quote in non-Rule 19c-3 securities, and if so, under what 
    conditions. Commenters in favor of lifting the NASD's automated 
    quotation ban believe that worthwhile computer generated quotes should 
    be permitted.324 For example, one commenter stresses that a ban on 
    all computer generated quotations impedes technological innovation, 
    protecting the franchise of inefficient market makers at the expense of 
    the investing public. Moreover, the commenter asserts, given the same 
    regulatory environment, there is no reason to believe that firms that 
    make automated markets will quote away from the market any more than 
    firms posting quotes manually.325
    ---------------------------------------------------------------------------
    
        \324\ See, e.g., BSE Letter; CSE Letter; D.E. Shaw Letter; 
    Investors Research Letters; Lehman Letter; Madoff Letter; Merrill 
    Letter; NSC Letter; NYSE Letter; Smith Barney Letter.
        \325\ D.E. Shaw Letter.
    ---------------------------------------------------------------------------
    
        Certain commenters, including the NASD, believe that the ban should 
    continue in effect. In general, these commenters believe that lifting 
    the ban could create systems capacity and data traffic problems, and 
    result in useless quotations that are automatically maintained away 
    from current market prices.326
    ---------------------------------------------------------------------------
    
        \326\ See, e.g., Dean Witter Letter; NASD Letter; PSE Letter; 
    RPM Specialist Letter.
    ---------------------------------------------------------------------------
    
        Even commenters in favor of lifting the ban tend to believe that, 
    while some types of computer generated quotes are appropriate, others, 
    such as quotations automatically maintained away from the best market 
    quotation, should not be permitted. The NASD, which generally favors 
    the ban on automated quotes, believes it may be appropriate to revise 
    its autoquote policy to permit a market maker to automatically update 
    its quote to match either the best bid or best offer, provided 
    liquidity is not withdrawn from the contra-side of the quotation. In 
    this situation, the NASD believes a market maker will be exposed to an 
    execution and will be genuinely contributing to market liquidity.
        The Commission believes that a total prohibition on the use of 
    computer generated quotes is not appropriate. Such an approach 
    excessively limits the use of sophisticated trading strategies that 
    rely on automation in the quotation process for their success, and it 
    also may act as a competitive disadvantage to market makers and 
    specialists that would otherwise rely on technology to meet their 
    quotation obligations more efficiently. In the latter instance, broad 
    prohibitions on the use of computer generated quotes may cause some 
    market makers and specialists to restrict the number of stocks in which 
    they are willing to make markets.
        While the Commission recognizes traditional concerns related to the 
    accessibility of computer generated quotes and the impact of such 
    quotes on systems capacity, it believes that more can and should be 
    done in this area. This is particularly true given the enhanced 
    quotation obligations that will be imposed on some market participants 
    under the revised Quote Rule. The Commission urges the NASD, ITS 
    Participants,327 and other interested market participants to 
    develop revised standards that would permit the use of computer 
    generated quotes that contribute value to the market. Specifically, the 
    Commission requests that the NASD and ITS Participants resolve this 
    issue before the effective date of the Quote Rule amendments. In the 
    absence of such progress, the Commission recognizes that it will 
    consider invoking its own authority to address this issue.
    ---------------------------------------------------------------------------
    
        \327\ The ITS Plan also places certain restrictions on the use 
    of computer generated quotes. See supra note 323. Given the 
    technologies that have developed during the nearly 20 years that 
    these ITS Plan restrictions have been in place, the Commission 
    requests that the ITS Participants review these limitations and 
    whether they continue to be appropriate, in whole or in part, and 
    whether new limitations should replace the existing provisions or 
    whether there should be any ITS Plan limitations on automated 
    quotes.
    ---------------------------------------------------------------------------
    
    ii. Expansion of ITS/CAES Access
        As discussed in the Proposing Release, the uniform application of 
    the Quote Rule to all exchange-listed securities raises the issue of 
    the disparate treatment of Rule 19c-3 and non-Rule 19c-3 securities 
    under the ITS Plan. The Commission solicited comment on this disparate 
    treatment. The same issue arises with the provision allowing the use of 
    an ECN as an intermediary in communicating quotes to the public 
    quotation system if equivalent access is provided.
        Currently, the ITS Plan provides access to the ITS System to any 
    Participant in any Rule 19c-3 security in which the Participant 
    disseminates continuous two-sided quotations, but excludes OTC market 
    makers from ITS access for non-Rule 19c-3 securities. In the past, 
    market makers in non-Rule 19c-3 securities were not subject to 
    mandatory quote requirements. The amendments to the Quote Rule adopted 
    today will subject OTC market makers and exchange specialists to the 
    same quotation requirements for all exchange-listed securities.
        The Commission requested comment on whether the Quote Rule 
    amendments justify an expansion of the linkage between ITS and the 
    NASD's CAES interface to provide ITS access to and from any market 
    maker for any exchange-listed security in which that market maker 
    disseminates continuous two-sided quotations. Numerous commenters 
    support expanding the linkage in this manner because they believe an 
    expansion will enhance fair competition and increase opportunities
    
    [[Page 48321]]
    
    for best execution.328 Several commenters also assert that 
    arguments previously made to exclude OTC market maker quotes in non-
    Rule 19c-3 securities from ITS are no longer valid.329
    ---------------------------------------------------------------------------
    
        \328\ See, e.g. D.E. Shaw Letter; Investors Research Letter; 
    Lehman Letter; NASD Letter; NSC Letter; Madoff Letter; Rothschild 
    Letter; Schwab Letter; STA Letter.
        \329\ See, e.g., Madoff Letter.
    ---------------------------------------------------------------------------
    
        One commenter specifically argues that adoption of the Commission's 
    proposals should end any objection to the NASD's full participation in 
    ITS because the operation of the Quote Rule will reduce opportunities 
    for OTC market makers to trade in ECNs while simultaneously availing 
    themselves of the voluntary aspect of the Quote Rule, and therefore, 
    will expand the imposition of NASD quotation requirements upon OTC 
    market makers. These requirements, according to the commenter, are 
    equal to those of any other market and add greater transparency and 
    liquidity to the markets for exchange-listed securities as well as the 
    NMS.330
    ---------------------------------------------------------------------------
    
        \330\ Id. Madoff states that the NASD now requires every OTC 
    market maker to conform with NMS principles, respect all other NMS 
    quotations in listed securities, and not trade through better quotes 
    in the NMS. Madoff further notes that, in contrast, exchanges do not 
    impose similar restrictions with respect to trading through off-
    exchange quotations.
    ---------------------------------------------------------------------------
    
        Those commenters opposed to the expansion generally believe that 
    the existing limitation on ITS access is justified in view of 
    disparities in customer protections afforded by exchanges and exchange 
    members when compared to customer protections mandated by NASD 
    rules.331
    ---------------------------------------------------------------------------
    
        \331\ See Amex Letter; BSE Letter; CHX Letter; CSE Letter; PSE 
    Letter; Specialists Assoc. Letter.
    ---------------------------------------------------------------------------
    
        The Commission recognizes that the expansion of ITS/CAES is a 
    significant issue of concern to many market participants. The 
    Commission therefore encourages a continuing dialogue among the ITS 
    Participants to solve this issue on a timely basis and in a manner 
    beneficial to the market as a whole.
    d. Operation of the Rule With Amended Definitions
    i. Amendment to 11Ac1-1(a)(25) (Definition of a ``Subject Security'')
        As a result of the amendment adopted today, OTC market makers and 
    exchange specialists who hold themselves out as willing to buy and sell 
    non-Rule 19c-3 securities on a regular or continuous basis, and that 
    account for more than 1% of the quarterly aggregate trading volume, 
    will be subject to the Quote Rule and required to make continuous two-
    sided quotations available to the public, even if they have not 
    previously elected to register as CQS market makers with the NASD. This 
    amendment will close a significant gap in the quotation information 
    that has been available heretofore to market participants and 
    investors. In a parallel action, the Commission is proposing for 
    comment an additional amendment to the Quote Rule.332 The 
    Commission believes that the additional proposal, if adopted, would 
    further improve transparency by providing investors with quotation 
    information on Nasdaq securities from significant OTC market makers and 
    specialists.
    ---------------------------------------------------------------------------
    
        \332\ See Companion Release.
    ---------------------------------------------------------------------------
    
    ii. Amendment to 11Ac1-1(a)(13) (Definition of an ``OTC Market Maker'')
        The definition of OTC market maker now includes any dealer holding 
    itself out as willing to transact business for its own account on a 
    regular or continuous basis, whether it transacts exclusively with its 
    own customers or with the customers of other dealers. Those dealers 
    that hold themselves out to customers as willing to execute orders on a 
    regular or continuous basis, whether by the internalization of customer 
    order flow in particular stocks or through arrangements with particular 
    firms to execute their customer order flow, now fall within the 
    definition of OTC market maker. Therefore, obligations under the Quote 
    Rule will now apply to dealers that internalize customer order flow or 
    hold themselves out to particular firms as willing to execute their 
    customer order flow, and that execute those orders on a regular or 
    continuous basis. As in the past, broker-dealers will not be considered 
    to be holding themselves out as regularly or continuously willing to 
    buy or sell a security if they occasionally execute a trade as 
    principal to accommodate a customer's request.
    iii. Amendment to 11Ac1-1(a)(6) (Definition of a ``Covered Security'')
        The amendment extends the coverage of the Quote Rule to all Nasdaq 
    securities where the rule had previously applied only to Nasdaq/
    National Market securities. As noted previously, NASD rules already 
    require a dealer that makes a market in a Nasdaq SmallCap security to 
    provide quotations.333 The Commission, therefore, does not believe 
    extending the Quote Rule to include securities covered by an existing 
    NASD rule will result in additional burdens on OTC market makers. 
    Although the definition of covered security has been amended to include 
    Nasdaq SmallCap securities, an exchange specialist or OTC market maker 
    still must make an election, pursuant to paragraphs (b)(5) (i) and 
    (ii), respectively, of the Quote Rule.334 Accordingly, although 
    the definition has been amended, an OTC market maker or specialist is 
    not mandated by the Quote Rule to provide quotations on Nasdaq SmallCap 
    securities. If, however, an exchange specialist or OTC market maker 
    makes an election to make available quotations, the firmness 
    obligations under paragraph (c) of the Quote Rule become operative.
    ---------------------------------------------------------------------------
    
        \333\ See NASD Rule 4613.
        \334\ 17 CFR 240.11Ac1-1(b)(5)(i)
    ---------------------------------------------------------------------------
    
    e. Effective Date
        The amendments to Rule 11Ac1-1 adopted by the Commission today will 
    become effective on January 10, 1997.
    
    C. Price Improvement for Customer Market Orders
    
    1. Proposed Rule
        In the Proposing Release, the Commission sought comment on a 
    market-wide Price Improvement Rule for customer market orders. The 
    proposed rule was designed to apply across exchange and OTC markets to 
    promote the execution quality of orders by providing increased 
    opportunities for customer orders to interact at better prices without 
    the intervention of a dealer. The proposal included a non-exclusive 
    safe harbor as one means by which a specialist or OTC market maker 
    could be assured that an order received a sufficient opportunity for 
    price improvement for purposes of the rule.
        The proposed rule was intended to encourage market participants to 
    take advantage of current technologies and provide customer market 
    orders with improved access to price improvement opportunities, 
    regardless of where such orders are routed for execution. Although the 
    proposed rule would have required specialists and OTC market makers to 
    provide price improvement opportunities for customer orders, the 
    Commission did not prescribe any particular method of achieving price 
    improvement in recognition of the fact that competition can produce 
    innovative price improvement mechanisms. The Commission proposed a non-
    exclusive safe harbor, however, to provide certainty regarding one 
    alternative by which a specialist or OTC market maker would be deemed 
    to have satisfied its price improvement obligation.
        Under the safe harbor, a specialist or OTC market maker would have 
    been deemed in compliance with the
    
    [[Page 48322]]
    
    proposed price improvement rule if it exposed, in its quote, a customer 
    market order at an improved price and provided the customer with a 
    guaranteed execution at the ``stop'' price.335 This procedure was 
    designed to promote the interaction of exposed orders at prices better 
    than the NBBO with orders or trading interest in other markets. The 
    safe harbor also was intended to lead to increased competition by 
    encouraging specialists and OTC market makers to compete more actively 
    for order flow on the basis of their published quotations. The 
    Commission made clear, however, that the order exposure procedures set 
    out in the proposed safe harbor neither would be mandatory, nor the 
    exclusive means by which to satisfy the obligation to provide an 
    opportunity for price improvement.
    ---------------------------------------------------------------------------
    
        \335\ The proposed safe harbor provided for an order to be 
    ``stopped'' at the national best bid (for a sell order) or offer 
    (for a buy order) for the lesser of either the full size of the 
    order, or the size associated with the national best bid (for a sell 
    order) or offer (for a buy order).
    ---------------------------------------------------------------------------
    
        Many of the 145 commenters discussed the proposed Price Improvement 
    Rule. The commenters raise numerous questions and concerns regarding 
    the proposed rule. For example, some commenters claim that an absolute 
    rule would reduce the broker-dealer's fiduciary obligation of best 
    execution to an algorithm, eliminating the exercise of professional 
    judgment in identifying price improvement opportunities.336 
    Instead, the commenters argue that customers and market professionals 
    should be able to use discretion in deciding when and how price 
    improvement should be sought.337
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        \336\ See, e.g., Goldman Sachs Letter; Jefferies Letter; Madoff 
    Letter; Merrill Letter; NYSE Letter; PaineWebber Letter; PSE Letter.
        \337\ See, e.g., CSE Letter; Goldman Sachs Letter; Madoff 
    Letter; Merrill Letter; NSC Letter; NYSE Letter; PSE Letter.
    ---------------------------------------------------------------------------
    
        In addition, several commenters are concerned that the proposed 
    safe harbor would become the industry standard. These commenters 
    believe that, although non-exclusive, the proposed safe harbor would 
    dictate the minimum acceptable standard to follow, thereby stifling 
    innovation and competition.338 Many commenters also are troubled 
    by various technical aspects regarding the application of the safe 
    harbor. For example, some commenters believe the 30-second exposure 
    period would be insufficient to allow other market participants to 
    respond to the exposed order, even with today's technology.339 
    Other commenters are concerned with the mechanics of the ``stopping'' 
    procedures.340 At least one commenter argues that the requirement 
    to stop stock blurs the distinction between price guarantees and price 
    improvement opportunities.341
    ---------------------------------------------------------------------------
    
        \338\ See, e.g., AZX Letter; Blume Letter; HHG Letter; Lehman 
    Letter; Merrill Letter; Morgan Stanley Letter; NASD Letter; Salomon 
    Letter; Schwab Letter; Smith Barney Letter; PaineWebber Letter; 
    Ruane Letter.
        Some commenters believe their current operations would satisfy 
    the rule and, therefore, they would not need to utilize the safe 
    harbor procedures. See, e.g., Amex Letter; BSE Letter; CHX Letter; 
    NYSE Letter; PSE Letter.
        \339\ See, e.g., Amex Letter; Blume Letter; BSE Letter; CHX 
    Letter; CSE Letter; NYSE Letter; PSE Letter; Schwab Letter;. But 
    see, e.g., Letter from Raymond E. Wooldridge, Chief Executive 
    Officer, Southwest Securities, to Mr. Jonathan G. Katz, Secretary, 
    SEC, dated January 9, 1996 (``Southwest Letter''); STANY Letter.
        \340\ See, e.g., Madoff Letter; MJT Letter; Smith Barney Letter.
        \341\ See Sutro Letter.
    ---------------------------------------------------------------------------
    
        The potential costs associated with the proposed rule also concern 
    many commenters. They claim that necessary systems upgrades would be 
    expensive.342 In addition, several commenters claim that the 
    number of quotes generated as a result of the safe harbor would pose a 
    serious threat to system capacity.343 Many commenters warn that 
    the increased traffic would reduce trading efficiency, decrease 
    transparency and increase overall risk.344 Some commenters also 
    state that market price integrity would be reduced due to the 
    proliferation of flickering, ephemeral quotations.345
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        \342\ See, e.g., Blume Letter; Dean Witter Letter; Fahnestock 
    Letter; Goldman Sachs Letter; LJR Letter; NASD Letter; PaineWebber 
    Letter; Ruane Letter; Salomon Letter; Schwab II Letter; SIA Letter.
        \343\ See, e.g., Bear Stearns Letter; FIF Letter; Merrill 
    Letter; PSE Letter; STANY Letter.
        \344\ See, e.g., Amex Letter; Bear Stearns Letter; Blume Letter; 
    FIF Letter; LJR Letter; Madoff Letter; Merrill Letter; Morgan 
    Stanley Letter; NASD Letter; PSE Letter; Salomon Letter; STA Letter; 
    STANY Letter; Specialist Assoc. Letter.
        \345\ See, e.g., Dean Witter Letter; ICI Letter; Merrill Letter; 
    Morgan Stanley Letter; NASD Letter; NYSE Letter; PSE Letter; Salomon 
    Letter; Schwab II Letter; Specialist Assoc. Letter; STANY Letter.
    ---------------------------------------------------------------------------
    
        A common suggestion from the commenters is that the Commission not 
    adopt the proposed rule prior to evaluating the effects of the other 
    initiatives contained in the proposal.346 Some commenters believe 
    that the amendments to the Quote Rule and the proposed Limit Order 
    Display Rule should act to narrow spreads by eliciting the true market 
    for a given security, thereby decreasing the utility and necessity of 
    seeking better prices for customer orders. According to these 
    commenters, if such results are achieved through the other initiatives, 
    the potential costs and significant market operations changes 
    associated with the proposed Price Improvement Rule would far outweigh 
    any potential benefit.
    ---------------------------------------------------------------------------
    
        \346\ See, e.g., Bear Stearns Letter; Dean Witter Letter; DOJ 
    Letter; Goldman Sachs Letter; Lehman Letter; Madoff Letter; Morgan 
    Stanley Letter; NASD Letter; NSC Letter; Schwab II Letter; SIA 
    Letter; Sutro Letter.
    ---------------------------------------------------------------------------
    
        Although the Commission continues to believe that the opportunity 
    for price improvement can contribute to providing customer orders with 
    enhanced executions, the Commission has determined to defer action on 
    the proposed Price Improvement Rule for the present time. The 
    Commission believes that the other initiatives adopted today will 
    greatly improve the price discovery process and the opportunity for 
    customer orders to receive enhanced execution prices. These initiatives 
    should act to narrow spreads by making available to all market 
    participants the true buying and selling interest in a given security. 
    The Commission believes, therefore, that the most appropriate course of 
    action is to monitor the operation of the initiatives adopted today, 
    and assess their impact on spreads, the quality of markets, and the 
    quality of executions. This assessment will enable the Commission to 
    better determine the need for further Commission action regarding 
    specific price improvement obligations.
    2. Best Execution Obligations
        The proposed Price Improvement Rule was designed to complement the 
    long-standing duties of broker-dealers to seek to obtain best execution 
    of their customer orders; the Commission did not intend for the 
    proposed rule to modify this existing best execution 
    obligation.347 Therefore, the Commission's decision to defer 
    consideration of the proposed rule in no way should be taken as an 
    indication that the duty of best execution has been altered.
    ---------------------------------------------------------------------------
    
        \347\ Proposing Release at 49.
    ---------------------------------------------------------------------------
    
        A broker-dealer's duty of best execution derives from common law 
    agency principles and fiduciary obligations, and is incorporated both 
    in SRO rules and, through judicial and Commission decisions, in the 
    antifraud provisions of the federal securities laws.348 This duty 
    of best execution requires a broker-dealer to seek the most favorable 
    terms reasonably available under the circumstances for a customer's 
    transaction.349 The scope of this duty of best execution must 
    evolve as changes occur in the market that give rise to improved 
    executions for customer orders, including
    
    [[Page 48323]]
    
    opportunities to trade at more advantageous prices. As these changes 
    occur, broker-dealers' procedures for seeking to obtain best execution 
    for customer orders also must be modified to consider price 
    opportunities that become ``reasonably available.'' 350
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        \348\ See Market 2000 Study, Study V at V-1, 2 and sources cited 
    therein.
        \349\ See Market 2000 Concept Release, supra note 10; Market 
    2000 Study, Study V.
        \350\ Proposing Release at 7-10.
    ---------------------------------------------------------------------------
    
        In the past the Commission has recognized the practical necessity 
    of automating the handling of small orders, and has indicated that 
    automated routing or execution of customer orders is not necessarily 
    inconsistent with best execution.351 At the same time, the 
    Commission has emphasized that best execution obligations require that 
    broker-dealers routing orders for automatic execution must periodically 
    assess the quality of competing markets to assure that order flow is 
    directed to markets providing the most beneficial terms for their 
    customers' orders.352 While in the past quote-based executions in 
    OTC securities were generally recognized as satisfying best execution 
    obligations, the development of efficient new facilities has altered 
    what broker dealers must consider in seeking best execution of customer 
    orders.353 The Commission thus noted the importance of the 
    opportunity for price improvement as a factor in best execution, 
    speaking in the context of aggregate order handling decisions for both 
    listed and OTC stocks.354 Therefore, the Commission believes that 
    routing order flow for automated execution, or internally executing 
    order flow on an automated basis, at the best bid or offer quotation, 
    would not necessarily satisfy a broker-dealer's duty of best execution 
    for small orders in listed and OTC securities.355
    ---------------------------------------------------------------------------
    
        \351\ Id. at 8.
        \352\ Payment for Order Flow Release, supra note 23, at n. 30 
    and accompanying text; See Securities Exchange Act Release No. 37046 
    (March 29, 1996), 61 FR 15322 (April 5, 1996) (``CSE Approval 
    Order''); Securities Exchange Act Release No. 37045 (March 29, 
    1996), 61 FR 15318 (April 5, 1996) (``BSE Approval Order'').
        \353\ Proposing Release at 10.
        \354\ Id.; see also Payment for Order Flow Release, supra note 
    23 at text accompanying notes 31-33. See CSE Approval Order, supra 
    note 352; BSE Approval Order, supra note 352.
        \355\ Proposing Release at 9-10; see also note 360 and 
    accompanying text (factors relevant to best execution).
    ---------------------------------------------------------------------------
    
        Both the rule and the amendments adopted today should further 
    improve a broker-dealer's ability to obtain improved executions for 
    customer orders. These changes will enhance the public quote by 
    including in the public quotation system many superior prices not 
    currently reflected there. The ECN amendment is intended to publicize 
    superior market maker ECN prices in the public quote, which should make 
    these prices more easily accessible. Similarly, the Display Rule will 
    include more customer prices in the public quote through requiring the 
    display of customer limit orders.
        Nonetheless, various markets and market makers may continue to 
    provide opportunities for executions at prices superior to the enhanced 
    national best bid and offer for their customer orders.356 For 
    example, some markets or market makers may continue to offer price 
    improvement opportunities, based on internal order flow or execution 
    algorithms. The Commission believes that broker-dealers deciding where 
    to route or execute small customer orders in listed or OTC securities 
    must carefully evaluate the extent to which this order flow would be 
    afforded better terms if executed in a market or with a market maker 
    offering price improvement opportunities. In conducting the requisite 
    evaluation of its internal order handling procedures, a broker-dealer 
    must regularly and rigorously examine execution quality likely to be 
    obtained from the different markets or market makers trading a 
    security.357 If different markets may be more suitable for 
    different types of orders or particular securities, the broker-dealer 
    will also need to consider such factors.
    ---------------------------------------------------------------------------
    
        \356\ Id.
        \357\ CSE Approval Order, 61 FR at 15329. ``Price improvement'' 
    in this context is defined as the difference between execution price 
    and the best quotes prevailing in the market at the time the order 
    arrived at the market or market maker. Any evaluation of price 
    improvement opportunities would have to consider not only the extent 
    to which orders are executed at prices better than the prevailing 
    quotes, but also the extent to which orders are executed at inferior 
    prices.
    ---------------------------------------------------------------------------
    
        Where material differences exist between the price improvement 
    opportunities offered by markets or market makers, these differences 
    must be taken into account by the broker-dealer. Similarly, in 
    evaluating its procedures for handling limit orders, the broker-dealer 
    must take into account any material differences in execution quality ( 
    e.g., the likelihood of execution) among the various markets or market 
    centers to which limit orders may be routed. The traditional non-price 
    factors affecting the cost or efficiency of executions also should 
    continue to be considered; 358 however, broker-dealers must not 
    allow an order routing inducement, such as payment for order flow or 
    the opportunity to trade with that order as principal, to interfere 
    with its duty of best execution.359 Of course, as the Commission 
    has previously noted, in light of a broker-dealer's obligation to 
    assess the quality of the markets to which it routes packaged order 
    flow absent specific instructions from customers, the Commission does 
    not believe that a broker-dealer violates its best execution obligation 
    merely because it receives payment for order flow or trades as 
    principal with customer orders.360
    ---------------------------------------------------------------------------
    
        \358\ See Market 2000 Study, Study V at V-2, 3.
        \359\ Payment for Order Flow Release, supra note 23.
        \360\ Id.
    ---------------------------------------------------------------------------
    
        Prices superior to the public quote may at times be available in 
    ECNs, even after adoption of the ECN amendment, based, for example, on 
    orders of institutional participants and others not covered by the ECN 
    amendment. Superior prices also may be available in other systems not 
    classified as ECNs. As the Commission noted in the Proposing Release in 
    September, 1995, and reiterates today, where reliable, superior prices 
    are readily accessible in such systems, broker-dealers should consider 
    these prices in making decisions regarding the routing of customer 
    orders.361 The Commission recognizes that many of these systems 
    are less accessible and involve higher costs for broker-dealers than 
    the public markets. In addition, in many cases it is not currently 
    feasible to efficiently obtain price information from these systems or 
    link to these systems on an automated basis. The Commission is not 
    suggesting that broker-dealers must engage in manual handling of small 
    orders if necessary to access these systems.362 Nonetheless, the 
    Commission believes that because technology is rapidly making these 
    systems more accessible, broker-dealers must regularly evaluate whether 
    prices or other benefits offered by these systems are reasonably 
    available for purposes of seeking best execution of these customer 
    orders. For example, if an ECN provides an automated link that makes it 
    cost effective for a broker-dealer to access these systems for its 
    retail orders on an automated basis, the broker-dealer must take the 
    prices and other relevant costs in that system into account in handling 
    these customer orders.
    ---------------------------------------------------------------------------
    
        \361\ Proposing Release at 10.
        \362\ The Commission has recognized that it may be impractical, 
    both in terms of time and expense, for a broker that handles a large 
    volume of orders to determine individually where to route each order 
    it received. Proposing Release at 8.
    ---------------------------------------------------------------------------
    
        Pursuant to the Display Rule, most customer limit orders at 
    superior prices will be required to be displayed and
    
    [[Page 48324]]
    
    included in the public quote.363 The display of a limit order by a 
    market maker directly affects its responsibilities in handling other 
    customer orders. The Commission has long said that broker-dealers must 
    consider quotation information contained in the public quotation system 
    in seeking best execution of customer orders.364 In executing 
    customer market orders, a market maker must give no less consideration 
    to the price of its own displayed customer limit order than any other 
    public quotation price. Therefore, under the new Display Rule, a market 
    maker that has displayed a customer limit order would be expected to 
    provide an offsetting customer market order an execution at that limit 
    price at least up to the size of the limit order.
    ---------------------------------------------------------------------------
    
        \363\ The Commission notes that the NASD's interpretation 
    prohibiting market makers from trading ahead of customer limit 
    orders applies both to displayed and nondisplayed customer limit 
    orders held by the market maker. See NASD Conduct Rule IM 2110-2 
    (Trading Ahead of Customer Limit Orders).
        \364\ See Quote Rule Adopting Release, supra note 208.
    ---------------------------------------------------------------------------
    
        In addition, the Commission notes that currently, some market 
    makers that hold a customer limit order on one side of the market, 
    priced better than the market maker's own quote, and a customer market 
    order on the other side of the market, will execute both orders as 
    principal rather than crossing the two orders. As a result, the market 
    order customer receives the best bid and offer rather than receiving 
    the benefit of a better limit order price. In light of the increased 
    opportunities for price improvement now available and the rules the 
    Commission is adopting today, the Commission believes that going 
    forward this practice is no longer appropriate given the broker-
    dealer's obligation, as part of its duty of best execution, to its 
    market order customer.365
    ---------------------------------------------------------------------------
    
        \365\ Cf., NASD Notice to Members 96-10 (February, 1996) at 43; 
    NASD Notice to Members 95-67 (August, 1995) at 417.
    ---------------------------------------------------------------------------
    
        In conclusion, although the Commission has determined for the 
    present to defer final action on the proposed Price Improvement Rule, 
    the Commission's adoption of the Display Rule and the Quote Rule 
    amendments should substantially improve public quotations. Moreover, 
    the Commission firmly believes that broker-dealers, when deciding where 
    to route or execute customer orders, must carefully consider and 
    evaluate opportunities for obtaining improved executions.
    
    IV. Authority
    
        As discussed above, the 1975 Act Amendments to the Exchange Act set 
    forth Congress' goals for a national market system. Several commenters 
    argue that the proposed rules violate Congress's direction that the 
    Commission facilitate the establishment of, rather than design, a 
    national market system.366 Many of these comments were directed at 
    the proposed Price Improvement Rule and in particular the proposed 
    price improvement safe harbor. The Commission today is deferring action 
    on that rule proposal. To the extent that the comments relate to the 
    rule and amendments adopted today, however, they reflect a fundamental 
    misunderstanding regarding the purpose of the rules and the 
    Commission's role in facilitating a national market system.
    ---------------------------------------------------------------------------
    
        \366\ See, e.g., ABA Letter; Fahnestock Letter; HHG Letter; LJR 
    Letter; NSC Letter; PaineWebber Letter; RPM Letter; Ruane Letter; 
    SIA Letter.
    ---------------------------------------------------------------------------
    
        The Commission's adoption of these rules is fully consistent with 
    the role that Congress envisioned in 1975 for the Commission. 
    Congress's direction to the Commission to ``facilitate'' the 
    establishment of a national market system for securities that 
    implemented Congressionally enumerated objectives was not intended as a 
    limitation on the Commission's authority but rather was ``designed to 
    provide maximum flexibility to the Commission and the securities 
    industry in giving specific content to the general concept of the 
    national market system.'' 367 Congress granted the Commission 
    broad rulemaking authority over the national market system and market 
    participants and this grant of specific rulemaking authority was not 
    conditioned on the expectation that the Commission refrain from using 
    it.
    ---------------------------------------------------------------------------
    
        \367\ Conference Report, supra note 213, at 92. See Senate 
    Report, supra note 31, at 8-9 (``the sounder approach appeared * * * 
    to be to establish a statutory scheme clearly granting the 
    Commission broad authority to oversee the implementation, operation, 
    and regulation of the national market system and at the same time to 
    charging it with the clear responsibility to assure that the system 
    develops and operates in accordance with Congressional determined 
    goals and objectives.''). The Conference Committee report on the 
    1975 Act Amendments indicates that the conferees adopted with minor 
    revisions the Senate's provisions concerning the national market 
    system. Conference Report, supra note 213, at 92.
    ---------------------------------------------------------------------------
    
        Although Congress expressed a preference that where possible the 
    national market system evolve through the interplay of competitive 
    forces, it recognized that ``competition may not be sufficient'' and 
    that in such cases, the Commission should act ``promptly and 
    effectively to insure that the essential mechanisms of an integrated 
    secondary trading system [be] put into place * * *.'' 368 Congress 
    specifically identified in 1975 some of the concerns addressed today 
    and the Commission has examined these issues on several occasions over 
    the intervening years in response to evolving market conditions and 
    technologies. In view of the caution and deliberation with which the 
    Commission has proceeded over the past 21 years, its actions today 
    cannot fairly be viewed as arresting natural competitive forces, but 
    rather should be regarded as an attempt to foster efficiency and 
    redress shortcomings in the national market system that have developed 
    since then, or that the securities industry on its own has been unable 
    to resolve over this time.
    ---------------------------------------------------------------------------
    
        \368\ Conference Report, supra note 213 at 92.
    ---------------------------------------------------------------------------
    
        The subject matter of these rule and rule amendments is an area of 
    the national market system in which Congress itself recognized that the 
    Commission's expertise and authority were paramount. Indeed, Section 
    11A was specifically enacted to eliminate ``arguments about the SEC's 
    authority'' in this area. For that reason, the Commission was given 
    ``pervasive rulemaking power'' with respect to the business of 
    collecting, processing, or publishing information relating to 
    quotations for and transactions in securities.369 The rules 
    adopted today implement Congress' goals as to dissemination of trading 
    information: ``to insure the availability of prompt and accurate 
    trading information, to assure that these communications networks are 
    not controlled or dominated by any particular market center, to 
    guarantee fair access to such systems by all brokers, dealers and 
    investors, and to prevent any competitive restriction on their 
    operation not justified by the purposes of the Exchange Act.'' 370
    ---------------------------------------------------------------------------
    
        \369\ Conference Report, supra note 213, at 93.
        \370\ Senate Report, supra note 31.
    ---------------------------------------------------------------------------
    
        It bears noting that the standards adopted by the Commission today 
    are intended to allow markets to adapt and evolve in meeting the 
    objectives of the national market system; the rules establish 
    performance standards but do not dictate market structure. With regard 
    to the Quote Rule, the rules do not determine how non-Rule 19c-3 market 
    makers may make markets or how electronic communications networks may 
    operate. Non-Rule 19c-3 market makers are free to operate as they 
    please so long as they report their quotations to the extent they 
    execute a certain level of volume in a security. Likewise, market 
    makers and specialists may place priced orders in ECNs of many 
    different designs as long as they change their quotes to reflect the 
    orders in the ECN or the ECNs publicly report the quotes and provide 
    access to such
    
    [[Page 48325]]
    
    priced orders. With regard to the Limit Order Display Rule, the rule 
    does not seek to create a central limit order book or central limit 
    order file. Broker-dealers are free to satisfy the rule in several 
    different ways, so long as the result is that customer limit orders 
    priced at or better than the NBBO are publicly displayed.
        Some commenters also argue that the proposed rules are contrary to 
    Congress' direction to assure fair competition between auction and 
    dealer markets as structures for the trading of securities 371 and 
    inappropriately introduce auction market principles into dealer 
    markets. Although requiring display of superior-priced customer limit 
    orders could be viewed as an auction market principle, such a 
    requirement does not supplant the basic features of a dealer market or 
    undermine competition between the exchange and OTC markets. Congress 
    clearly intended that dealer markets would benefit from use of some 
    auction market principles 372 and the 1975 Amendments specifically 
    announce as a goal of the national market system that customer orders 
    be able to interact without the intervention of a dealer to the extent 
    that such a goal is consistent with other national market system 
    objectives.373 At a minimum, where feasible, customer limit orders 
    should have a meaningful opportunity to interact with customer market 
    orders.374
    ---------------------------------------------------------------------------
    
        \371\ See, e.g., Goldman Sachs Letter; Jefferies Letter; Merrill 
    Lynch Letter; RPM Letter; Schwab I Letter; Schwartz & Wood Letter; 
    SIA Letter; Specialist Assoc. Letter; see also Exchange Act Section 
    11A(a)(1)(C)(ii), 15 U.S.C. 78k-1(a)(1)(C)(ii).
        \372\ Senate Report, supra note 31, at 16.
        \373\ Exchange Act Section 11A(a)(1)(C)(v).
        \374\ Exchange Act Section 11A(a)(1)(C)(v).
    ---------------------------------------------------------------------------
    
        One of the main benefits contemplated by Congress was that the 
    national market system would enable investors in dealer markets to 
    execute against another limit order or market order at a better price 
    than currently being quoted by a dealer for his own account.375 
    Display of superior-priced limit orders would permit investors to 
    compete in some cases with market makers and specialists, thereby 
    increasing the competitiveness of dealer markets in these securities 
    and enhancing the quality of customer limit order execution. Display of 
    customer limit orders, however, would not compromise the essential 
    features of dealer markets. In the absence of any superior-priced 
    customer limit orders, dealers would continue to compete for market 
    orders at their published quotations and would be able to execute 
    against customer limit orders that would otherwise prevent the market 
    maker from trading with a market order. Further, the widespread use by 
    OTC dealers of ECNs to trade at prices better than the dealers' 
    published quotes is of such recent vintage that it can hardly be viewed 
    as a necessary part of a dealer market structure.376
    ---------------------------------------------------------------------------
    
        \375\ Senate Report supra note 31, at 16.
        \376\ While the rule and rule amendments adopted today function 
    as an integrated response to the problems the Commission has 
    identified in the implementation of a NMS, each separately advances 
    the Congressional goals of market efficiency, fair competition, 
    transparency, and best execution, and accordingly the Commission 
    intends that they be treated as severable for purposes of review.
    ---------------------------------------------------------------------------
    
    V. Summary of Final Regulatory Flexibility Act Analysis
    
        This following discussion summarizes the Commission's analysis of 
    the rules adopted today under the Regulatory Flexibility Act. A 
    complete final copy of the Final Regulatory Flexibility Act is 
    available in the Public File.
        The rules adopted today by the Commission are intended to allow 
    markets to adapt and evolve in meeting the objectives of the national 
    market system. In this regard, the rules establish performance 
    standards but do not dictate market structure. The Quote Rule does not 
    dictate how market makers or specialists that trade non-Rule 19c-3 
    securities may conduct their market making activities or how ECNs may 
    service their subscribers. Market makers will be able to continue their 
    regular market making activities so long as they report their 
    quotations if they trade more than 1% of the transaction volume in a 
    security. Likewise, market makers and specialists may place priced 
    orders in ECNs of many different designs as long as they change their 
    quotes to reflect better priced orders they have entered in ECNs or, 
    alternatively, such ECNs provide for the public reporting of these 
    prices and provide access to such priced orders. Moreover, broker-
    dealers are free to satisfy the Display Rule in several different ways, 
    so long as the result is that customer limit orders priced at or better 
    than the NBBO are publicly displayed in accordance with the rule.
    
    A. Display Rule
    
        The Commission considered several significant alternatives to Rule 
    11Ac1-4 consistent with the Rule's objectives and designed to minimize 
    the impact of the rule on small entities. The Commission solicited 
    comment on, among other things: (i) Whether the display requirement 
    should be based on a de minimis threshold; (ii) the classes of 
    securities to which the Rule should apply; (iii) whether to permit 
    limit orders to be delivered to an exchange- or association-sponsored 
    system that displays limit orders in accordance with the rule; and (iv) 
    whether to permit limit orders to be delivered to an ECN or a PTS. The 
    Commission believes that the rule as adopted imposes a smaller burden 
    upon small brokers and dealers than do other alternatives considered.
        The Commission believes that the ability of brokers and dealers to 
    send a limit order to another party or system that will display that 
    order provides all brokers and dealers, including small brokers and 
    dealers, with the greatest possible flexibility to satisfy the NMS 
    objectives embodied in the rule in the most economical manner. In this 
    regard, the Commission decided to expand one of the exceptions to the 
    display requirement that will permit market makers to comply with the 
    rule by delivering customer limit orders to an ECN that complies with 
    the ECN amendment to the Quote Rule. Furthermore, the Commission added 
    a new exemptive provision that enables the Commission to exempt any 
    responsible broker or dealer, ECN, exchange, or association from the 
    requirements of the Display Rule.
        The Commission considered allowing display of a representative size 
    of a limit order rather than the full size, but concluded that display 
    of the full size will provide the most accurate picture of the depth of 
    the market at a particular price. The Commission does not believe that 
    it is practicable to exempt small entities from the Display Rule 
    because to do so would be inconsistent with the Commission's statutory 
    mandate to protect investors. In that regard, the Commission believes 
    that the pricing and size conventions documented in the 21(a) Report 
    referenced above make it imperative that the requirements of the 
    Display Rule apply to all market participants with equal force. The 
    Commission notes that any exception for small brokers and dealers could 
    create an incentive for Nasdaq market makers to create special market 
    making subsidiaries qualifying as small broker-dealers which would be 
    free to engage in the anti-competitive practices identified in the 
    21(a) Report.
    
    B. Quote Rule
    
        Allowing market makers that deal actively in securities without 
    publicizing their activity or making available their prices undermines 
    the NMS goal of transparency. The Commission believes that those 
    dealers should be recognized as market makers and their quotations 
    publicized so that investors may know of, and trade on similar terms 
    with, those market makers. Therefore, the definition of OTC
    
    [[Page 48326]]
    
    market maker now includes any dealer holding itself out as willing to 
    transact business for its own account on a regular or continuous basis, 
    whether it transacts exclusively with its own customers or with the 
    customers of other dealers. Thus, those dealers that internalize 
    customer order flow in particular stocks or through arrangements with 
    other firms to execute that order flow, now fall within the definition 
    of OTC market maker and are subject to the obligations under the Quote 
    Rule. As in the past, broker-dealers will not be considered to be 
    holding themselves out as regularly or continuously willing to buy or 
    sell a security if they occasionally execute a trade as principal to 
    accommodate a customer's request. In response to the suggestions of 
    some commenters, the Commission has modified the amendment to make 
    clear that more than one isolated transaction is necessary before a 
    dealer is designated an OTC market maker.
        In addition, the Commission believes that extending the 1% 
    threshold based on quarterly aggregate trading volume to non-Rule 19c-3 
    securities is a reasonable method to improve the scope of quotation 
    information to include significant OTC market makers and specialists. 
    This 1% threshold, currently in effect for Rule 19c-3 securities, has 
    proved effective in supplying comprehensive quotation information to 
    the market at large. Moreover, based on the increase in third market 
    trading volume for these securities, the Commission does not believe 
    this standard is unduly burdensome on OTC market makers. Rather, the 
    Commission believes this threshold strikes a balance between requiring 
    the dissemination of all quotation interest and accommodating those 
    specialists and OTC market makers that may be small entities. The 
    Commission believes that OTC market makers and specialists that account 
    for 1% or less of the aggregate volume are not active enough to justify 
    the additional expense of providing continuous quotation display. 
    Accordingly, the Commission believes the ``greater than 1% aggregate 
    trading volume'' threshold for mandatory quotations continues to be 
    appropriate. To limit a possible inconsistency in the treatment of 
    exchange-listed and Nasdaq securities, the Commission today is 
    proposing that the 1% test be extended from all exchange-listed 
    securities to all Nasdaq-listed securities.
        The Commission considered several significant alternatives to the 
    proposed amendments to the Quote Rule consistent with the Rule's 
    objectives and designed to minimize the impact of the amendments on 
    small entities. The Commission solicited comment on numerous 
    alternatives to the amendments proposed to ensure that investors 
    receive consolidated quotations that truly reflect the best prices 
    available for a security. The Commission solicited comment on, among 
    other issues: (i) Whether the Commission should require SROs to amend 
    their rules to permit computer-generated quotations; (ii) whether there 
    existed alternatives to the ECN proposal that minimized certain 
    consequences of the rule while assuring public dissemination of the 
    best priced orders in such systems; (iii) whether there should be 
    exceptions to the ECN proposal and under what circumstances; and (iv) 
    whether the objectives of the Quote Rule and the ECN amendment could be 
    achieved by allowing ECNs to furnish prices to the applicable SRO, 
    while providing access to the prices in their ECN. The Commission 
    believes that the amendments as adopted impose a smaller burden upon 
    small brokers and dealers than does any other alternative considered.
        In recognition of the concerns raised by some commenters, the ECN 
    display alternative is designed to preserve the benefits associated 
    with the anonymity that certain ECNs currently offer to subscribing 
    market makers and specialists. This alternative also ensures that the 
    best market maker and specialist prices in the ECN are publicly 
    disseminated and that non-subscribing brokers and dealers may trade 
    with the orders represented by those prices. Under the display 
    alternative, the price of a specialist's or market maker's order 
    entered into an ECN would be publicly disseminated while the specialist 
    or market maker remains anonymous. This alternative not only preserves 
    anonymity, but also eliminates the risk that a market maker or 
    specialist may be exposed to multiple executions at the ECN price. With 
    the addition of the alternative, the ECN amendment permits the display 
    of the best price either in the specialist's or market maker's quote or 
    through an ECN that provides for the dissemination of the best market 
    maker and specialist prices entered into the ECN.
        The Commission also notes that the ECN display alternative reduces 
    the compliance burden on broker-dealers, including small entities, by 
    permitting specialists and market makers to comply with the ECN 
    amendment if the ECN into which the market maker's order is entered 
    ensures that the best market maker prices entered therein are 
    communicated to an exchange, association or securities information 
    processor and the ECN provides a means for brokers and dealers to trade 
    with the orders market makers and specialists put in the ECN.
        The Commission recognizes that the ECN display alternative may 
    reduce the content of information that is publicly available because 
    under this alternative, the identity of the market maker or specialist 
    that entered the better priced order in the ECN will be withheld. The 
    Commission believes this result is justified because the inside prices 
    and full sizes of orders entered by market makers and specialists will 
    be in the public quotation system to inform the entire market of these 
    prices and ECNs will provide equivalent access to those prices. 
    Moreover, the Commission believes the benefits of facilitating the use 
    of ECNs, by permitting the continued anonymity of market makers and 
    specialists, more than offset the reduced information available on the 
    identity of a particular market maker or specialist.
        The Commission believes the data it has reviewed supports the need 
    for prompt adoption of the ECN amendment to the Quote Rule. As 
    discussed more fully in the Appendix to the 21(a) Report, an analysis 
    of data for April through June 1994 shows that approximately 85% of 
    bids and offers displayed by market makers on Instinet and 90% of bids 
    and offers displayed on SelectNet (an ECN sponsored by the NASD) were 
    at better prices than those disseminated to the public via Nasdaq. In 
    addition, approximately 77% of trades executed on Instinet and 60% of 
    trades executed on SelectNet were at prices superior to the Nasdaq 
    inside spread. Given this strong evidence that investors would benefit 
    from public dissemination of these hidden prices that are broadly 
    disseminated to subscribers in these systems, the Commission believes 
    that it is appropriate to adopt the amendments to the Quote Rule.
        The Commission does not believe that it is practicable to exempt 
    small entities from the Quote Rule amendments because to do so would be 
    inconsistent with the Commission's statutory mandate to protect 
    investors. In this regard, the Commission notes the clear evidence of a 
    two-tiered market, in which market makers routinely trade at one price 
    with customers and at better prices with ECN participants. The 
    Commission believes that it is imperative to further the long-standing 
    objectives of the 1975 Amendments to ensure reliable and accurate 
    quotes by making these prices available to the public. The Commission 
    believes that any exception for small brokers and
    
    [[Page 48327]]
    
    dealers could create an incentive for Nasdaq market makers to create 
    special market making subsidiaries qualifying as small broker-dealers 
    which would be free to engage in the anti-competitive practices 
    identified in the 21(a) Report.
        A final copy of the Final Regulatory Flexibility Act analysis is 
    available in the Public File.
    
    VI. Paperwork Reduction Act
    
        As set forth in the Proposing Release,377 the proposed 
    amendments to Rule 11Ac1-1 and proposed Rule 11Ac1-4 contain 
    collections of information within the meaning of the Paperwork 
    Reduction Act (``PRA''). Accordingly, proposed amendments to Rule 
    11Ac1-1 and proposed Rule 11Ac1-4 were submitted to the Office of 
    Management and Budget (``OMB'') for review pursuant to Section 3507 of 
    the PRA (44 U.S.C. 3507), and were approved by OMB which assigned the 
    following control numbers: Amendments to Rule 11Ac1-1, control number 
    3235-0461; Rule 11Ac1-4, control number 3235-0462. An agency may not 
    conduct or sponsor, and a person is not required to respond to, a 
    collection of information unless it displays a valid OMB control 
    number. This is the final notice regarding the collection of 
    information under Rule 11Ac1-4, the Display Rule. A new notice 
    regarding the collections of information under Rule 11Ac1-1, the Quote 
    Rule, may be found in the Companion Release (published elsewhere in the 
    Federal Register today) which proposes an additional amendment to the 
    Quote Rule. The PRA section in the preamble of the Companion Release 
    provides new estimates of the burden in responding to the collections 
    of information under the Quote Rule as a whole.
    ---------------------------------------------------------------------------
    
        \377\ Proposing Release at 70.
    ---------------------------------------------------------------------------
    
        The reporting requirement in Rule 11Ac1-4 is found in 17 CFR 
    240.11Ac1-4. The collection of information is mandatory and responses 
    are not confidential. The respondents are OTC market makers, as defined 
    under the rule. (Although exchange specialists are also required to 
    follow the rule, as noted in the Proposing Release the Commission does 
    not anticipate any significant additional burden on exchange 
    specialists in light of current exchange order handling practices.) The 
    Rule requires market makers to change their published quotation to 
    reflect the price and/or size of a customer limit order that would 
    improve their published bid or offer or otherwise ensure that such 
    limit order is displayed. The burden on market makers will depend on 
    the extent and variety of their market-making activities and their 
    choice of the various compliance options offered by the regulations. 
    The ability of market makers to utilize facilities of national 
    securities exchanges, registered national securities associations, and 
    ECNs to comply with the reporting requirement should ease the 
    compliance burden. The proposed rule would have permitted market makers 
    to execute a limit order or send a limit order to another market maker 
    or exchange or association facility that would ensure display of such 
    orders in lieu of the market makers' own display. Rule 11Ac1-4 as 
    adopted maintains these alternatives and also permits respondents to 
    send a limit order to an ECN meeting certain criteria. The information 
    reported will be displayed to all persons who have access to a 
    quotation montage as that term is defined in 17 CFR 240.11Ac1-2(a)(16).
        The Commission carefully considered comments received from the NASD 
    and SIA concerning the Commission's burden estimates.378 The NASD 
    stated that the Commission underestimated the number of limit orders to 
    be displayed per trading day, given the NASD's view that Rule 11Ac1-4 
    will lead to increased limit order exposure. After considering the 
    NASD's comment, and based upon further review of the market data, the 
    Commission is revising its burden estimate for Rule 11Ac1-4 as follows. 
    There are approximately 570 respondents. Each respondent on average 
    will respond to the collection of information 42,000 times per year, 
    based on a 252 trading day year. The total time burden for each 
    respondent per year is estimated to be 35 hours, based on an estimate 
    of 3 seconds per response (i.e., the time it takes to update a quote to 
    reflect a limit order, or to transmit the order for display 
    elsewhere).379 The total annual aggregate burden for all 
    respondents is estimated to be 19,950 hours.
    ---------------------------------------------------------------------------
    
        \378\ The SIA noted that they join in the concerns expressed by 
    the NASD that the Commission's estimates under the PRA are too low, 
    and need to be revised and extended to include the proposed safe 
    harbor under Rule 11Ac1-5. SIA Letter at 4. As noted above, the 
    Commission is not adopting the Price Improvement Rule at this time.
        \379\ The NASD commented that it believes the PRA burden 
    estimate should include the time market makers spend analyzing 
    market trends and following quotation and last sale information. The 
    Commission has determined not to revise its burden estimate based on 
    this comment, because market makers otherwise engage in such 
    activities apart from the collection of information requirement. For 
    example, market makers are already required to monitor the markets 
    to ensure that they do not trade ahead of customer limit orders.
    ---------------------------------------------------------------------------
    
    VII. Effects on Competition
    
        Section 23(a)(2) of the Exchange Act 380 requires the 
    Commission to consider the anti-competitive effects of any rules it 
    adopts thereunder, and to balance them against the benefits that 
    further the purposes of the Act. As discussed above, several commenters 
    raised concerns regarding the competitive implications of the order 
    handling proposals.381 The foregoing discussion contains extensive 
    analysis of the competitive effects of both the rule and rule 
    amendments; this section summarizes the Commission's conclusions. The 
    Commission has considered the proposals in light of the comments and 
    the standard embodied in Section 23(a)(2) and has concluded any burdens 
    on competition imposed by the Display Rule and the amendments to the 
    Quote Rule are necessary and appropriate in furtherance of the purposes 
    of the Exchange Act, in particular, the purposes of Section 11A.
    ---------------------------------------------------------------------------
    
        \380\ 15 U.S.C. 78w(a)(2).
        \381\ See ABA Letter; HHG Letter; NASD Letter.
    ---------------------------------------------------------------------------
    
        The Commission notes that the primary burden imposed by the Display 
    Rule will be to require exchange specialists and OTC market makers to 
    ensure that customer limit orders improving their quotes are displayed. 
    The Commission believes that if systems upgrades are necessary, those 
    systems upgrades reflect one-time charges. The Commission also notes 
    that ensuring public dissemination of limit orders enhances market 
    transparency, increases pricing efficiency, and quote-based 
    competition, and permits investors' orders to interact with all 
    available market interest. Moreover, the limit order display rule will 
    provide an opportunity for investors to compete directly in the market. 
    This additional competition should limit certain anticompetitive 
    practices identified in the 21(a) Report and discussed supra. For the 
    reasons discussed above, the Commission does not believe the Display 
    Rule will have a significantly different effect on wholesale and retail 
    market makers.382 The Commission notes that the Antitrust Division 
    of the U.S. Department of Justice similarly concluded that the Display 
    Rule will promote competition and will thereby benefit the investing 
    public.
    ---------------------------------------------------------------------------
    
        \382\ See supra note 124 and accompanying text.
    ---------------------------------------------------------------------------
    
        Similarly, the Commission notes that the primary burden imposed by 
    the ECN Amendment to the Quote Rule will be to require exchange 
    specialists and OTC market makers to add personnel or upgrade systems 
    to ensure that their quotes reflect priced orders entered into those 
    ECNs that do not disseminate
    
    [[Page 48328]]
    
    order information to the relevant exchange or association. The 
    Commission believes that such systems upgrades reflect one-time 
    charges. The Commission believes that the ECN amendment to the Quote 
    Rule will impose only limited competitive burdens on ECNs. ECNs which 
    have attributes that differentiate them from other types of electronic 
    order routing and order execution systems, will have a choice whether 
    to disseminate order information to the relevant exchanges or 
    association. While choosing this alternative will result in some system 
    costs, the Commission believes that the alternative will provide ECNs 
    with additional business opportunities, including increased order flow. 
    The ECN amendment should allow ECNs to function as valuable facilities 
    for their subscribers, and should not harm ECNs significantly in their 
    competition with other order execution systems.383 The Commission 
    also notes that ensuring public dissemination of market makers' and 
    specialists' priced orders entered into ECNs enhances market 
    transparency, pricing efficiency, price competition, and allows 
    investors' orders to interact with all available market interest.
    ---------------------------------------------------------------------------
    
        \383\ Although the Antitrust Division of the U.S. Department of 
    Justice expressed concerns about the effects of the ECN amendment as 
    originally proposed, the Commission believes that with the quote 
    dissemination alternative, the amendment will not impose any 
    unnecessary or inappropriate burdens on competition.
    ---------------------------------------------------------------------------
    
        Finally, with respect to the amendments extending the Mandatory 
    Quote Rule to non-Rule 19c-3 securities, the primary burden imposed 
    will be to require certain brokers and dealers to register as CQS 
    market makers and make continuous two-sided quotes available to the 
    public. The Commission believes that the benefit to the investing 
    public of ensuring that available market interest is disseminated to 
    the public will enhance competition by facilitating the routing of 
    investor orders to the market center displaying the best quotation for 
    a security. The Commission believes that the added transparency 
    resulting from the amendment outweighs any burden to competition that 
    may be imposed.
    
    List of Subjects in 17 CFR Part 240
    
        Broker-dealers, Confidential business information, Reporting and 
    recordkeeping requirements, and Securities.
    
    Text of the Rules
    
        For the reasons set out in the preamble, the Commission amends Part 
    240 of Chapter II of Title 17 of the Code of Federal Regulation as 
    follows:
    
    PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
    1934
    
        1. The general authority citation for Part 240 is revised to read 
    as follows:
    
        Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 
    77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1, 78l, 78m, 
    78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-
    23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
    * * * * *
        2. Section 240.11Aa3-1 is amended by revising paragraph (a)(4) to 
    read as follows:
    
    
    Sec. 240.11Aa3-1  Dissemination of transaction reports and last sale 
    data with respect to transactions in reported securities.
    
        (a) Definitions. * * *
        (4) The term reported security shall mean any security or class of 
    securities for which transaction reports are collected, processed and 
    made available pursuant to an effective transaction reporting plan.
    * * * * *
        3. Section 240.11Ac1-1 is revised to read as follows:
    
    
    Sec. 240.11Ac1-1  Dissemination of quotations.
    
        (a) Definitions. For the purposes of this section:
        (1) The term aggregate quotation size shall mean the sum of the 
    quotation sizes of all responsible brokers or dealers who have 
    communicated on any exchange bids or offers for a covered security at 
    the same price.
        (2) The term association shall mean any association of brokers and 
    dealers registered pursuant to Section 15A of the Act (15 U.S.C. 78o-
    3).
        (3) The terms best bid and best offer shall mean the highest priced 
    bid and the lowest priced offer.
        (4) The terms bid and offer shall mean the bid price and the offer 
    price communicated by an exchange member or OTC market maker to any 
    broker or dealer, or to any customer, at which it is willing to buy or 
    sell one or more round lots of a covered security, as either principal 
    or agent, but shall not include indications of interest.
        (5) The term consolidated system shall mean the consolidated 
    transaction reporting system.
        (6) The term covered security shall mean any reported security and 
    any other security for which a transaction report, last sale data or 
    quotation information is disseminated through an automated quotation 
    system as described in Section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 
    78c(a)(51)(A)(ii)).
        (7) The term effective transaction reporting plan shall have the 
    meaning provided in Sec. 240.11Aa3-1(a)(3).
        (8) The term electronic communications network, for the purposes of 
    Sec. 240.11Ac1-1(c)(5), shall mean any electronic system that widely 
    disseminates to third parties orders entered therein by an exchange 
    market maker or OTC market maker, and permits such orders to be 
    executed against in whole or in part; except that the term electronic 
    communications network shall not include:
        (i) Any system that crosses multiple orders at one or more 
    specified times at a single price set by the ECN (by algorithm or by 
    any derivative pricing mechanism) and does not allow orders to be 
    crossed or executed against directly by participants outside of such 
    times; or
        (ii) Any system operated by, or on behalf of, an OTC market maker 
    or exchange market maker that executes customer orders primarily 
    against the account of such market maker as principal, other than 
    riskless principal.
        (9) The term exchange market maker shall mean any member of a 
    national securities exchange (``exchange'') who is registered as a 
    specialist or market maker pursuant to the rules of such exchange.
        (10) The term exchange-traded security shall mean any covered 
    security or class of covered securities listed and registered, or 
    admitted to unlisted trading privileges, on an exchange; provided, 
    however, That securities not listed on any exchange that are traded 
    pursuant to unlisted trading privileges are excluded.
        (11) The term make available, when used with respect to bids, 
    offers, quotation sizes and aggregate quotation sizes supplied to 
    quotation vendors by an exchange or association, shall mean to provide 
    circuit connections at the premises of the exchange or association 
    supplying such data, or at a common location determined by mutual 
    agreement of the exchanges and associations, for the delivery of such 
    data to quotation vendors.
        (12) The term odd-lot shall mean an order for the purchase or sale 
    of a covered security in an amount less than a round lot.
        (13) The term OTC market maker shall mean any dealer who holds 
    itself out as being willing to buy from and sell to its customers, or 
    otherwise, a covered security for its own account on a regular or 
    continuous basis otherwise than on an exchange in amounts of less than 
    block size.
    
    [[Page 48329]]
    
        (14) The term plan processor shall have the meaning provided in 
    Sec. 240.11Aa3-2(a)(7).
        (15) The term published aggregate quotation size shall mean the 
    aggregate quotation size calculated by an exchange and displayed by a 
    quotation vendor on a terminal or other display device at the time an 
    order is presented for execution to a responsible broker or dealer.
        (16) The terms published bid and published offer shall mean the bid 
    or offer of a responsible broker or dealer for a covered security 
    communicated by it to its exchange or association pursuant to this 
    section and displayed by a quotation vendor on a terminal or other 
    display device at the time an order is presented for execution to such 
    responsible broker or dealer.
        (17) The term published quotation size shall mean the quotation 
    size of a responsible broker or dealer communicated by it to its 
    exchange or association pursuant to this section and displayed by a 
    quotation vendor on a terminal or other display device at the time an 
    order is presented for execution to such responsible broker or dealer.
        (18) The term quotation size, when used with respect to a 
    responsible broker's or dealer's bid or offer for a covered security, 
    shall mean:
        (i) The number of shares (or units of trading) of that covered 
    security which such responsible broker or dealer has specified, for 
    purposes of dissemination to quotation vendors, that it is willing to 
    buy at the bid price or sell at the offer price comprising its bid or 
    offer, as either principal or agent; or
        (ii) In the event such responsible broker or dealer has not so 
    specified, a normal unit of trading for that covered security.
        (19) The term quotation vendor shall mean any securities 
    information processor engaged in the business of disseminating to 
    brokers, dealers or investors on a real-time basis, bids and offers 
    made available pursuant to this section, whether distributed through an 
    electronic communications network or displayed on a terminal or other 
    display device.
        (20) The term reported security shall mean any security or class of 
    securities for which transaction reports are collected, processed and 
    made available pursuant to an effective transaction reporting plan.
        (21) The term responsible broker or dealer shall mean:
        (i) When used with respect to bids or offers communicated on an 
    exchange, any member of such exchange who communicates to another 
    member on such exchange, at the location (or locations) designated by 
    such exchange for trading in a covered security, a bid or offer for 
    such covered security, as either principal or agent; provided, however, 
    That, in the event two or more members of an exchange have communicated 
    on such exchange bids or offers for a covered security at the same 
    price, each such member shall be considered a ``responsible broker or 
    dealer'' for that bid or offer, subject to the rules of priority and 
    precedence then in effect on that exchange; and further provided, That 
    for a bid or offer which is transmitted from one member of an exchange 
    to another member who undertakes to represent such bid or offer on such 
    exchange as agent, only the last member who undertakes to represent 
    such bid or offer as agent shall be considered the ``responsible broker 
    or dealer'' for that bid or offer; and
        (ii) When used with respect to bids and offers communicated by a 
    member of an association to another broker or dealer or to a customer 
    otherwise than on an exchange, the member communicating the bid or 
    offer (regardless of whether such bid or offer is for its own account 
    or on behalf of another person).
        (22) The term revised bid or offer shall mean a market maker's bid 
    or offer which supersedes its published bid or published offer.
        (23) The term revised quotation size shall mean a market maker's 
    quotation size which supersedes its published quotation size.
        (24) The term specified persons, when used in connection with any 
    notification required to be provided pursuant to paragraph (b)(3) of 
    this section and any election (or withdrawal thereof) permitted under 
    paragraph (b)(5) of this section, shall mean:
        (i) Each quotation vendor;
        (ii) Each plan processor; and
        (iii) The processor for the Options Price Reporting Authority (in 
    the case of a notification for a subject security which is a class of 
    securities underlying options admitted to trading on any exchange).
        (25) The term subject security shall mean:
        (i) With respect to an exchange:
        (A) Any exchange-traded security other than a security for which 
    the executed volume of such exchange, during the most recent calendar 
    quarter, comprised one percent or less of the aggregate trading volume 
    for such security as reported in the consolidated system; and
        (B) Any other covered security for which such exchange has in 
    effect an election, pursuant to paragraph (b)(5)(i) of this section, to 
    collect, process, and make available to quotation vendors, bids, 
    offers, quotation sizes, and aggregate quotation sizes communicated on 
    such exchange; and
        (ii) With respect to a member of an association:
        (A) Any exchange-traded security for which such member acts in the 
    capacity of an OTC market maker unless the executed volume of such 
    member, during the most recent calendar quarter, comprised one percent 
    or less of the aggregate trading volume for such security as reported 
    in the consolidated system; and
        (B) Any other covered security for which such member acts in the 
    capacity of an OTC market maker and has in effect an election, pursuant 
    to paragraph (b)(5)(ii) of this section, to communicate to its 
    association bids, offers and quotation sizes for the purpose of making 
    such bids, offers and quotation sizes available to quotation vendors.
        (b) Dissemination requirements for exchanges and associations. (1) 
    Every exchange and association shall establish and maintain procedures 
    and mechanisms for collecting bids, offers, quotation sizes and 
    aggregate quotation sizes from responsible brokers or dealers who are 
    members of such exchange or association, processing such bids, offers 
    and sizes, and making such bids, offers and sizes available to 
    quotation vendors, as follows:
        (i) Each exchange shall at all times such exchange is open for 
    trading, collect, process and make available to quotation vendors the 
    best bid, the best offer, and aggregate quotation sizes for each 
    subject security listed or admitted to unlisted trading privileges 
    which is communicated on any exchange by any responsible broker or 
    dealer, but shall not include:
        (A) Any bid or offer executed immediately after communication and 
    any bid or offer communicated by a responsible broker or dealer other 
    than an exchange market maker which is cancelled or withdrawn if not 
    executed immediately after communication; and
        (B) Any bid or offer communicated during a period when trading in 
    that security has been suspended or halted, or prior to the 
    commencement of trading in that security on any trading day, on that 
    exchange.
        (ii) Each association shall, at all times that last sale 
    information with respect to reported securities is reported pursuant to 
    an effective transaction reporting plan, collect, process and make 
    available to quotation vendors the best bid, best offer, and quotation 
    sizes communicated otherwise than on an exchange by each member of such 
    association acting in the capacity of an
    
    [[Page 48330]]
    
    OTC market maker for each subject security and the identity of that 
    member (excluding any bid or offer executed immediately after 
    communication), except during any period when over-the-counter trading 
    in that security has been suspended.
        (2) Each exchange shall, with respect to each published bid and 
    published offer representing a bid or offer of a member for a subject 
    security, establish and maintain procedures for ascertaining and 
    disclosing to other members of that exchange, upon presentation of 
    orders sought to be executed by them in reliance upon paragraph (c)(2) 
    of this section, the identity of the responsible broker or dealer who 
    made such bid or offer and the quotation size associated with it.
        (3)(i) If, at any time an exchange is open for trading, such 
    exchange determines, pursuant to rules approved by the Securities and 
    Exchange Commission pursuant to section 19(b)(2) of the Act (15 U.S.C. 
    78s(b)(2)), that the level of trading activities or the existence of 
    unusual market conditions is such that the exchange is incapable of 
    collecting, processing, and making available to quotation vendors the 
    data for a subject security required to be made available pursuant to 
    paragraph (b)(1) of this section in a manner that accurately reflects 
    the current state of the market on such exchange, such exchange shall 
    immediately notify all specified persons of that determination. Upon 
    such notification, responsible brokers or dealers that are members of 
    that exchange shall be relieved of their obligation under paragraph 
    (c)(2) of this section and such exchange shall be relieved of its 
    obligations under paragraphs (b) (1) and (2) of this section for that 
    security: provided, however, That such exchange will continue, to the 
    maximum extent practicable under the circumstances, to collect, 
    process, and make available to quotation vendors data for that security 
    in accordance with paragraph (b)(1) of this section.
        (ii) During any period an exchange, or any responsible broker or 
    dealer that is a member of that exchange, is relieved of any obligation 
    imposed by this section for any subject security by virtue of a 
    notification made pursuant to paragraph (b)(3)(i) of this section, such 
    exchange shall monitor the activity or conditions which formed the 
    basis for such notification and shall immediately renotify all 
    specified persons when that exchange is once again capable of 
    collecting, processing, and making available to quotation vendors the 
    data for that security required to be made available pursuant to 
    paragraph (b)(1) of this section in a manner that accurately reflects 
    the current state of the market on such exchange. Upon such 
    renotification, any exchange or responsible broker or dealer which had 
    been relieved of any obligation imposed by this section as a 
    consequence of the prior notification shall again be subject to such 
    obligation.
        (4) Nothing in this section shall preclude any exchange or 
    association from making available to quotation vendors indications of 
    interest or bids and offers for a subject security at any time such 
    exchange or association is not required to do so pursuant to paragraph 
    (b)(1) of this section.
        (5)(i) Any exchange may make an election for purposes of paragraph 
    (a)(25)(i)(B) of this section for any covered security, by collecting, 
    processing, and making available bids, offers, quotation sizes, and 
    aggregate quotation sizes in that security; except that for any covered 
    security previously listed or admitted to unlisted trading privileges 
    on only one exchange and not traded by any OTC market maker, such 
    election shall be made by notifying all specified persons, and shall be 
    effective at the opening of trading on the business day following 
    notification.
        (ii) Any member of an association acting in the capacity of an OTC 
    market maker may make an election for purposes of paragraph 
    (a)(25)(ii)(B) of this section for any covered security, by 
    communicating to its association bids, offers, and quotation sizes in 
    that security; except that for any other covered security listed or 
    admitted to unlisted trading privileges on only one exchange and not 
    traded by any other OTC market maker, such election shall be made by 
    notifying its association and all specified persons, and shall be 
    effective at the opening of trading on the business day following 
    notification.
        (iii) The election of an exchange or member of an association for 
    any covered security pursuant to this paragraph (b)(5) shall cease to 
    be in effect if such exchange or member ceases to make available or 
    communicate bids, offers, and quotation sizes in such security.
        (c) Obligations of responsible brokers and dealers. (1) Each 
    responsible broker or dealer shall promptly communicate to its exchange 
    or association, pursuant to the procedures established by that exchange 
    or association, its best bids, best offers, and quotation sizes for any 
    subject security.
        (2) Subject to the provisions of paragraph (c)(3) of this section, 
    each responsible broker or dealer shall be obligated to execute any 
    order to buy or sell a subject security, other than an odd-lot order, 
    presented to it by another broker or dealer, or any other person 
    belonging to a category of persons with whom such responsible broker or 
    dealer customarily deals, at a price at least as favorable to such 
    buyer or seller as the responsible broker's or dealer's published bid 
    or published offer (exclusive of any commission, commission equivalent 
    or differential customarily charged by such responsible broker or 
    dealer in connection with execution of any such order) in any amount up 
    to its published quotation size.
        (3)(i) No responsible broker or dealer shall be obligated to 
    execute a transaction for any subject security as provided in paragraph 
    (c)(2) of this section to purchase or sell that subject security in an 
    amount greater than such revised quotation if:
        (A) Prior to the presentation of an order for the purchase or sale 
    of a subject security, a responsible broker or dealer has communicated 
    to its exchange or association, pursuant to paragraph (c)(1) of this 
    section, a revised quotation size; or
        (B) At the time an order for the purchase or sale of a subject 
    security is presented, a responsible broker or dealer is in the process 
    of effecting a transaction in such subject security, and immediately 
    after the completion of such transaction, it communicates to its 
    exchange or association a revised quotation size, such responsible 
    broker or dealer shall not be obligated by paragraph (c)(2) of this 
    section to purchase or sell that subject security in an amount greater 
    than such revised quotation size.
        (ii) No responsible broker or dealer shall be obligated to execute 
    a transaction for any subject security as provided in paragraph (c)(2) 
    of this section if:
        (A) Before the order sought to be executed is presented, such 
    responsible broker or dealer has communicated to its exchange or 
    association pursuant to paragraph (c)(1) of this section, a revised bid 
    or offer; or
        (B) At the time the order sought to be executed is presented, such 
    responsible broker or dealer is in the process of effecting a 
    transaction in such subject security, and, immediately after the 
    completion of such transaction, such responsible broker or dealer 
    communicates to its exchange or association pursuant to paragraph 
    (c)(1) of this section, a revised bid or offer; provided, however, That 
    such responsible broker or dealer shall nonetheless be obligated to 
    execute any such order in such subject security as provided in 
    paragraph (c)(2) of this section at its revised bid or offer in any
    
    [[Page 48331]]
    
    amount up to its published quotation size or revised quotation size.
        (4) Subject to the provisions of paragraph (b)(4) of this section:
        (i) No exchange or OTC market maker may make available, disseminate 
    or otherwise communicate to any quotation vendor, directly or 
    indirectly, for display on a terminal or other display device any bid, 
    offer, quotation size, or aggregate quotation size for any covered 
    security which is not a subject security with respect to such exchange 
    or OTC market maker; and
        (ii) No quotation vendor may disseminate or display on a terminal 
    or other display device any bid, offer, quotation size, or aggregate 
    quotation size from any exchange or OTC market maker for any covered 
    security which is not a subject security with respect to such exchange 
    or OTC market maker.
        (5)(i) Entry of any priced order for a covered security by an 
    exchange market maker or OTC market maker in that security into an 
    electronic communications network that widely disseminates such order 
    shall be deemed to be:
        (A) A bid or offer under this section, to be communicated to the 
    market maker's exchange or association pursuant to paragraph (c) of 
    this section for at least the minimum quotation size that is required 
    by the rules of the market maker's exchange or association if the 
    priced order is for the account of a market maker, or the actual size 
    of the order up to the minimum quotation size required if the priced 
    order is for the account of a customer; and
        (B) A communication of a bid or offer to a quotation vendor for 
    display on a display device for purposes of paragraph (c)(4) of this 
    section.
        (ii) An exchange market maker or OTC market maker that has entered 
    a priced order for a covered security into an electronic communications 
    network that widely disseminates such order shall be deemed to be in 
    compliance with paragraph (c)(5)(i)(A) of this section if the 
    electronic communications network:
        (A) Provides to an exchange or association (or an exclusive 
    processor acting on behalf of one or more exchanges or associations) 
    the prices and sizes of the orders at the highest buy price and the 
    lowest sell price for such security entered in, and widely disseminated 
    by, the electronic communications network by exchange market makers and 
    OTC market makers for the covered security, and such prices and sizes 
    are included in the quotation data made available by the exchange, 
    association, or exclusive processor to quotation vendors pursuant to 
    this section; and
        (B) Provides, to any broker or dealer, the ability to effect a 
    transaction with a priced order widely disseminated by the electronic 
    communications network entered therein by an exchange market maker or 
    OTC market maker that is:
        (1) Equivalent to the ability of any broker or dealer to effect a 
    transaction with an exchange market maker or OTC market maker pursuant 
    to the rules of the exchange or association to which the electronic 
    communications network supplies such bids and offers; and
        (2) At the price of the highest priced buy order or lowest priced 
    sell order, or better, for the lesser of the cumulative size of such 
    priced orders entered therein by exchange market makers or OTC market 
    makers at such price, or the size of the execution sought by the broker 
    or dealer, for the covered security.
        (d) Exemptions. The Commission may exempt from the provisions of 
    this section, either unconditionally or on specified terms and 
    conditions, any responsible broker or dealer, electronic communications 
    network, exchange, or association if the Commission determines that 
    such exemption is consistent with the public interest, the protection 
    of investors and the removal of impediments to and perfection of the 
    mechanism of a national market system.
        4. Section 240.11Ac1-4 is added to read as follows:
    
    
    Sec. 240.11Ac1-4  Display of customer limit orders.
    
        (a) Definitions. For purposes of this section:
        (1) The term association shall mean any association of brokers and 
    dealers registered pursuant to Section 15A of the Act (15 U.S.C. 78o-
    3).
        (2) The terms best bid and best offer shall have the meaning 
    provided in Sec. 240.11Ac1-1(a)(3).
        (3) The terms bid and offer shall have the meaning provided in 
    Sec. 240.11Ac1-1(a)(4).
        (4) The term block size shall mean any order:
        (i) Of at least 10,000 shares; or
        (ii) For a quantity of stock having a market value of at least 
    $200,000.
        (5) The term covered security shall mean any ``reported security'' 
    and any other security for which a transaction report, last sale data 
    or quotation information is disseminated through an automated quotation 
    system as described in section 3(a)(51)(A)(ii) of the Act (15 U.S.C. 
    78c(a)(51)(A)(ii)).
        (6) The term customer limit order shall mean an order to buy or 
    sell a covered security at a specified price that is not for the 
    account of either a broker or dealer; provided, however, That the term 
    customer limit order shall include an order transmitted by a broker or 
    dealer on behalf of a customer.
        (7) The term electronic communications network shall have the 
    meaning provided in Sec. 240.11Ac1-1(a)(8).
        (8) The term exchange-traded security shall have the meaning 
    provided in Sec. 240.11Ac1-1(a)(10).
        (9) The term OTC market maker shall mean any dealer who holds 
    itself out as being willing to buy from and sell to its customers, or 
    otherwise, a covered security for its own account on a regular or 
    continuous basis otherwise than on a national securities exchange in 
    amounts of less than block size.
        (10) The term reported security shall have the meaning provided in 
    Sec. 240.11Ac1-1(a)(20).
        (b) Specialists and OTC market makers. For all covered securities:
        (1) Each member of an exchange that is registered by that exchange 
    as a specialist, or is authorized by that exchange to perform functions 
    substantially similar to that of a specialist, shall publish 
    immediately a bid or offer that reflects:
        (i) The price and the full size of each customer limit order held 
    by the specialist that is at a price that would improve the bid or 
    offer of such specialist in such security; and
        (ii) The full size of each customer limit order held by the 
    specialist that:
        (A) Is priced equal to the bid or offer of such specialist for such 
    security;
        (B) Is priced equal to the national best bid or offer; and
        (C) Represents more than a de minimis change in relation to the 
    size associated with the specialist's bid or offer.
        (2) Each registered broker or dealer that acts as an OTC market 
    maker shall publish immediately a bid or offer that reflects:
        (i) The price and the full size of each customer limit order held 
    by the OTC market maker that is at a price that would improve the bid 
    or offer of such OTC market maker in such security; and
        (ii) The full size of each customer limit order held by the OTC 
    market maker that:
        (A) Is priced equal to the bid or offer of such OTC market maker 
    for such security;
        (B) Is priced equal to the national best bid or offer; and
        (C) Represents more than a de minimis change in relation to the 
    size associated with the OTC market maker's bid or offer.
    
    [[Page 48332]]
    
        (c) Exceptions. The requirements in paragraph (b) of this section 
    shall not apply to any customer limit order:
        (1) That is executed upon receipt of the order.
        (2) That is placed by a customer who expressly requests, either at 
    the time that the order is placed or prior thereto pursuant to an 
    individually negotiated agreement with respect to such customer's 
    orders, that the order not be displayed.
        (3) That is an odd-lot order.
        (4) That is a block size order, unless a customer placing such 
    order requests that the order be displayed.
        (5) That is delivered immediately upon receipt to an exchange or 
    association-sponsored system, or an electronic communications network 
    that complies with the requirements of Sec. 240.11Ac1-1(c)(5)(ii) with 
    respect to that order.
        (6) That is delivered immediately upon receipt to another exchange 
    member or OTC market maker that complies with the requirements of this 
    section with respect to that order.
        (7) That is an ``all or none'' order.
        (d) Exemptions. The Commission may exempt from the provisions of 
    this section, either unconditionally or on specified terms and 
    conditions, any responsible broker or dealer, electronic communications 
    network, exchange, or association if the Commission determines that 
    such exemption is consistent with the public interest, the protection 
    of investors and the removal of impediments to and perfection of the 
    mechanism of a national market system.
    
        Dated: September 6, 1996.
    
        By the Commission.
    Margaret H. McFarland,
    Deputy Secretary.
    [FR Doc. 96-23210 Filed 9-11-96; 8:45 am]
    BILLING CODE 8010-01-P
    
    
    

Document Information

Published:
09/12/1996
Department:
Securities and Exchange Commission
Entry Type:
Rule
Action:
Final Rules.
Document Number:
96-23210
Dates:
January 10, 1997. For specific phase-in dates for the Display Rule, see section III.A.3.d of this Release.
Pages:
48290-48332 (43 pages)
Docket Numbers:
Release No. 34-37619A, File No. S7-30-95
RINs:
3235-AG66: Amendments to Rule 11Ac1-1 (Quote Rule), Proposed Rule 11Ac1-4 Limit Order Display
RIN Links:
https://www.federalregister.gov/regulations/3235-AG66/amendments-to-rule-11ac1-1-quote-rule-proposed-rule-11ac1-4-limit-order-display
PDF File:
96-23210.pdf
CFR: (8)
17 CFR 240.11Aa3-2(a)(7)
17 CFR 240.11Ac1-1(a)(4)
17 CFR 240.11Ac1-1(a)(20)
17 CFR 240.11Ac1-1(c)(5)
17 CFR 240.11Ac1-4(c)(4)
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