02-28427. Self-Regulatory Organizations; Order Approving Proposed Rule Change by the Philadelphia Stock Exchange, Inc. Relating to PACE Guarantee Exemption

November 1, 2002.

I. Introduction

On September 12, 2002, the Philadelphia Stock Exchange, Inc. (“Phlx” or “Exchange”) submitted to the Securities and Exchange Commission (“SEC” or “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”),^[1] and Rule 19b-4 thereunder,^[2] a proposed rule change to exempt specialists from the requirement to execute certain orders that are traded-through by another market if those orders are for the exchange-traded funds (“ETFs”) tracking the Nasdaq-100 Index (“QQQs”), the Dow Jones Industrial Average (“DIAMONDs”), and the Standard & Poor's 500 Index (“SPDRs”).^[3]

The proposed rule change was published for comment in the Federal Register on October 2, 2002.^[4] No comments were received on the proposal. This order approves the proposal.

II. Description of the Proposal

A. Background

The Phlx is a participant in the Intermarket Trading System (“ITS”). The ITS is an order routing network designed to facilitate intermarket trading in exchange-listed equity securities among participating self-regulatory organizations (“SROs”) based on current quotation information emanating from their markets. The terms of the linkage are governed by the ITS Plan, a national market system plan approved by the Commission pursuant to Section 11A of the Act and Rule 11Aa3-2 thereunder.^[5]

Section 8(d)(i) of the ITS Plan provides that absent reasonable justification or excuse, a member of a Participant Exchange should not effect trade-throughs.^[6] If, however, a trade-through does occur and a complaint is received through ITS from the party whose bid or offer was traded through, the party who initiated the trade-through may be required to satisfy the bid or offer traded through or take other remedial action.^[7] Each Participant Exchange, including the Phlx,^[8] has adopted and obtained Commission approval of a “trade-through rule,” which is substantively the same as that provided in the ITS Plan.

In a recent Order, the Commission recognized that the ITS trade-through provisions were designed to encourage market participants to display their trading interest, and to help achieve best execution for customer orders in exchange-listed securities.^[9] The Commission also acknowledged, however, that these rules were designed at a time when “the order routing and execution facilities of markets were much slower, intermarket competition was less keen, and the minimum quote increment for exchange-listed securities was 1/8 of a dollar ($ 0.125).”^[10] The Commission noted that with the introduction of decimal pricing and technology changes that greatly reduced execution times, the trade-through provisions of the ITS Plan have limited the ability of a Participant to provide an automated execution when a better price is displayed by another Participant that does not offer automated executions.^[11] In support of this conclusion, the Commission explained that certain electronic systems are able to deliver executions in a fraction of a second, while ITS participants have, at a minimum, thirty seconds to respond to a commitment to trade. Because of this, “an ITS Participant seeking to execute a transaction at a price inferior to the price quoted by another ITS Participant must generally either (i) attempt to access the other Participant's quote, which could delay the customer's transaction by thirty seconds or more, or (ii) become potentially liable to the other Participant for the amount by which its quote was traded through.”^[12]

In its Order, the Commission stated that the ITS trade-through provisions were particularly restrictive in the case of the QQQs, DIAMONDs and SPDRs, as these ETFs are highly liquid securities, and their value is derived from the values of the underlying shares. The Commission noted that immediate execution of these securities might be more important than the opportunity to obtain a better price to certain investors.^[13] To address this issue, the Commission granted a de minimis exemption from the trade-through provisions of the ITS Plan with respect to transactions in the QQQs, DIAMONDs and SPDRs that are effected at a price no more than three cents away from the best bid and offer quoted in the Consolidated Quote System (“CQS”). This exemption, which went into effect on September 4, 2002 and will remain in effect until June 4, 2003, allows Participants to execute transactions, through automatic execution or otherwise, without attempting to access the quotes of other Participants when the expected price improvement would not be significant.^[14]

B. Applicability to the Phlx

Phlx Rule 229.10(a)(iii) requires a Phlx specialist to execute certain orders that are traded-through by another market center.^[15] Although the Exchange Rule imposes this obligation on the specialist, the specialist is entitled to satisfaction of those orders pursuant to Section 8(d) of the ITS Plan. However, for trade-throughs that are enumerated in the ITS Exemption Order and therefore are no longer prohibited by the ITS Plan, the specialist does not have recourse to seek satisfaction for these orders and is alone responsible for those executions. Therefore, the Phlx believes that its provision guaranteeing an execution no longer makes sense, and further believes that the provision now unduly burdens specialists by requiring a specialist to execute orders in situations where the specialist does not have access to trading at that price. Thus, the Exchange is proposing to amend Phlx Rule 229 Supplementary Material Section 10(a)(iii) to state that the obligations described therein shall not apply to the ETFs that are the subject of the ITS Exemption Order for so long as the exemption granted in the order remains in effect.

III. Discussion

After careful review, the Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange.^[16] In particular, the Commission finds that the proposed rule is consistent with the requirements of Section 6(b)(5) of the Act ^[17] because it is designed to facilitate transactions in securities; to remove impediments to and perfect the mechanism of a free and open market and a national market system; and, in general, to protect investors and the public interest; and is not designed to permit unfair discrimination between customers, issuers, brokers or dealers.

By adopting the proposed exemption, the Exchange removes the specialist's obligation to provide trade-through protection in situations where it will not be permitted to seek satisfaction through ITS from the primary market. This obligation was one the Phlx assumed voluntarily in order to make its market more attractive to sources of order flow, not an obligation the Act imposes on a market. The Commission believes that the business decision to potentially forego order flow by no longer providing print protection is a judgment the Act allows the Phlx to make.^[18]

IV. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the Act,^[19] that the proposed rule change (SR-Phlx-2002-49) is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[20]

Jill M. Peterson,

Assistant Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  The Exchange does not currently trade DIAMONDs or SPDRs but may determine to do so in the future. The Exchange does trade QQQs.

4.  See Securities Exchange Act Release No. 46545 (September 24, 2002), 67 FR 61944. The proposed rule change is currently in effect as a pilot. See Securities Exchange Act Release Nos. 46481 (September 10, 2002), 67 FR 58669 (September 17, 2002)(notice of immediate effectiveness of pilot for the period September 4, 2002 to October 4, 2002); 46615 (October 8, 2002), 67 FR 63723 (October 15, 2002)(notice of immediate effectiveness of extension of pilot to November 3, 2002.)

5.  See Securities Exchange Act Release No. 19456 (January 27, 1983), 48 FR 4938 (February 3, 1983). The SROs participating in ITS include the American Stock Exchange LLC (“Amex”), the Boston Stock Exchange, Inc. (“BSE”), the Chicago Board Options Exchange, Inc. (“CBOE”), the Chicago Stock Exchange, Inc. (“CSE”), the Cincinnati Stock Exchange, Inc. (“Cincinnati”), the National Association of Securities Dealers, Inc. (“NASD”), the New York Stock Exchange, Inc. (“NYSE”), the Pacific Stock Exchange, Inc. (“PCX”), and the Phlx (collectively “Participant Exchanges”).

6.  A trade-through results when a member purchases (or sells) a security at a price that is higher (lower) than the price offered in one or more of the other ITS participant's markets. See ITS Plan, Section 8(d)(i).

7.  See ITS Plan, Exhibit B.

8.  See Phlx Rule 2001A.

9.  See Securities Exchange Act Release No. 46428 (August 28, 2002), 67 FR 56607 (September 4, 2002) at 56607 (“ITS Exemption Order”).

10.  Id.

11.  Id.

12.  Id. at 56607-8.

13.  Id.

14.  Id. at 56608.

15.  Specifically, this Rule provides that if 100 or more shares print through the limit price on any exchange(s) eligible to compose the PACE Quote, which is the best bid/ask quote among the Amex, BSE, Cincinnati, CSE, NYSE, PCX, Phlx, and the Intermarket Trading System/Computer Assisted Execution System (“ITS/CAES”), after the time of entry of any such order into PACE, the specialist shall execute all such orders at the limit price without waiting for an accumulation of 1000 shares to price at the limit price on the NYSE. See also Phlx Rule 229, Supplementary Material Section .10(a)(ii).

16.  In approving this rule proposal, the Commission notes that it has also considered the proposed rule's impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

17.  15 U.S.C. 78f(b)(5).

18.  The Commission notes that the Phlx's proposed rule change will remain in effect only until the expiration of the Commission's ITS Exemption Order on June 4, 2003.

19.  15 U.S.C. 78f(b)(2).

20.  17 CFR 200.30-3(a)(12).