Proposed Rule2022-27617
Order Competition Rule
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
January 3, 2023
Issuing agencies
Securities and Exchange Commission
Abstract
The Securities and Exchange Commission ("Commission") is proposing to amend the regulation governing the national market system ("NMS") under the Securities Exchange Act of 1934 ("Exchange Act") to add a new rule designed to promote competition as a means to protect the interests of individual investors and to further the objectives of an NMS. The proposed rule would prohibit a restricted competition trading center from internally executing certain orders of individual investors at a price unless the orders are first exposed to competition at that price in a qualified auction operated by an open competition trading center. The proposed rule would also include limited exceptions to this general prohibition. In addition, the Commission is proposing to amend the regulation governing the NMS to add new defined terms included in the proposed rule.
Full Text
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[Federal Register Volume 88, Number 1 (Tuesday, January 3, 2023)]
[Proposed Rules]
[Pages 128-245]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2022-27617]
[[Page 127]]
Vol. 88
Tuesday,
No. 1
January 3, 2023
Part II
Securities and Exchange Commission
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17 CFR Parts 240 and 242
Order Competition Rule; Proposed Rule
Federal Register / Vol. 88 , No. 1 / Tuesday, January 3, 2023 /
Proposed Rules
[[Page 128]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-96495; File No. S7-31-22]
RIN 3235-AM57
Order Competition Rule
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing to amend the regulation governing the national market system
(``NMS'') under the Securities Exchange Act of 1934 (``Exchange Act'')
to add a new rule designed to promote competition as a means to protect
the interests of individual investors and to further the objectives of
an NMS. The proposed rule would prohibit a restricted competition
trading center from internally executing certain orders of individual
investors at a price unless the orders are first exposed to competition
at that price in a qualified auction operated by an open competition
trading center. The proposed rule would also include limited exceptions
to this general prohibition. In addition, the Commission is proposing
to amend the regulation governing the NMS to add new defined terms
included in the proposed rule.
DATES: Comments should be received on or before March 31, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
<bullet> Use the Commission's internet comment form (<a href="https://www.sec.gov/rules/submitcomments.htm">https://www.sec.gov/rules/submitcomments.htm</a>); or
<bullet> Send an email to <a href="/cdn-cgi/l/email-protection#b0c2c5dcd59dd3dfddddd5dec4c3f0c3d5d39ed7dfc6"><span class="__cf_email__" data-cfemail="3745425b521a54585a5a525943447744525419505841">[email protected]</span></a>. Please include
File Number S7-31-22 on the subject line.
Paper Comments
<bullet> Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-31-22. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's website (<a href="http://www.sec.gov/rules/proposed.shtml">http://www.sec.gov/rules/proposed.shtml</a>).
Comments are also available for website viewing and printing in the
Commission's Public Reference Room, 100 F Street NE, Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. Operating conditions may limit access to the Commission's Public
Reference Room. All comments received will be posted without change.
Persons submitting comments are cautioned that the Commission does not
redact or edit personal identifying information from comment
submissions. You should submit only information that you wish to make
available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any materials will
be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at <a href="http://www.sec.gov">www.sec.gov</a> to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Dan Gray, Senior Special Counsel,
Jennifer Dodd, Special Counsel, or Stacia Sowerby, Special Counsel, at
(202) 551-5500, Office of Market Supervision, Division of Trading and
Markets, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment amendments to Regulation NMS [17 CFR 242.600 through 242.614]
(``Regulation NMS'') that would add new 17 CFR 242.615 (``Proposed Rule
615''), add new defined terms to 17 CFR 242.600 (``Rule 600'') that are
used in Proposed Rule 615, and make conforming amendments to defined
terms in 17 CFR 242.602, 17 CFR 242.611, and 17 CFR 242.614; and
conforming amendments to defined terms in 17 CFR 240.3a51-1, 17 CFR
240.13h-1, 17 CFR 242.105, 17 CFR 242.201, 17 CFR 242.204, and 17 CFR
242.1000.
Table of Contents
I. Introduction
II. Overview of Market Structure for NMS Stocks
A. Investors
B. Trading Centers
C. Order Types and Trading Costs
D. Quantitative Measures of Order Execution Quality and Trading
Costs
1. Description of Quantitative Measures
2. Examples of Calculating Measures of Order Execution Quality
and Trading Costs
III. Statutory and Regulatory Background
A. Statutory Framework for an NMS
B. Current Regulatory Components of the NMS for NMS Stocks
1. Rules Addressing Consolidated Market Data
2. Rules Addressing Order Handling and Execution
3. Rules Addressing Access to Trading Centers
4. Disclosure of Order Routing Practices and Order Execution
Statistics
IV. Description of Proposed Rule 615
A. Overview of Order Competition Requirement
B. Coverage of Proposed Rule 615
1. Definition of Segmented Order
2. Definition of Open Competition Trading Center
3. Definition of Restricted Competition Trading Center
4. Definition of Originating Broker
5. Exceptions
C. Qualified Auction Requirements
1. Auction Messages
2. Auction Responses
3. Pricing Increment
4. Fees and Rebates
5. Auction Execution Priority
D. Open Competition Trading Center Requirements
E. Originating Broker Requirements
F. Broker-Dealer Requirements
G. National Securities Exchange Requirements
V. Request for Comment
VI. Paperwork Reduction Act Analysis
A. Summary of Collection of Information
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
B. Proposed Use of Information
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
C. Respondents
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
D. Burdens
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures for Excluding
Subscribers
E. Collection of Information Is Mandatory
F. Confidentiality of Information Collected
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
G. Retention Period for Recordkeeping Requirements
H. Request for Comments
VII. Economic Analysis
A. Introduction
B. Baseline
1. Competition for Liquidity Provision in NMS Stocks
[[Page 129]]
2. Segmentation of Individual Investor Order Flow
3. Institutional Investor Interactions With Retail Orders
4. Execution Quality of Individual Investor Marketable Orders in
NMS Stocks
5. Variation in Wholesaler Execution Quality
6. Retail Broker Services
7. Rules Addressing Consolidated Market Data
C. Economic Effects
1. Benefits
2. Costs
3. Competition
4. Efficiency
5. Capital Formation
D. Reasonable Alternatives
1. Variation in Provisions Regarding Segmentation and Routing
2. Alternate Definitions of Segmented Orders
3. Variation in Auction Design
4. Variation in Exceptions to the Order Competition Requirement
5. Variation in the Definition of Open Competition Trading
Centers
6. Wholesaler Information Barriers
7. Display Quotes in Retail Liquidity Programs
8. Creation of a Retail Best Bid and Offer
9. Disclosure of Execution Quality of Individual Investor Orders
E. Request for Comments
VIII. Regulatory Flexibility Act Certification
IX. Consideration of Impact on the Economy
Statutory Authority
I. Introduction
The Commission is proposing a new rule, Proposed Rule 615 of
Regulation NMS, entitled the ``Order Competition Rule,'' to promote a
more competitive, transparent, and efficient market structure for NMS
stocks, with resulting benefits to investors. Proposed Rule 615 would
require that certain orders of individual investors be exposed to
competition in fair and open auctions, before such orders could be
executed internally by trading centers that restrict order-by-order
competition.\1\ The Commission believes that the proposal would better
advance each of the five Congressional objectives for an NMS set forth
in section 11A of the Exchange Act.\2\ In particular, Proposed Rule 615
is designed to benefit individual investors by promoting competition
and transparency as means to enhance the opportunity for their orders
to receive more favorable prices than they receive in the current
market structure, as well as to benefit investors generally by giving
them an opportunity to interact directly with a large volume of
individual investor orders that are mostly inaccessible to them in the
current market structure. This section provides an overview of that
market structure and how that market structure may impact investors.
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\1\ ``Order-by-order'' competition in this context means an
opportunity to compete to trade with individual investor orders by
offering the most favorable price for each order based on the
particular characteristics of the order, including the nature of the
NMS stock, the size of the order, and market conditions at the time
the order is submitted. Section II below provides an overview of the
current market structure for NMS stocks, including descriptions of
key terms used in this release that readers may find useful to
assess and comment on the Commission's proposal. Among many others,
these terms include ``individual investors,'' ``trading centers,''
and ``wholesalers.''
\2\ 15 U.S.C. 78k-1 (``section 11A''). These objectives are: (1)
economically efficient execution of securities transactions; (2)
fair competition among brokers and dealers, among exchange markets,
and between exchange markets and markets other than exchange
markets; (3) the availability to brokers, dealers, and investors of
information with respect to quotations for and transactions in
securities; (4) the practicability of brokers executing investors'
orders in the best market; and (5) an opportunity, consistent with
objectives 1 and 4, for investors' orders to be executed without the
participation of a dealer. 15 U.S.C. 78k-1(a)(1)(C).
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As discussed in sections II and VII below, individual investors
primarily use market orders and marketable limit orders (collectively
known as ``marketable orders'') to trade in NMS stocks. Market
participants who use these orders seek to trade immediately at the best
available prices in the market. Broker-dealers route more than 90% of
marketable orders of individual investors in NMS stocks to a small
group of six off-exchange dealers, often referred to as
``wholesalers.'' \3\ The wholesaling business is highly concentrated,
with two firms capturing approximately 66% of the executed share volume
of wholesalers as of the first quarter of 2022.\4\ The practice of
separately identifying and routing the marketable orders of individual
investors to wholesalers is a form of ``segmentation.'' The term
``segmentation'' can refer to any practice by which a certain category
of orders is identified and treated differently for execution than
other categories of orders.
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\3\ Table 3, infra, section VII.B.2.a.
\4\ See infra note 372.
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As discussed in the economic analysis in section VII.B.2 below,
individual investor orders are segmented because they are ``low-cost''
flow--they impose lower adverse selection costs on liquidity providers
than the unsegmented order flow routed to national securities
exchanges. ``Adverse selection'' involves situations where buyers and
sellers have different information, and specifically for a liquidity
provider, refers to the extent to which prices move against it after a
trade. For example, if the price of a stock drops right after a
liquidity provider buys it, the liquidity provider has suffered from
adverse selection. Generally, the more severe the adverse selection,
the larger the ``effective spread'' that would be expected for a trade
because liquidity providers require a wider effective spread to
compensate them for the higher cost of adverse selection.\5\ In this
respect, the size of effective spreads can be interpreted as a measure
of the average adverse selection that liquidity providers expect to
suffer when trading with incoming orders. Data analysis conducted for
this proposal reveals that the average adverse selection costs of
orders routed to wholesalers are far lower than the average adverse
selection costs of orders routed to national securities exchanges.\6\
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\5\ As explained in more detail in section II.D below, the
``effective spread'' of a trade is measured as double the difference
between the trade's execution price and the midpoint of the national
best bid and offer at the time of order receipt. Adverse selection
reflects the ``price impact'' of a trade, which is measured as the
difference between the midpoint of the national best bid and offer
at the time of the trade and the midpoint of the national best bid
and offer at a specified time (e.g., one minute or five minutes)
after the time of the trade.
\6\ Table 7, infra, section VII.B.4 (adverse selection costs, as
measured by price impact, of marketable orders of individual
investors in all NMS stocks are 71% lower at wholesalers (1.26 basis
points) than on exchanges (4.40 basis points)).
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The primary benefit of segmentation for individual investors is
that it can provide an opportunity for their low-cost orders to be
executed at better prices than those generally available on national
securities exchanges, a practice known as ``price improvement.'' \7\ As
discussed in section VII below, wholesalers often provide some price
improvement relative to the best publicly quoted prices for round lot
sizes on national securities exchanges.\8\
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\7\ Section VII.B.4 below discusses an analysis of wholesaler
trading data indicating the relationship between segmentation,
adverse selection costs, and order execution quality.
\8\ Table 5, infra, section VII.B.4 (83.17% of marketable orders
routed to wholesalers receive price improvement when compared to the
best publicly quoted prices for round lot sizes on national
securities exchanges, and 8.78% of marketable orders routed to
national securities exchanges receive such price improvement). These
better prices are due in large part to the ability of wholesalers to
offer sub-penny prices that are not permitted on national securities
exchanges and other trading centers. The current rules that govern
sub-penny trading are discussed in section III.B.2.c below.
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Price improvement, however, is not the same as competitive order
execution. Today, the primary business model of wholesalers is to trade
bilaterally as principal with individual investor orders (a form of
``internalization''). Typically, the way broker-dealers choose a
wholesaler for any particular order is not based on the
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price the wholesaler is willing to provide for that order, as
wholesalers do not display or otherwise indicate in real-time the
prices at which they are willing to trade with individual investor
orders. Instead, a wholesaler is often chosen by a formula that depends
on past execution quality of the wholesaler, its relationship with the
broker-dealer, and other factors. In addition, the bilateral nature of
the wholesaler business model not only restricts contemporaneous
competition among wholesalers, it also restricts opportunities for
other market participants to trade with the low-cost flow. Once a
wholesaler receives an individual investor's marketable order, the
wholesaler's execution of the order does not face competition at all--
the wholesaler typically executes the order internally without
providing any opportunity for other market participants, including
institutional investors, to compete to provide more favorable prices
for the order.\9\ This lack of order-by-order competition among market
participants is particularly significant in the market for NMS stocks,
which is an order-driven market in which a wide range of market
participants, including institutional investors, seek to provide
liquidity on national securities exchanges by posting orders for the
approximately 12,000 NMS stocks. In contrast, the listed options market
is a quote-driven market in which professional market makers dominate
liquidity provision by displaying quotes in the more than 1,000,000
different options series. In sum, in the current market structure for
NMS stocks, individual investor orders are not merely segmented; they
also are isolated from order-by-order competition by a wide range of
market participants, which, as discussed below, can affect the prices
that individual investors receive for their orders.
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\9\ As shown in Table 7, infra, section VII.B.4, wholesalers
execute internally (in ``principal transactions'') 90.44% of the
dollar volume of executed marketable orders routed to them. As
discussed in section VII.B.2.b below, wholesalers primarily obtain
external executions of the remaining volume of the marketable orders
in ``riskless principal'' transactions.
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Data analysis suggests that opening up individual investor orders
to order-by-order competition would lead to significantly better prices
for those investors. In a fully competitive market, competition among
liquidity providers would be expected to drive the amount of price
improvement that an order receives to a level commensurate with its
adverse selection cost (setting aside other relevant costs). All else
equal, the lower an order's expected adverse selection cost, the
greater would be the order's expected price improvement. However, as
discussed in section VII.C.1.b below, the current isolation of
individual investor orders from order-by-order competition results in
suboptimal price improvement for such orders. The Commission labels
this forgone price improvement ``competitive shortfall.'' Based on an
analysis of trading data from the wholesalers and national securities
exchanges in the first quarter of 2022, the competitive shortfall is
estimated to be approximately 1.08 basis points per dollar traded by
wholesalers or 1.08 cents for every $100 traded, with an estimated
total annual competitive shortfall of $1.5 billion.\10\
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\10\ Table 18 and Table 19, infra, section VII.C.1.b (figures in
text are for the CAT rebate base competitive shortfall estimates).
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In addition to this competitive shortfall, the isolation of
individual investor orders at wholesalers prevents other investors from
having an opportunity to trade with this low-cost flow. Institutional
investors that currently submit their own marketable orders on national
securities exchanges and other trading centers potentially could trade
at better prices if given an opportunity to interact with the
marketable orders of individual investors in fair and open
auctions.\11\ For example, data analysis indicates that undisplayed
liquidity often is available at trading centers other than wholesalers
when a wholesaler executes marketable orders of individual investors at
prices less favorable for the individual investor than the prices of
the undisplayed liquidity.\12\ Moreover, if institutional investors
that currently pay a full ``spread'' (that is, the difference between
the highest price bid and the lowest price offer) to access liquidity
were able instead to interact in auctions with the marketable orders of
individual investors that currently are mostly inaccessible to them,
these institutional investors could benefit from lower spread
costs.\13\
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\11\ See, e.g., section VII.B.3, infra, discussing institutional
investor interactions with retail orders.
\12\ Table 20, infra, section VII.C.1.b.
\13\ See, e.g., Section VII.C.1.c, infra, discussing potential
improved execution quality for institutional investor orders.
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The Commission is proposing Rule 615 to encourage greater
competition for individual investor order execution. Proposed Rule 615
generally would require that individual investor orders be exposed to
order-by-order competition in fair and open auctions designed to obtain
the best prices before such orders could be internalized by wholesalers
or any other type of trading center that restricts order-by-order
competition. As a result, individual investor orders could continue to
receive the benefits of segmentation (i.e., better prices that reflect
the low adverse selection costs of those orders), but without the
negative effects of those orders being isolated from order-by-order
competition (i.e., such better prices not fully reflecting the low
adverse selection costs of those orders; and a substantial percentage
of those orders seldom being accessible to institutional investors and
other market participants). In sum, the auctions required by Proposed
Rule 615 are intended to enhance competitive forces as a means to
protect the interests of investors in the NMS.
In developing the specific elements of Proposed Rule 615, the
Commission has been guided by this goal of benefiting investors by
enhancing competition. The overriding objective of these elements of
Proposed Rule 615 is to maximize the opportunity for a wide range of
market participants to participate in auctions on terms that will
promote the best possible prices for the orders of individual
investors. In this respect, the Commission has drawn from its
experience with the operation of existing auctions for orders in listed
options and tailored Proposed Rule 615 to promote fair and open
auctions that reflect the particular nature of the market for NMS
stocks. As discussed in section IV below, these elements would include
the wide dissemination of auction messages in consolidated market data,
requirements that any fees and rebates be capped at a low level
($0.0005 per share for auction prices of $1 or more) and be flat across
all market participants, and requirements for execution priority of
auction responses that give no advantage to the broker-dealer that
routed the marketable order of an individual investor to the auction.
In addition, the Commission has limited the scope of Proposed Rule
615 to contexts in which an auction could be most beneficial for
individual investors. For example, individual investors that trade many
times per day tend to use marketable orders that pose higher adverse
selection risk for liquidity providers; hence, their orders would be
outside the scope of the rule.\14\ In addition, proposed exceptions are
provided for orders with a market value of $200,000 or more and for
orders with execution prices (including prices constrained by non-
marketable limit prices) that are very favorable for individual
investors (i.e., the midpoint of the best displayed round lot
[[Page 131]]
quotations or better).\15\ These exceptions would not be mandatory,
however, which means that broker-dealers could choose whether or not to
route orders with these characteristics to an auction.
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\14\ See infra section IV.B.1; section VII.D.2.c.
\15\ As discussed in section IV.B.1 below, a subset of non-
marketable limit orders with prices not as favorable for individual
investors (i.e., beyond the midpoint of the best displayed round lot
quotations) would not qualify for the proposed exceptions.
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As discussed in section VII.D, the Commission assessed several
alternatives to Proposed Rule 615, both to the design of the required
auctions and to the auction approach itself. The Commission
preliminarily considers Proposed Rule 615 to be the best approach for
investors. As described throughout this release, and in more detail in
section IV, Proposed Rule 615 is designed to maintain the price
improvement benefits of the segmentation of individual investor orders
and to enhance those benefits through the introduction of order-by-
order competition with a wide range of market participants, including
institutional investors, through an auction mechanism that is fast,
low-cost, transparent, and fair.
The next two sections of this release are intended to provide
background information on the current structure and regulation of the
market for NMS stocks that will help promote understanding of the
details of the Commission's proposal. Section II provides a general
overview of the current market structure for NMS stocks, and section
III provides background on the statutory and regulatory framework for
NMS stocks. Section IV then describes the proposal in detail, and
section V consolidates all Commission requests for comment on the
proposal.
II. Overview of Market Structure for NMS Stocks
This section provides an overview of the market structure for NMS
stocks,\16\ particularly focusing on the types of market participants,
order types, and trading costs that will be referred to throughout this
release.\17\ An understanding of the current market structure,
particularly the trading costs of different types of market
participants, including liquidity takers and liquidity providers, is
critically important when assessing the rationale and objectives of
Proposed Rule 615.
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\16\ NMS stocks generally include equity securities other than
options that are listed on a national securities exchange. Rule
600(b)(55) of Regulation NMS defines ``NMS stock'' as any NMS
security other than an option, and Rule 600(b)(54) defines ``NMS
security'' to mean any security or class of securities for which
transaction reports are collected, processed, and made available
pursuant to an effective transaction reporting plan, or an effective
NMS plan for reporting transactions in listed options. The
definition of NMS stock does not include securities that are not
listed on a national securities exchange, sometimes referred to as
``over-the-counter'' or ``OTC'' securities.
\17\ A much more extensive discussion of the ``market
microstructure'' of securities markets is provided by treatises on
the subject. See, e.g., Larry Harris, Trading and Exchanges: Market
Microstructure for Practitioners (Oxford University Press 2003)
(``Harris Treatise''); Joel Hasbrouck, Empirical Market
Microstructure: The Institutions, Economics, and Econometrics of
Securities Trading (Oxford University Press 2007) (``Hasbrouck
Treatise'').
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A. Investors
Section 11A(a)(2) of the Exchange Act \18\ provides that the
Commission should have due regard for the protection of ``investors''
when facilitating the establishment of an NMS. As used in this release,
the term ``individual investor'' will refer to natural persons that
trade relatively infrequently for their own or closely related
accounts.\19\ Individual investors generally trade in relatively small
sizes that can be executed against immediately available liquidity.
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\18\ 15 U.S.C. 78k-1(a)(2).
\19\ For a discussion of the specific orders covered by Proposed
Rule 615, see Proposed Rule 600(b)(91) (defining the term
``segmented order'') and section IV.B.1 below (discussing the
proposed definition of ``segmented order''). As discussed in section
IV.B, the Commission is proposing to add definitions to Rule 600(b)
of Regulation NMS and adjust the numbering of current definitions
accordingly. Throughout this release, unless otherwise noted,
references to existing Rule 600(b) definitions are to the
definitions as they are currently numbered. References to proposed
new definitions are designated with ``Proposed Rule 600(b)'' and
reflect the proposed adjusted numbering.
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The term ``institutional investor'' as used in this release refers
to investors that trade in much larger sizes and much more frequently
than individual investors. Many institutional investors, such as
pension funds and mutual funds, operate on behalf of a large number of
individuals. Because institutional investors need to trade in large
sizes that can exceed immediately available liquidity, their large
``parent'' orders typically will be broken into smaller ``child''
orders. Institutional investors typically are focused primarily on
obtaining the best price for their large parent orders as a whole.\20\
The child orders will be fed into the market gradually so as to
minimize the extent to which market prices move away before the full
size of a parent order is executed, which is known as ``slippage.'' One
means for institutional investors to minimize slippage is to limit
``information leakage'' concerning the unexecuted portions of their
large parent orders by closely controlling the impact of the execution
of their child orders on market prices.
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\20\ See, e.g., Securities Exchange Act Release No. 61358 (Jan.
14, 2010), 75 FR 3594, 3604-3605 (Jan. 21, 2010) (``Equity Market
Structure Concept Release'') (measuring the transaction costs of
institutional investors ``can be extremely complex'' because their
``large orders often are broken up into smaller child orders and
executed in a series of transactions'' and ``[m]etrics that apply to
small order executions may miss how well or poorly the large order
traded overall.'').
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B. Trading Centers
Trades in NMS stocks are executed at a number of different types of
trading centers.\21\ As discussed below, trading centers that currently
trade NMS stocks can be divided into five categories: (1) national
securities exchanges operating SRO trading facilities; \22\ (2)
alternative trading systems (``ATSs'') that trade NMS stocks (``NMS
Stock ATSs''); (3) exchange market makers; (4) wholesalers; and (5) any
other broker-dealer that executes orders internally by trading as
principal or crossing orders as agent.\23\
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\21\ Rule 600(b)(95) of Regulation NMS defines ``trading
center'' as a national securities exchange or national securities
association that operates a self-regulatory organization (``SRO'')
trading facility, an alternative trading system, an exchange market
maker, an OTC market maker, or any other broker or dealer that
executes orders internally by trading as principal or crossing
orders as agent.
\22\ Rule 600(b)(89) of Regulation NMS defines ``SRO trading
facility'' as, among other things, a facility operated by a national
securities exchange that executes orders in a security.
\23\ ``Broker'' is generally defined in section 3(a)(4)(A) of
the Exchange Act as any person engaged in the business of effecting
transactions in securities for the account of others. 15 U.S.C.
78c(a)(4)(A). ``Dealer,'' in turn, is generally defined in section
3(a)(5)(A) of the Exchange Act as any person engaged in the business
of buying and selling securities for such person's own account
through a broker or otherwise. 15 U.S.C. 78c(a)(5)(A). The term
``broker-dealer'' is used in this release to encompass all brokers,
all dealers, and firms that are both brokers and dealers.
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National securities exchanges, among other things, operate SRO
trading facilities that bring together purchasers and sellers of NMS
stocks and execute their trades, fall within the definition of an
exchange in section 3(a)(1) of the Exchange Act,\24\ and are required
to register under section 6 of the Exchange Act.\25\ As discussed
further in section III.A below, national securities exchanges are
subject to a comprehensive regulatory regime that, among other things,
requires that their rules not impose any burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act and not be designed to permit unfair discrimination between
customers,
[[Page 132]]
issuers, and broker-dealers. All national securities exchanges publicly
display quotations for NMS stocks in consolidated market data and are
known as ``lit'' trading centers. As discussed in section III.B.1
below, the best-priced quotations of round lots of national securities
exchanges (highest priced bids to buy and lowest priced offers to sell)
are included in the consolidated market data feeds currently
disseminated by centralized securities information processors
(``SIPs''). In the first quarter of 2022, 16 national securities
exchanges executed 59.7% of share volume in NMS stocks.\26\
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\24\ Section 3(a)(1) of the Exchange Act defines ``exchange''
as, among other things, any organization that provides facilities
for bringing together purchasers and sellers of securities. 15
U.S.C. 78c(1).
\25\ 15 U.S.C. 78f.
\26\ Table 1, infra, section VII.B.1.
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NMS Stock ATSs operate facilities that fall within the definition
of an exchange in section 3(a)(1) of the Exchange Act, but, as
discussed in section III.B.3.b below, they are exempted from that
definition if they register as broker-dealers and otherwise comply with
Regulation ATS under the Exchange Act.\27\ No NMS Stock ATS currently
displays quotations in NMS stocks in consolidated market data. The
trading centers that do not display quotations are known as ``dark''
trading centers or ``dark pools.'' An NMS Stock ATS is required to
provide fair access to its services if it had 5% or more of the average
daily volume with respect to an NMS stock during four of the preceding
six calendar months,\28\ and as of November 30, 2022, one NMS Stock ATS
discloses on its Form ATS-N that it is subject to these fair access
requirements for securities that are available for trading on its
platform.\29\ In the first quarter of 2022, 32 ATSs executed 10.2% of
volume in NMS stocks.\30\
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\27\ 17 CFR 240.3a1-1(a)(2); see also Securities Exchange Act
Release No. 40760 (Dec. 8, 1998), 63 FR 70844, 70858 (Dec. 22, 1998)
(``Regulation ATS Adopting Release'') (stating that the Commission
would not consider making an assessment whether a particular system
should register as an exchange unless such system exceeded the
volume thresholds specified in 17 CFR 240.3a1-1(b): during three of
preceding four calendar quarters, the system had (1) 50% or more of
the average daily dollar trading volume in any security and 5% or
more of the average daily dollar trading volume in any class of
security; or (2) 40% or more of the average daily dollar trading
volume in any class of securities).
\28\ See Rule 301(b)(5); infra section III.B.3.b (discussing
fair access requirements for NMS Stock ATSs).
\29\ See Dealerweb Inc., Form ATS-N/OFA, Part III, Items 11
(Trading Services, Facilities and Rules) and Item 25 (Fair Access)
(filed Oct. 24, 2022), <a href="https://www.sec.gov/Archives/edgar/data/817462/000081746222000015/0000817462-22-000015-index.htm">https://www.sec.gov/Archives/edgar/data/817462/000081746222000015/0000817462-22-000015-index.htm</a> (disclosing
that the NMS Stock ATS is subject to the fair access requirements in
symbols SPY and QQQ). This NMS Stock ATS generally limits its
eligible subscribers to market makers, banks, broker-dealers, and
asset managers with at least $10 under management. See id. at Part
III, Item 1 (Types of Subscribers) and Item 2 (Eligibility for ATS
Services). Access to Form ATS-Ns filed by NMS Stock ATSs are
available on the Commission's website at <a href="https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm">https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm</a>.
\30\ Table 1, infra, section VII.B.1.
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An exchange market maker is defined in Rule 600(b)(32) of
Regulation NMS as any member of a national securities exchange that is
registered as a specialist or market maker pursuant to the rules of
such exchange. Exchange rules typically require exchange market makers
to provide liquidity by displaying quotations at which they are willing
to buy and sell NMS stocks for their own account.\31\ In this respect,
exchange market makers fall within the definition of a ``dealer'' in
section 3(a)(5) of the Exchange Act as buying and selling NMS stocks
for their own accounts as part of a regular business. The on-exchange
volume of exchange market makers in NMS stocks is included in the
volume for national securities exchanges referenced above because it is
reported by such exchanges.
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\31\ See, e.g., New York Stock Exchange LLC (``NYSE'') Rule 104
(Dealing and Responsibilities of DMMs) (requiring the exchange's
Designated Market Makers (``DMMs'') to maintain a continuous two-
sided quote for securities in which the DMM unit is registered with
the exchange) available at <a href="https://nyseguide.srorules.com/rules">https://nyseguide.srorules.com/rules</a>.
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Wholesalers fall within the definition of an OTC market maker in
Rule 600(b)(64) of Regulation NMS--any dealer that holds itself out as
being willing to buy from and sell to its customers, or others, in the
United States, an NMS stock for its own account on a regular or
continuous basis otherwise than on a national securities exchange in
amounts of less than block size. The term ``wholesaler'' is not defined
in Regulation NMS, but commonly refers to an OTC market maker that
seeks to attract orders from broker-dealers that service the accounts
of individual investors,\32\ referred to in this release as ``retail
brokers.'' \33\ The public order-routing reports required by 17 CFR
242.606 (``Rule 606'') \34\ show that the six largest wholesalers
collectively paid retail brokers $235 million in payment for order flow
(``PFOF'') in the first quarter of 2022 for orders in NMS stocks.\35\
Many retail brokers do not accept PFOF for marketable orders in NMS
stocks routed to wholesalers, though the retail brokers that do accept
PFOF represent 73.88% of the dollar volume of marketable orders of
retail brokers routed to wholesalers.\36\
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\32\ Another type of business operated by some OTC market makers
is known as a ``single dealer platform,'' which primarily seeks to
attract the orders of institutional investors for internal
execution. Infra section VII.B.3.
\33\ As discussed in section VII.B.1.a below, the Commission has
identified six firms as wholesalers based on the public order
routing disclosures of retail brokers. Retail broker services are
discussed in section VII.B.6 below.
\34\ Rule 606 is discussed in section III.B.4 below.
\35\ See infra section VII.B.6.a.
\36\ See Table 14, infra section VII.B.5.c.
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Wholesalers do not display or otherwise reveal the prices at which
they are willing to execute individual investor orders internally.
Moreover, as discussed in section III.B.3 below, while they are subject
to Commission and SRO requirements as broker-dealers, wholesalers are
not subject to a statutory or regulatory requirement to provide fair
access. They are not required to provide an opportunity for other
market participants, including institutional investors and other
exchange market makers, to compete on an order-by-order basis to
provide the best prices for the individual investor orders that the
wholesalers internalize. Some institutional investors, for example,
consider this order flow to be ``inaccessible.'' \37\ In the first
quarter of 2022, six large wholesalers internally executed 23.9% of
share volume in NMS stocks.\38\
---------------------------------------------------------------------------
\37\ See, e.g., Cowen, Inc., ``Cowen Market Structure: Retail
Trading--What's going on, what may change, and what can you do about
it?'' (Mar. 23, 2021), available at <a href="https://www.cowen.com/insights/retail-trading-whats-going-on-what-may-change-and-what-can-institutional-traders-do-about-it/">https://www.cowen.com/insights/retail-trading-whats-going-on-what-may-change-and-what-can-institutional-traders-do-about-it/</a> (``Market makers print most of
these shares internally at their firm, so they trade off-exchange.
One way we have for isolating retail volume is to look at the share
of volume that trades off-exchange, but not in a dark pool. We refer
to this as `inaccessible liquidity.' This is because most
institutional orders--whether they are executed via algos directly
or by high touch desks--primarily go to exchanges and dark
pools.'').
\38\ Table 1, infra, section VII.B.1.
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The fifth and final category of trading center that executes trades
in NMS stocks is a catchall category encompassing broker-dealers that
execute orders internally by trading as principal or crossing orders as
agent. In the first quarter of 2022, over 230 broker-dealers (other
than NMS Stock ATSs and OTC market makers) reported trades in NMS
stocks, which accounted for the remaining 6.3% of share volume in NMS
stocks.\39\
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\39\ Table 1, infra, section VII.B.1.
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C. Order Types and Trading Costs
When seeking to buy and sell NMS stocks, investors submit orders
through the broker-dealers that service their accounts. The order type
most frequently used to trade by individual investors is a ``market''
order, which simply instructs a broker-dealer to seek an execution of
the order at the best available price in the market. In contrast to
market orders, a ``limit order'' specifies a ``limit price''--a price
[[Page 133]]
beyond which the investor is not willing to trade. Limit prices reflect
an intention to ``buy low and sell high.'' For example, a buy order
with a limit price of $20 means the investor would like to buy as soon
as possible, but only at a price that is $20 or less. Conversely, a
sell order with a limit price of $20 means the investor would like to
sell as soon as possible, but only at a price that is $20 or more.
In practice, the likelihood and speed of execution of limit orders
can vary greatly depending primarily on the relation between their
limit prices and the best-priced quotations that are displayed by
national securities exchanges in the consolidated market data feeds. As
discussed in section III.B.1 below, these quotations are in ``round
lot'' sizes, which currently are 100 shares or more for nearly all NMS
stocks. The highest price bid for an NMS stock is known as the national
best bid (``NBB''), and the lowest price offer for an NMS stock is
known as the national best offer (``NBO''). Collectively, the NBB and
NBO are known as the national best bid and offer (``NBBO''). When a
limit order to buy has a limit price that is equal to or greater than
the NBO, it is known as a ``marketable'' limit order because it can be
executed immediately at the best displayed quote to sell. Similarly, a
limit order to sell is marketable when it has a limit price that is
equal to or less than the NBB.\40\
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\40\ Rule 600(b)(47) of Regulation NMS defines a ``marketable
limit order'' as any buy order with a limit price equal to or
greater than the NBO at the time of order receipt, or any sell order
with a limit price equal to or less than the NBB at the time of
order receipt.
---------------------------------------------------------------------------
For example, assume the NBB is $20.00 and the NBO is $20.10. A buy
limit order with a price of $20.10 or higher is marketable, and a sell
limit order with $20.00 or lower is marketable. Marketable limit orders
are similar to market orders with respect to their willingness to trade
immediately at the best displayed prices or better and will be referred
to collectively in this release as ``marketable orders.''
Investors that use marketable orders to trade immediately at the
best available prices are known as ``liquidity takers'' and generally
incur a trading cost for the service, known as a ``spread.'' In the
example above, when the NBBO is $20.00 and $20.10, the quoted spread is
10 cents. An investor that wished to avoid paying a spread could use a
``non-marketable'' limit order in an attempt to become a ``liquidity
provider.'' A non-marketable limit order to buy has a limit price that
is less than the NBO, and a non-marketable limit order to sell has a
limit price that is greater than the NBB.\41\ For example, again using
the example when the NBBO is $20.00 and $20.10, an investor could
submit a buy limit order with a limit price of $20.00. This buy order
is not marketable because it is priced less than the NBO of $20.10 and
therefore cannot be executed immediately against the best displayed
offer. A non-marketable limit order generally will ``rest'' on the
continuous order book of a trading center awaiting the arrival of a
contra-side marketable order against which it can execute. In the
example, if the resting non-marketable limit order to buy were able to
obtain an execution at its limit price of $20.00 (e.g., by interacting
with a contra-side marketable order to sell), the investor would have
succeeded in trading at a price that was 10 cents lower than if the
investor had used a marketable order and traded at the NBO of $20.10.
The risk, however, of using a non-marketable limit order is that it may
not execute at all if market prices move away from the order (i.e.,
prices increase for buy orders and decrease for sell orders). If this
happens, the investor will incur an opportunity cost by missing a
trade.
---------------------------------------------------------------------------
\41\ Rule 600(b)(57) of Regulation NMS defines ``non-marketable
limit order'' as any limit order other than a marketable limit
order.
---------------------------------------------------------------------------
Using the example of an NBBO of $20.00 and $20.10, assume the
investor submitted a non-marketable order to buy with a limit price of
$20.00, but did not obtain an execution and the NBBO then rose to
$20.15 and $20.25. Seeing that the market was moving away, the investor
decided to cancel the unexecuted non-marketable order and replace it
with a marketable order to buy, which then was executed at the new NBO
price of $20.25. In this case, the investor incurred an opportunity
cost of 15 cents--the difference between (1) the original NBO price of
$20.10 that the investor likely could have obtained if the investor
first had used a marketable order to buy at $20.10 rather than using
the non-marketable order in an unsuccessful attempt to buy at $20.00,
and (2) the price of $20.25 at which the investor actually obtained an
execution.
In sum, an investor's decision of whether to use marketable orders
or non-marketable orders to trade can depend on an often complex
judgment of whether prices are likely to move in the short-term future.
Individual investors, who typically do not follow market prices closely
throughout a trading day, often will not feel in the best position to
make this judgment and generally choose to be liquidity takers by using
marketable orders to obtain the certainty of an immediate execution at
a displayed price or better.\42\ Accordingly, a key source of trading
costs for individual investors are the spreads they pay when using
marketable orders. The narrower the spreads, the lower the prices at
which they will buy and the higher the prices at which they will sell,
which translate into lower trading costs and higher investment returns.
Conversely, wider spreads mean higher trading costs and lower
investment returns.
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\42\ Rule 606 order-routing reports reveal that customers of
retail brokers used marketable orders for approximately 39-40% of
their trades and used ``other'' orders for approximately 26-27% of
their trades. Table 3, infra, section VII.B.2.a. As presented in
Table 2 in section VII.B.2.a below, however, the PFOF rates received
from wholesalers for these ``other'' orders almost exactly matched
the rates received from wholesalers for marketable limit orders.
Accordingly, it is likely that most of these other orders were
marketable (i.e., immediately executable at the best available
prices), although the orders may have had particular characteristics
that led them to be classified as other orders.
---------------------------------------------------------------------------
The spread costs of individual investors highlight the role played
by liquidity providers in determining spreads. Liquidity providers
determine spreads by setting the prices at which they are willing to
trade with marketable orders as such orders are submitted by liquidity
takers. Liquidity providers can include professional market
intermediaries, such as exchange market makers and OTC market makers
(including wholesalers), as well as investors that use non-marketable
limit orders. For example, national securities exchanges, which display
the quotations that determine the NBBO, all operate continuous order
books. Unexecuted non-marketable orders that have been routed to an
exchange rest on its continuous order book awaiting an opportunity for
interaction with incoming contra-side orders. Using the NBBO example of
$20.00 and $20.10, assume a national securities exchange has displayed
limit orders resting on its continuous order book with limit prices
that equal the NBBO, but then an institutional investor submits a buy
order with a limit price of $20.02 for display on the continuous order
book. At this point, there will be a new NBB of $20.02 and the NBBO
spread will have been reduced from 10 cents to 8 cents. If an
individual investor's market order to sell was routed to the exchange,
the order would execute at the new NBB of $20.02, saving the individual
investor two cents per share compared to the old NBB of $20.00.
For liquidity providers, the adverse selection costs of trading
with a given
[[Page 134]]
marketable order flow are a key factor for determining the prices at
which they are willing to trade with such flow, particularly for
professional market intermediaries. These market intermediaries
generally seek to generate short-term trading profits by buying and
selling on a continuous basis and capturing a spread between their buys
and sells. Adverse selection costs reflect the extent to which prices
move against the liquidity provider in the seconds and minutes after a
trade, which increases the difficulty faced by the liquidity provider
in successfully capturing a spread between buys and sells.
For example, assume an NBBO of $20.00 and $20.10, and a market
maker provides liquidity by trading with a contra-side marketable sell
order at the $20.00 NBB. The market maker may hope to profit by quickly
providing liquidity to a contra-side marketable buy order at the $20.10
NBO and thereby earning a 10 cent spread. Seconds later, however, and
before the market maker is able to liquidate the buy position, the NBBO
declines to $19.85 and $19.95. In this case, the market maker has
bought immediately prior to a 15 cent decline in the NBBO. This
subsequent move in the NBBO is known as ``price impact.'' Instead of
earning a 10 cent spread as it hoped by providing liquidity when the
NBBO was $20.00 and $20.10, the market maker would realize a loss of 5
cents on its position if it then provided liquidity to a contra-side
marketable buy order by selling at the new NBO of $19.95. Therefore,
the market maker had an adverse selection cost of 15 cents.
Accordingly, market makers assess the potential adverse selection costs
of the liquidity-taking order flow with which they are likely to
interact when setting the spreads at which they are willing to provide
liquidity to such flow. Segmentation of marketable orders with low
adverse selection costs is a means for liquidity providers to control
such costs. As discussed in section VII,\43\ the marketable orders of
individual investors routed to wholesalers have adverse selection costs
(as measured by price impact) that are approximately 71% lower than the
adverse selection costs of orders routed to national securities
exchanges. The low adverse selection costs of the segmented marketable
orders of individual investors generally enable wholesalers to offer
better prices for such orders than would be available for unsegmented
orders routed to national securities exchanges.
---------------------------------------------------------------------------
\43\ See Table 7, infra, section VII.B.4.
---------------------------------------------------------------------------
The trading examples thus far have assumed that trades occur at the
NBBO prices, which are determined by round lot quotations displayed on
national securities exchanges. In fact, however, trades can be executed
on national securities exchanges at prices that are better than NBBO
prices (``NBBO price improvement''). Marketable orders routed to access
the NBBO at a national securities exchange can obtain NBBO price
improvement in two primary contexts. First, a national securities
exchange may have displayed orders on its continuous order book with
sizes less than round lots, known as ``odd lot quotations,'' that are
priced better than the NBBO. If a contra-side marketable order is
routed to a national securities exchange with such an odd lot
quotation, the contra-side marketable order will interact with the odd-
lot quotation and receive a better price than the NBBO. Second, there
may be undisplayed non-marketable limit orders resting on the
continuous order book of a national securities exchange with prices
that are better than such exchange's displayed quotations. One common
example is an NBBO midpoint order. An NBBO midpoint order has an
execution price that is pegged to, and accordingly fluctuates with, the
midpoint of the NBBO. If the NBBO is $20.00 and $20.10, and an NBBO
midpoint order to sell is resting on the continuous order book of a
national securities exchange, a marketable order to buy that is routed
to such exchange will execute at the NBBO midpoint price of $20.05
rather than the NBO of $20.10. By trading at the NBBO midpoint, the
incoming marketable buy order has obtained an immediate execution
without paying any spread, and the resting NBBO midpoint order to sell
has not earned any spread. Institutional investors may use undisplayed
NBBO midpoint orders because they provide an opportunity to trade with
contra-sided marketable flow, but without the information leakage (and
potential slippage) that could occur if their orders were displayed.
D. Quantitative Measures of Order Execution Quality and Trading Costs
A variety of quantitative measures can be used to assess the
quality of order executions that broker-dealers obtain for their
individual investor customers, as well as more generally the trading
costs of liquidity takers and liquidity providers. 17 CFR 242.605
(``Rule 605'') of Regulation NMS,\44\ for example, requires many
trading centers, including national securities exchanges and
wholesalers, to make data files publicly available on a monthly basis
that include detailed measures of execution quality for marketable and
non-marketable orders in NMS stocks. This section will describe some of
the quantitative measures included in Rule 605 data, as well as provide
concrete examples illustrating specifically how the measures are
calculated. These quantitative measures are referenced extensively
throughout this release to explain the rationale for and the potential
economic effects of Proposed Rule 615.
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\44\ Rule 605 is discussed in section III.B.4 below.
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1. Description of Quantitative Measures
The following is a list, with brief descriptions, of quantitative
measures of order execution quality and trading costs in NMS stocks
that are included in, or can be derived from, Rule 605 data files.
Specific examples of how the measures are calculated will be provided
in section II.D.2 below.
As stated above, NBBO price improvement is the amount by which the
execution price of a marketable order is better than the relevant NBBO
quotation at the time a marketable order is received by a trading
center.\45\ For marketable buy orders, it is the amount by which the
buy order received a price lower than the NBO at the time of order
receipt. For marketable sell orders, it is the amount by which the sell
order received a price higher than the NBB at the time of order
receipt.
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\45\ Rule 600(b)(36) of Regulation NMS defines ``executed with
price improvement'' as, for buy orders, execution at a price lower
than the NBO at the time of order receipt and, for sell orders,
execution at a price higher than the NBB at the time of order
receipt.
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``NBBO quoted half-spread'' is one-half of the difference between
the NBO and NBB, as measured at the time when a marketable order is
received by a trading center. The full quoted spread is halved to
reflect the spread cost for establishing or liquidating a position
(long or short). For example, if an investor uses a marketable order to
buy at the NBO (incurring a half-spread to establish a long position),
but then is able to use a non-marketable order to sell at the NBO
(earning a half-spread to liquidate the long position), the investor
would have paid a net spread of 0 cents on the ``round-trip''
transaction.
``Effective half-spread'' is the half-spread actually paid by a
marketable order. It is calculated by comparing execution prices with
the NBBO midpoint, rather than the relevant NBB or NBO, at the time of
order receipt.\46\
[[Page 135]]
Accordingly, a trading center's average effective half-spread for
marketable orders may be narrower or wider than the NBBO quoted half-
spread, depending on the extent to which execution prices at a trading
center are inside, at, or outside NBBO prices.
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\46\ Rule 600(b)(8) of Regulation NMS defines ``average
effective spread'' as the share-weighted average of effective
spreads for order executions calculated, for buy orders, as double
the amount of difference between the execution price and the
midpoint of the NBB and NBO at the time of order receipt and, for
sell orders, as double the amount of difference between the midpoint
of the NBB and NBO at the time of order receipt and the execution
price.
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``Price impact'' is the extent to which the NBBO midpoint moves
against the liquidity provider for a marketable order in a short time
period after the order execution. For Rule 605 reporting, the time
period is five minutes after the time of order execution. For the
analyses of CAT data provided in section VII.B.4 below, the time period
is one minute after the time of order execution.\47\ Price impact
measures the extent of adverse selection costs faced by a liquidity
provider and is closely related to realized half-spread (described
next). When price impact and realized half-spread are calculated using
the same post-trade time period, the difference between the effective
half-spread and the realized half-spread on a trade will equal the
price impact of the trade.\48\
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\47\ The analysis in section VII.B.4 below uses one minute to
reflect the increase in trading speed in the years since Rule 605
was adopted.
\48\ See, e.g., Hasbrouck Treatise at 147 (``The execution cost
based on the pretrade bid-ask midpoint (BAM) is also known as the
effective cost. Since 2001, the U.S. SEC has required U.S. equity
markets to compute effective costs and make summary statistics
available on the Web . . . . The rule . . . also requires
computation of the realized cost . . . . The difference between
effective and realized costs is sometimes used as an estimate of the
price impact of the trade. The realized cost can also be interpreted
as the revenue of the dealer who sold to the customer . . . and then
covered his position at the subsequent BAM.'').
---------------------------------------------------------------------------
``Realized half-spread'' is calculated similarly to the effective
half-spread, but, instead of using the NBBO midpoint at the time of
order receipt, the realized spread calculation uses the NBBO midpoint a
short time period after the execution of a marketable order.\49\ For
Rule 605 reporting, the time period is five minutes after the time of
order execution. For the analyses of CAT data provided in section
VII.B.4 below, the time period is one minute after the time of order
execution.\50\ When deciding to include realized spread statistics in
Rule 605 reports, the Commission stated that the smaller the average
realized spread, ``the more market prices have moved adversely to the
market center's liquidity providers after the order was executed,''
which shrinks the spread ``realized'' by the liquidity providers.\51\
The Commission further stated that the average realized spread
statistic for market and marketable limit orders potentially could help
``to spur more vigorous competition to provide the best prices to these
orders to the benefit of many retail investors.'' \52\ In sum, by
capturing the extent of adverse selection costs faced by liquidity
providers, realized spreads are designed to provide a more accurate
measure of the potential profitability of trading for liquidity
providers than do effective spreads.\53\
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\49\ Rule 600(b)(9) of Regulation NMS generally defines
``average realized spread'' as the share-weighted average of
realized spreads for order executions calculated, for buy orders, as
double the amount of difference between the execution price and the
midpoint of the NBB and NBO five minutes after the time of order
execution and, for sell orders, as double the amount of difference
between the midpoint of the NBB and NBO five minutes after the time
of order execution and the execution price.
\50\ The analysis in section VII.B.4 below uses a one-minute
period to reflect the increase in trading speed in the years since
Rule 605 was adopted.
\51\ Securities Exchange Act Release No. 43590 (Nov. 17, 2000),
65 FR 75414, 75424 (Dec. 1, 2000).
\52\ Id.
\53\ See, e.g., Harris Treatise at 286 (``Informed traders buy
when they think that prices will rise and sell otherwise. If they
are correct, they profit, and whoever is on the other side of their
trade loses. When dealers trade with informed traders, prices tend
to fall after the dealer buys and rise after the dealer sells. These
price changes make it difficult for dealers to complete profitable
round-trip trades. When dealers trade with informed traders, their
realized spreads are often small or negative. Dealers therefore must
be very careful when trading with traders they suspect are well
informed.'').
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2. Examples of Calculating Measures of Order Execution Quality and
Trading Costs
When the execution quality and trading cost measures described
above are calculated and averaged for a large volume of orders at
different trading centers, the results can reveal important information
about the nature of the order execution quality and trading costs
across different trading centers. Section VII below, which provides an
economic analysis of Proposed Rule 615, makes extensive use of data
analyses using these measures.
The following two examples are patterned on those analyses,
particularly the empirical finding that the marketable orders of
individual investors routed to wholesalers have adverse selection costs
(as measured by price impact) that, on average, are approximately 71%
lower than the marketable orders routed to national securities
exchanges. The examples are intended to illustrate how quantitative
measures of order execution quality and trading costs are calculated in
these two contexts that are most relevant for understanding the
empirical basis for Proposed Rule 615. The examples show how a
difference in the adverse selection costs of order flow routed to two
different trading centers can result in more price improvement and
narrower effective spreads at the trading center with lower adverse
selection costs (the wholesaler) than at the trading center with higher
adverse selection costs (the exchange), yet still result in wider
realized spreads (i.e., spreads realized by the liquidity provider
after estimating for adverse selection costs) at the wholesaler than at
the exchange.
The first example below (``Exchange Example'') presents the
execution of an unsegmented marketable order to buy at a national
securities exchange at a price that matches the NBBO, and the second
example below (``Wholesaler Example'') presents the execution of a
segmented marketable order to buy of an individual investor at a
wholesaler at a price better than the NBBO. The examples use the
calculation methodology prescribed by Rule 605 of Regulation NMS,
except that statistics are presented for the half-spread associated
with a single buy or sell order rather than the full spread statistics
prescribed for Rule 605, which are doubled to reflect estimates of
round-trip (offsetting buy and sell) trading costs.\54\ Half-spreads
are used to more clearly present the calculations for the single order
in each of the examples.
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\54\ The definitions of ``average effective spread'' and
``average realized spread'' provided in Rule 600(b)(8) and (9) of
Regulation NMS, which are incorporated in Rule 605, prescribe
doubling of the amounts by which an order execution price differs
from the NBBO midpoint at the time of order receipt (for effective
spreads) and five minutes after the time of order execution (for
realized spreads).
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The data used for the two examples are labeled as follows:
execution price of marketable order (``ExP''), NBB at time of order
receipt (``NBB<INF>t0</INF>''), NBO at time of order receipt
(``NBO<INF>t0</INF>''), NBBO midpoint at time of order receipt
(``MP<INF>t0</INF>''), and NBBO midpoint 5 minutes after time of order
execution (``MP<INF>t5</INF>'').
The execution quality and trading cost measures for the two
examples of marketable orders to buy are calculated as follows:
NBBO quoted half-spread: \1/2\ x (NBO<INF>t0</INF>-NBB<INF>t0</INF>)
NBBO price improvement: NBO<INF>t0</INF>-ExP
Effective half-spread: ExP-MP<INF>t0</INF>
Price impact: MP<INF>t5</INF>-MP<INF>t0</INF>
Realized half-spread: ExP-MP<INF>t5</INF>
The data and calculations for the two examples are as follows:
[[Page 136]]
------------------------------------------------------------------------
Exchange example Wholesaler example
------------------------------------------------------------------------
EXP............................. $110.05........... $110.04.
NBBT0........................... $110.00........... $110.00.
NBOT0........................... $110.05........... $110.05.
MPT0............................ $110.025.......... $110.025.
MPT5............................ $110.055.......... $110.035.
NBBO PRICE IMPROVEMENT.......... 0 cents........... 1 cent.
NBBO QUOTED HALF-SPREAD......... 2.5 cents......... 2.5 cents.
EFFECTIVE HALF-SPREAD........... 2.5 cents......... 1.5 cents.
PRICE IMPACT.................... 3 cents........... 1 cent.
REALIZED HALF-SPREAD............ <0.5 cents>....... 0.5 cents.
------------------------------------------------------------------------
In the Exchange Example and Wholesaler Example, the NBBO is the
same at the time of order receipt for both marketable buy orders, but
the national securities exchange in the Exchange Example executes the
order at the NBO with no NBBO price improvement, while the wholesaler
in the Wholesaler Example executes the marketable buy order with NBBO
price improvement of one cent. Consequently, the NBBO quoted half-
spread is the same for both trades (2.5 cents), but the effective half-
spread is wider for the liquidity provider on the national securities
exchange (2.5 cents) than for the wholesaler (1.5 cents) because of the
1 cent NBBO price improvement provided by the wholesaler. The price
impact of the order routed to the national securities exchange is 3
cents, while the price impact of the order routed to the wholesaler is
only 1 cent. Accordingly, the adverse selection cost for the liquidity
provider on the national securities exchange was 3 cents, while the
adverse selection cost for the wholesaler was 1 cent.
The difference in adverse selection costs leaves the liquidity
provider on the national securities exchange in the Exchange Example
with a narrower realized half-spread of negative 0.5 cents, while the
wholesaler in the Wholesaler Example preserves a positive realized
half-spread of 0.5 cents. Stated another way, the wholesaler provided
some NBBO price improvement (1 cent), but its adverse selection cost
savings compared to the liquidity provider on the national securities
exchange was 2 cents, and as a result the wholesaler was able to
capture a realized half-spread that was one cent wider than the
liquidity provider on the national securities exchange. If, however,
the wholesaler had provided NBBO price improvement that matched its
cost savings, the individual investor would have received NBBO price
improvement of 2 cents rather than 1 cent. In this case, the realized
half-spread for both the wholesaler and the liquidity provider on the
national securities exchange would have been the same--negative 0.5
cents.
In this respect, the Exchange Example and Wholesaler Example
highlight the key order-by-order competition objective of Proposed Rule
615. As discussed in section VII.C.2.b below, competition among a wide
range of liquidity providers on national securities exchanges is
intense and results in realized spreads for unsegmented orders that are
narrower than the realized spreads captured by wholesalers for the
segmented orders of individual investors. Another way of stating the
same point is that wholesalers do not provide average NBBO price
improvement that matches their savings in average adverse selection
costs from securing the opportunity to trade first with the segmented
orders of individual investors. Proposed Rule 615 would enable order-
by-order competition to provide the best prices to the segmented
marketable orders of individual investors. By providing an opportunity
for a wide variety of liquidity providers to compete to provide the
best prices for the segmented marketable orders of individual
investors, Proposed Rule 615 is designed to expand the level of NBBO
price improvement currently provided by wholesalers to match the low
adverse selection costs of such orders.
III. Statutory and Regulatory Background
The development of today's market structure for NMS stocks has been
guided by the Congressional determination set forth in section 11A of
the Exchange Act that the United States should have an NMS in which
multiple competing markets are linked together through communications
and data processing facilities. This section III first will discuss the
Exchange Act framework for an NMS. It then will summarize the rules
that the Commission has adopted over the years to facilitate the
development of an NMS, with particular focus on rules that address the
handling and execution of investor orders in NMS stocks. Many aspects
of Proposed Rule 615, as described in section IV below, are designed to
build on the existing statutory framework and Commission rules
discussed in this section III.
A. Statutory Framework for an NMS
Section 11A of the Exchange Act, enacted as part of the Securities
Acts Amendments of 1975,\55\ sets forth the statutory framework for an
NMS. Section 11A(a)(2) directs the Commission, having due regard for
the public interest, the protection of investors, and the maintenance
of fair and orderly markets, to use its authority under the Exchange
Act to facilitate the establishment of an NMS for securities in
accordance with the Congressional findings and objectives set forth in
section 11A(a)(1) of the Exchange Act.\56\ Section 11A(a)(1)(C) sets
forth the finding of Congress that it is in the public interest and
appropriate for the protection of investors and the maintenance of fair
and orderly markets to assure five objectives:
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\55\ Public Law 94-29, 89 Stat. 97 (1975).
\56\ Section 11A(a)(3)(B) also provides the Commission the
authority to require the SROs, by rule or order, ``to act jointly .
. . in planning, developing, operating, or regulating [an NMS] (or a
subsystem thereof).''
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(1) economically efficient execution of securities transactions;
(2) fair competition among brokers and dealers, among exchange
markets, and between exchange markets and markets other than exchange
markets;
(3) the availability to brokers, dealers, and investors of
information with respect to quotations for and transactions in
securities;
(4) the practicability of brokers executing investors' orders in
the best market; and
(5) an opportunity, consistent with the foregoing objectives of
efficient execution of securities transactions and practicability of
brokers executing investors' orders in the best market, for investors'
orders to be executed without the participation of a dealer.\57\
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\57\ Section 11A(a)(1) of the Exchange Act.
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A variety of Exchange Act provisions grant the Commission specific
[[Page 137]]
rulemaking authority in different contexts to fulfill its
responsibility to facilitate the establishment of an NMS that assures
the five objectives. Three of these Exchange Act authorizations are
particularly relevant in the context of rules to address the handling
and execution of investor orders in NMS stocks.
First, section 11A(c)(1)(E) addresses the routing of orders by
broker-dealers. It authorizes the Commission to prescribe rules, as
necessary or appropriate in the public interest, for the protection of
investors, or otherwise in furtherance of the Exchange Act to assure
that all exchange members and brokers-dealers transmit and direct
orders for the purchase or sale of NMS stocks in a manner consistent
with the establishment and operation of an NMS.\58\
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\58\ 15 U.S.C. 78k-1(c)(1)(E).
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Second, section 11A(c)(1)(F) grants rulemaking authority to assure
equal regulation of all markets for NMS stocks, as well as of all
exchange members and broker-dealers effecting transactions in NMS
stocks.\59\ The meaning of the term ``equal regulation'' is specified
in section 3(b)(36), which provides that a class of persons or markets
is subject to equal regulation if no member of the class has a
competitive advantage over any other member thereof resulting from a
disparity in their regulation under the Exchange Act which the
Commission determines is unfair and not necessary or appropriate in
furtherance of the purposes of the Exchange Act.
---------------------------------------------------------------------------
\59\ 15 U.S.C. 78k-1(c)(1)(F).
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Third, section 15(c)(5) addresses the practices of dealers, such as
wholesalers. It authorizes the Commission to prescribe rules setting
forth specified and appropriate standards with respect to dealing for
dealers (other than specialists registered on a national securities
exchange) acting in the capacity of a market maker or otherwise that
are necessary or appropriate in the public interest and for the
protection of investors, to maintain fair and orderly markets, or to
remove impediments to and perfect the mechanism of an NMS.\60\
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\60\ 15 U.S.C. 78o(c)(5).
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In addition to these grants of rulemaking authority to facilitate
the development of an NMS, section 6 of the Exchange Act \61\
specifically addresses the types of access to trading services that one
type of market--a national securities exchange--is required to provide
to broker-dealers and market participants. Access to the trading
services of a market is essential for that market to be linked together
with other markets in an NMS.
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\61\ 15 U.S.C. 78f.
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First, section 6(b)(2) requires that, subject to the provisions of
section 6(c) relating to statutory disqualification and other concerns,
the rules of the exchange must provide that any registered broker-
dealer may become a member of such exchange.\62\ Broker-dealers
generally need to become exchange members, as an initial matter, to
obtain access to many of the trading services of an exchange.
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\62\ 15 U.S.C. 78f(b)(2).
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Second, section 6(b)(4) requires that the rules of the exchange
provide for the equitable allocation of reasonable dues, fees, and
other charges among its members and issuers and other persons using its
facilities.\63\ This provision recognizes that the opportunity for
different market participants to access trading services at a market
can be greatly affected by the charges for those services.
---------------------------------------------------------------------------
\63\ 15 U.S.C. 78f(b)(4).
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Third, section 6(b)(5) requires that the rules of the exchange are
designed to, among other things, ``remove impediments to and perfect
the mechanism of a free and open market and [an NMS], and, in general,
to protect investors and the public interest.'' \64\ Section 6(b)(5)
further requires that the rules of the exchange are not designed ``to
permit unfair discrimination between customers, issuers, brokers, or
dealers.'' \65\ These provisions broadly help ensure fair and efficient
access to the trading services of national securities exchanges, both
by requiring them to act affirmatively to promote high quality markets
and by prohibiting them from acting negatively by unfairly
discriminating between customers, issuers, or broker-dealers.
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\64\ 15 U.S.C. 78f(b)(5).
\65\ Id.
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Finally, section 6(b)(8) requires that ``the rules of the exchange
do not impose any burden on competition not necessary or appropriate in
furtherance of the purposes'' of the Exchange Act.\66\ This provision
further restricts a national securities exchange's ability to limit
access to its trading services in an anti-competitive manner.
---------------------------------------------------------------------------
\66\ 15 U.S.C. 78f(b)(8).
---------------------------------------------------------------------------
To help ensure that national securities exchanges operate according
to rules consistent with their statutory obligations, section 19(b)(1)
of the Exchange Act \67\ requires SROs,\68\ including national
securities exchanges, to file with the Commission any proposed rule
change.\69\ The Commission publishes for public comment all SRO
proposed rule changes.\70\ For new or materially modified trading
services, a proposed rule change generally cannot become effective, and
the national securities exchange cannot implement such rule change,
until the Commission has approved it as consistent with the
requirements of the Exchange Act.\71\
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\67\ 15 U.S.C. 78s(b)(1).
\68\ See 15 U.S.C. 78c(b)(26) (defining ``self-regulatory
organization'' to include, among other things, any national
securities exchange or registered securities association).
\69\ Section 19(b)(1) of the Exchange Act defines a ``proposed
rule change'' to be any proposed change in, addition to, or deletion
from the rules of an SRO. 15 U.S.C. 78s(b)(1). Section 3(a)(27) of
the Exchange Act generally defines ``rules'' to include the
constitution, articles of incorporation, bylaws, and rules, or
instruments corresponding to the foregoing and the stated policies,
practices, and interpretations of an exchange, association, or
clearing agency as the Commission, by rule, may determine to be
necessary or appropriate in the public interest or for the
protection of investors to be deemed to be rules of such exchange,
association, or clearing agency. 15 U.S.C. 78c(a)(27). Rule 19b-4(b)
under the Exchange Act defines ``stated policy, practice, or
interpretation'' to mean, in part, any material aspect of the
operation of the facilities of the SRO or any statement made
generally available that establishes or changes any standard, limit,
or guideline with respect to the rights, obligations, or privileges
of persons or the meaning, administration, or enforcement of an
existing rule. 17 CFR 240.19b-4(b).
\70\ See 15 U.S.C. 78s(b)(1).
\71\ If the Commission does not approve or disapprove a proposed
rule change within the required timeframe prescribed by section 19
of the Exchange Act, it is ``deemed to have been approved.'' 15
U.S.C. 78s(b)(2)(D).
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Section 15A of the Exchange Act \72\ includes many requirements for
the rules of a national securities association that are analogous to
those prescribed for national securities exchanges. FINRA is currently
the only registered national securities association. Broker-dealers
that handle customer orders in NMS stocks or trade NMS stocks in the
off-exchange market generally must become FINRA members.\73\ Section
15A does not, however, impose fair access requirements on the broker-
dealer members of FINRA. Accordingly, broker-dealers that trade
internally are not subject to the statutory access requirements that
apply to national securities exchanges under section 6 of the Exchange
Act.
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\72\ 15 U.S.C. 78o-3.
\73\ See 15 U.S.C. 78o(b)(8). The Commission has proposed to
amend 17 CFR 240.15b9-1, which provides an exemption from
association membership for certain exchange members. Securities
Exchange Act Release No. 95388 (July 29, 2022), 87 FR 49930 (Aug.
12, 2022) (proposing to replace a de minimis allowance with narrower
exemptions from association membership).
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B. Current Regulatory Components of the NMS for NMS Stocks
Over the years since 1975, the Commission has used its Exchange Act
[[Page 138]]
authority to adopt a series of rules to fulfill its regulatory
responsibility to facilitate the establishment of an NMS. In doing so,
it particularly has emphasized the importance of promoting competition
as a means to protect investors and to achieve the five statutory
objectives for an NMS. In its request for comment on issues relating to
market fragmentation in 2000,\74\ for example, the Commission stated
that the section 11A findings and objectives can be summed up in two
fundamental principles. First, the interests of investors (both large
and small) are preeminent, ``especially the efficient execution of
their securities transactions at prices established by vigorous
competition.'' \75\ Second, investor interests are best served by a
market structure that, to the greatest extent possible, maintains the
benefits of ``both an opportunity for interaction of all buying and
selling interest'' in individual securities and ``fair competition
among all types of market centers'' seeking to provide a forum for the
execution of securities transactions.\76\ The Commission further stated
that competition among multiple competing markets can isolate investor
orders and that this ``may reduce competition on price, which is one of
the most important benefits of greater interaction of buying and
selling interest in an individual security.'' \77\
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\74\ Securities Exchange Act Release No. 42450 (Feb. 23, 2000),
65 FR 10577 (Feb. 28, 2000) (``Market Fragmentation Concept
Release'').
\75\ Id. at 10580.
\76\ Id. (emphasis in original).
\77\ Id. (emphasis in original).
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In 2005, the Commission adopted Regulation NMS to consolidate the
NMS rules it had previously adopted under section 11A and to include
new rules designed to modernize and strengthen equity market
structure.\78\ It again emphasized the importance of competition among
orders to obtain the best prices for investors, stating that this basic
principle was recognized in the legislative history of section 11A:
``Investors must be assured that they are participants in a system
which maximizes the opportunities for the most willing seller to meet
the most willing buyer.'' \79\ The Commission summed up its approach to
achieving an NMS as resisting suggestions that it adopt an approach
focusing on a single form of competition that, while perhaps easier to
administer, ``would forfeit the distinct, but equally vital, benefits
associated with both competition among markets and competition among
orders.'' \80\
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\78\ Securities Exchange Act Release No. 51808 (June 9, 2005),
70 FR 37496 (June 29, 2005) (``Regulation NMS Adopting Release'').
\79\ Id. at 37499 (quoting H.R. Rep. 94-123, 94th Cong., 1st
Sess. 50 (1975)). The Commission further quoted this legislative
history for section 11A of the Exchange Act to emphasize the
importance of ensuring that investor orders are able to be executed
in a market with the best price: ```market fragmentation becomes of
increasing concern in the absence of mechanisms designed to assure
that public investors are able to obtain the best price for
securities regardless of the type or physical location of the market
upon which his transaction may be executed.''' Id. at 37499 n.13.
\80\ Id.
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Four categories of the Regulation NMS rules are particularly
important in the context of Proposed Rule 615: (1) consolidated market
data; (2) order handling and execution; (3) access to trading centers;
and (4) disclosure of order routing practices and order execution
statistics.
1. Rules Addressing Consolidated Market Data
Several rules under Regulation NMS set forth requirements for
consolidated market data, which, as defined in Rule 600(b)(19) and (21)
of Regulation NMS, includes information concerning quotations and
transactions in NMS stocks. 17 CFR 242.601 (``Rule 601'') provides for
the dissemination of transaction information; 17 CFR 242.602 (``Rule
602'') provides for the dissemination of quotation information; 17 CFR
242.603 (``Rule 603'') requires, among other things, the national
securities exchanges and national securities associations to act
jointly for disseminating consolidated market data; and 17 CFR 242.608
(``Rule 608'') addresses the joint-NMS plans that currently are
responsible for operating the facilities for collecting and
disseminating consolidated market data in NMS stocks.
In 2020, the Commission adopted a new rule and amended existing
rules to establish a new infrastructure for consolidated market data
and to update and significantly expand the content of consolidated
market data (``MDI Rules'').\81\ The MDI Rules have not yet been
implemented and, as discussed below, given their unimplemented status,
the description of Proposed Rule 615 in section IV below reflects the
regulatory structure currently in place for consolidated market data.
Section VII below addresses the economic effects of Proposed Rule 615,
taking into account both the regulatory structure currently in place
and the unimplemented MDI Rules. This section III.B.1 first will
briefly summarize the currently implemented regulatory structure for
consolidated market data. It then will discuss the status of the
implementation of MDI Rules and how it would not affect the operation
of and need for Proposed Rule 615.
---------------------------------------------------------------------------
\81\ Securities Exchange Act Release No. 90610 (Dec. 9, 2020),
86 FR 18596 (Apr. 9, 2021) (``MDI Adopting Release''); see also The
Nasdaq Stock Market LLC, et al v. SEC, No. 21-1100 (D.C. Cir. May
24, 2022) (upholding these Commission amendments to market data
rules adopted in the MDI Adopting Release). The MDI Adopting Release
provides a comprehensive discussion of the current arrangements for
consolidated market data, as well as the adopted but unimplemented
rules to change these current arrangements.
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a. Current Regulatory Structure for Consolidated Market Data
As stated in section II.B above, consolidated market data currently
is collected and disseminated by the centralized SIPs. For quotation
information, only the 16 exchanges that currently trade NMS stocks
provide quotation information to the SIPs for dissemination in
consolidated market data.\82\ FINRA has the only SRO display-only
facility (the ADF) for quotations. No broker-dealer, however, currently
uses the ADF to display quotations in NMS stocks in consolidated market
data. For transaction information, all of the national securities
exchanges that trade NMS stocks and FINRA provide real-time transaction
information to the SIPs for dissemination in consolidated market data.
Such information includes the symbol, price, and size of the
transaction. A notable difference, however, between the transaction
information provided by the national securities exchanges and the
transaction information provided by FINRA is that the identity of the
particular exchange that executed a trade is included in consolidated
market data, while the
[[Page 139]]
identity of the particular FINRA member responsible for reporting a
trade, such as a wholesaler or other type of broker-dealer, is not
included in consolidated market data.\83\
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\82\ Currently, these national securities exchanges are: Cboe
BYX Exchange, Inc. (``Cboe BYX''); Cboe BZX Exchange, Inc. (``Cboe
BZX''); Cboe EDGA Exchange, Inc. (``Cboe EDGA''); Cboe EDGX
Exchange, Inc. (``Cboe EDGX''); Investors Exchange LLC (``IEX'');
Long-Term Stock Exchange, Inc. (``LTSE''); MEMX LLC (``MEMX''); MIAX
Pearl, LLC (``MIAX PEARL''); Nasdaq BX, Inc. (``Nasdaq BX''); Nasdaq
PHLX LLC (``Nasdaq Phlx''); The Nasdaq Stock Market LLC
(``Nasdaq''); NYSE; NYSE American LLC (``NYSE American''); NYSE
Arca, Inc. (``NYSE Arca''); NYSE Chicago, Inc. (``NYSE CHX''); and
NYSE National, Inc. (``NYSE National''). The Commission approved
rules proposed by BOX Exchange LLC (``BOX'') for the listing and
trading of certain equity securities that would be NMS stocks on a
facility of BOX known as BSTX LLC (``BSTX''), but BSTX is not yet
operational. See Securities Exchange Act Release Nos. 94092 (Jan.
27, 2022), 87 FR 5881 (Feb. 2, 2022) (SR-BOX-2021-06) (approving the
trading of equity securities on the exchange through a facility of
the exchange known as BSTX); 94278 (Feb. 17, 2022), 87 FR 10401
(Feb. 24, 2022) (SR-BOX-2021-14) (approving the establishment of
BSTX as a facility of BOX). BSTX cannot commence operations as a
facility of BOX until, among other things, the BSTX Third Amended
and Restated Limited Liability Company Agreement approved by the
Commission as rules of BOX is adopted. Id. at 10407.
\83\ Separate from the dissemination of real-time transaction
information in consolidated market data, FINRA publishes statistics
on trading volume at member firms, including ATSs and wholesalers,
that are aggregated on a weekly basis. Publication of the aggregate
volume statistics is delayed by two weeks for some NMS stocks and by
four weeks for others. The statistics are available at <a href="https://www.finra.org/filing-reporting/otc-transparency">https://www.finra.org/filing-reporting/otc-transparency</a>.
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b. Unimplemented MDI Rules
When implemented, the MDI Rules will modify the current regulatory
structure for consolidated market data in two respects. First, they
will enhance the content of consolidated market data by defining three
new data elements as ``core data'' \84\--(1) information about better
priced quotations in higher priced stocks (to be implemented through a
new definition of ``round lot'' \85\ and the inclusion of certain
``odd-lot information''),\86\ (2) information about quotations that are
outside of the best-priced quotations (to be implemented through a new
``depth of book data'' definition),\87\ and (3) information about
orders that are participating in auctions (to be implemented through a
new definition of ``auction information'').\88\ As discussed below in
section III.B.1.b.ii, the MDI Rules will enhance the content of
consolidated market data, but the enhanced content of consolidated
market data still will not include all of the quotation information
currently available to market participants that purchase proprietary
data feeds that are disseminated individually by national securities
exchanges. Second, the MDI Rules will enhance the provision of
consolidated market data by adopting a new decentralized model that
replaces the SIPs with ``competing consolidators'' \89\ and ``self-
aggregators.'' \90\ Under the decentralized model, the relevant SROs
(national securities exchanges that trade NMS stocks and FINRA) will be
required to provide their data directly to multiple competing
consolidators and self-aggregators rather than to a centralized
SIP.\91\
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\84\ The term ``core data'' is defined in section 600(b)(21) of
Regulation NMS.
\85\ The term ``round lot'' is defined in section 600(b)(82) of
Regulation NMS.
\86\ The term ``odd lot information'' is defined in section
600(b)(59) of Regulation NMS.
\87\ The term ``depth of book data'' is defined in section
600(b)(26) of Regulation NMS.
\88\ The term ``auction information'' is defined in section
600(b)(5) of Regulation NMS.
\89\ The term ``competing consolidator'' is defined in section
600(b)(16) of Regulation NMS.
\90\ The term ``self-aggregator'' is defined in section
600(b)(83) of Regulation NMS.
\91\ Rule 603(b) of Regulation NMS requires, among other things,
every national securities exchange on which an NMS stock is traded
and national securities association to make available to all
competing consolidators and self-aggregators its information with
respect to quotations for and transactions in NMS stocks.
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i. Implementation of the MDI Rules
In the MDI Adopting Release in 2020, the Commission outlined a
phased transition plan for the implementation of the MDI Rules.\92\ The
first step was the filing of amendments to the effective NMS market
data plan(s) as required under Rule 614(e) of Regulation NMS.\93\ The
Commission's approval of such amendments will be the starting point for
the rest of the implementation schedule. While the Commission can
approve NMS plan amendments within 90 days of the date of their
publication in the Federal Register if the Commission finds them to be
consistent with the standards set forth in Rule 608 of Regulation
NMS,\94\ the Commission may, under rule 608(b)(2)(i), institute
proceedings to determine whether to approve or disapprove proposed
amendments, which proceedings must conclude within 180 days of notice
publication of the proposed amendments but can be extended by an
additional 120 days.\95\ Therefore, the maximum time permitted under
rule 608 for Commission action is 300 days.
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\92\ MDI Adopting Release, supra note 81, 86 FR at 18698-18701.
\93\ 17 CFR 242.614(e). The participants of the effective NMS
market data plan(s) filed proposed amendments on Nov. 5, 2021, which
were published for comment in the Federal Register. Securities
Exchange Act Release Nos. 93615 (Nov. 19, 2021), 86 FR 67800 (Nov.
29, 2021); 93625 (Nov. 19, 2021), 86 FR 67517 (Nov. 26, 2021); 93620
(Nov. 19, 2021), 86 FR 67541 (Nov. 26, 2021); 93618 (Nov. 19, 2021),
86 FR 67562 (Nov. 26, 2021) (``MDI Plan Amendments'').
\94\ 17 CFR 242.608(b)(2).
\95\ 17 CFR 242.608(b)(2). The Commission instituted proceedings
to determine whether to approve or disapprove the MDI Plan
Amendments. Securities Exchange Act Release Nos. 94310 (Feb. 24,
2022), 87 FR 11748 (Mar. 2, 2022); 94309 (Feb. 24, 2022), 87 FR
11763 (Mar. 2, 2022); 94308 (Feb. 24, 2022), 87 FR 11755 (Mar. 2,
2022); 94307 (Feb. 24, 2022), 87 FR 11787 (Mar. 2, 2022).
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After the Commission finds that the plan amendments required under
Rule 614(e) are consistent with the Rule 608 standards and approves
such amendments, the next step will be a 180-day development period,
during which competing consolidators can register with the Commission.
The development period is followed by a 90-day testing period.\96\ Once
the testing period concludes, a 180-day parallel operation period will
begin during which the SIPs and the decentralized consolidation model
will operate in parallel.\97\
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\96\ MDI Adopting Release, supra note 81, 86 FR at 18699-700.
\97\ During the parallel operation period, the SIPs will
continue to disseminate the data that they currently disseminate and
competing consolidators will be permitted to offer consolidated
market data products, including odd-lot information. Because the
round lot definition will be implemented during a later phase
consistent with the MDI Adopting Release, the SIPs and competing
consolidators will collect, consolidate and disseminate NMS data
that will be based on the current national securities exchange
definitions of round lot. Id. at 18699-18701.
---------------------------------------------------------------------------
Within 90 days of the end of the parallel operation period, the
operating committee(s) of the effective NMS plan(s), in consultation
with relevant market participants, will make a recommendation to the
Commission as to whether the SIPs should be decommissioned. The SIPs
will only cease operations to the extent that the Commission approves
an amendment pursuant to Rule 608 to the effective NMS plan(s) to
effectuate such a cessation.\98\
---------------------------------------------------------------------------
\98\ Id. at 18701. Following the cessation of the operations of
the SIPs, the changes necessary to implement the new round lot sizes
will be tested for 90 days and then implemented. Id. The Commission
also is proposing to accelerate implementation of the round lot
sizes. See Securities Exchange Act Release No. 96494 (Dec. 14, 2022)
(File No. S7-30-22) (Regulation NMS: Minimum Pricing Increments,
Access Fees, and Transparency of Better Priced Orders) (``Minimum
Pricing Increments Proposal''). The Commission encourages commenters
to review that proposal to determine whether it might affect their
comments on this proposing release.
---------------------------------------------------------------------------
The plan participants of two effective NMS plans filed the MDI Plan
Amendments on November 5, 2021.\99\ On September 21, 2022, the
Commission disapproved the proposed amendments.\100\ As a result, new
proposed amendments pursuant to Rule 608 will need to be developed and
filed for implementation of the MDI Rules.
---------------------------------------------------------------------------
\99\ See supra note 93.
\100\ Securities Exchange Act Release Nos. 95848 (Sept. 21,
2022), 87 FR 58544 (Sept. 27, 2022); 95849 (Sept. 21, 2022), 87 FR
58592 (Sept. 27, 2022); 95850 (Sept. 21, 2022), 87 FR 58560 (Sept.
27, 2022); 95851 (Sept. 21, 2022), 87 FR 58613 (Sept. 27, 2022).
---------------------------------------------------------------------------
The Commission does not believe that the subsequent implementation
of the MDI Rules would substantially affect the operation of Proposed
Rule 615. In the existing regulatory structure, the national securities
exchanges and FINRA would be required to provide the SIPs with the
necessary data (including the auction messages specified in Proposed
Rule 615(c)(1)) and the quotation and transaction information specified
in the proposed definition of ``open competition trading center'' in
Proposed Rule 600(b)(64) of Regulation NMS). When the MDI Rules are
subsequently implemented, a
[[Page 140]]
decentralized model would replace the SIPs, and the national securities
exchanges and FINRA would provide this information directly to the
competing consolidators and self-aggregators pursuant to Rule 603(b) of
Regulation NMS.\101\
---------------------------------------------------------------------------
\101\ The MDI Adopting Release states that the benefits of a
decentralized model for consolidated market data are gains in
efficiency and innovation for delivering consolidated market data,
reduced content and latency differentials between consolidated
market data and proprietary market data, and increased market
resiliency. MDI Adopting Release, supra note 81, 86 FR at 18778. As
discussed in section III.B.1.b.ii below, the Commission does not
believe that these benefits of the MDI Rules substantially reduce
the need to propose Rule 615 to address the goals stated herein.
---------------------------------------------------------------------------
As noted above, auction information is to be included in the
expanded content of consolidated market data that can be disseminated
by competing consolidators under the MDI Rules. Market participants in
the decentralized model will have a choice of whether to purchase
consolidated market data products that include auction information, as
well as any of the other components of consolidated market data.\102\
The fees that ultimately are approved for the different components of
consolidated market data will affect the extent to which market
participants choose to purchase auction information,\103\ but, as
discussed above, the fees are not known at this time. Any fees for
auction information will be required to be fair, reasonable, and not
unreasonably discriminatory,\104\ and, as such, the Commission does not
anticipate that such fees would be so high as to deter a substantial
number of market participants interested in participating in auctions
under Proposed Rule 615 from purchasing consolidated data products that
include auction information.
---------------------------------------------------------------------------
\102\ See, e.g., id. at 18751 (competing consolidators will not
be required to offer consolidated market products that ``include all
of the content of expanded core data'' and market participants ``may
choose not to take in all of the new core data elements in every
instance.'').
\103\ See, e.g., id. at 18764 (because fees will depend on
future action by the effective NMS system plans, the Commission
``cannot be certain of the level of those fees or whether such fees
would provide discounts'' for those end users who wish to receive
subsets of consolidated market data).
\104\ See, e.g., id. at 18773 (the fees for the data content
underlying consolidated market data must be ``fair, reasonable and
not unreasonably discriminatory'').
---------------------------------------------------------------------------
ii. Implementation of the MDI Rules Will Not Substantially Reduce the
Need To Propose Rule 615 To Address the Goals Stated Herein
As stated in section I above, Proposed Rule 615 is designed to
promote order-by-order competition and thereby achieve two primary
goals for the benefit of investors--(1) obtain better prices for the
execution of the marketable orders of individual investors that
currently are segmented at wholesalers, and (2) expand opportunities
for such individual investor orders to meet directly with other
investor orders without the participation of a dealer (such as a
wholesaler). The MDI Rules would not substantially reduce the need to
propose Rule 615 to address the goals stated herein.
The MDI Rules will enhance the content of consolidated market data
and thereby benefit those market participants that currently use SIP
data and decide to purchase the enhanced elements of consolidated
market data. As the MDI Adopting Release stated, however,
implementation of the MDI Rules will not expand the content of data
already available to sophisticated market participants that purchase
the proprietary data feeds that are individually disseminated by the
national securities exchanges.\105\ The Commission stated its
understanding that ``approximately 50 to 100 firms purchase all of the
proprietary [depth-of-book] feeds from the exchanges and do not rely on
the SIP data for their trading.'' \106\ Moreover, these 50 to100 firms
that currently use proprietary data feeds play a significant role in
the current market structure.\107\ For example, the MDI Adopting
Release stated that ``nearly all orders entered in the [NMS], including
retail orders, touch a component (typically the order router of the
executing broker) that uses proprietary data in order to reduce
execution costs and improve execution quality.'' \108\ Furthermore, the
Commission understands that the wholesalers, as six of the highest
volume trading firms in the U.S. equity markets, currently pay for and
use the proprietary data feeds. One wholesaler submitted a comment on
the MDI Rules stating that it would be unable to remain competitive,
even after the MDI Rules were implemented, without continuing to
purchase proprietary data feeds.\109\
---------------------------------------------------------------------------
\105\ See, e.g., id. at 18752 (``[a]lthough expanded core data
will not contain all of the data contained in proprietary [depth of
book] feeds, the Commission believes that it will contain data that
will be useful for market participants''); id. at 18754 (the
potentially lower cost of consolidated market data ``will come at
the expense of losing the full set of data currently available via
proprietary feeds,'' because the consolidated market data definition
``does not include all data elements currently available via
proprietary data feeds.'').
\106\ Id. at 18728.
\107\ See, e.g., id. at 18734 n. 1724 (Commission analysis
showed that 91.6% of the message volume on exchanges in a sample
week came from just 50 firms that use proprietary data feeds).
\108\ Id. at 18734.
\109\ Id. at 18793 n. 2386 (commenters agreed that ``switching
to new consolidated market data would come with this expense of
losing some data compared to the proprietary data feeds,'' with one
stating that it would be ``unable to remain competitive even after
the final amendments are in place without continuing to purchase
proprietary data feeds.''); see also id. at 18795 (stating
possibility that potential participants in automated market making
and other latency sensitive trading businesses could not ``compete
effectively without using the data that would remain exclusive to
proprietary feeds'').
---------------------------------------------------------------------------
Statements in the MDI Adopting Release addressing the benefits of
the MDI Rules are consistent with a conclusion that the MDI Rules can
benefit SIP data users that currently do not purchase the proprietary
data feeds, but will not substantially reduce the need to propose Rule
615 to address the goals stated herein. For example, the MDI Adopting
Release stated that the ``odd-lot aggregation methodology'' of the MDI
Rules ``would benefit market participants by promoting tighter spreads
in all stocks, especially high priced ones.'' \110\ All of the odd lot
quotations that will be aggregated, however, were already included in
an order-by-order basis in the proprietary data feeds that the
Commission understands the wholesalers use. As the MDI Adopting Release
stated, the inclusion of odd-lot quote information in core data will
improve transparency and ``reduce information asymmetry between market
participants who already receive this information through proprietary
[depth-of-book] feeds and market participants who choose to subscribe
to this aspect of core data and previously did not receive this
information.\111\
---------------------------------------------------------------------------
\110\ MDI Adopting Release, supra note 81, 86 FR at 18615.
\111\ Id. at 18753.
---------------------------------------------------------------------------
In addition, the MDI Adopting Release states that ``because richer,
more timely consolidated market data may enhance the ability of broker-
dealers to obtain the most favorable terms reasonably available under
the circumstances, including the best reasonably available price and
other factors, for their customer orders, broker-dealers should
consider the availability of consolidated market data for purposes of
evaluating best execution.'' \112\ The availability of additional
quotation information in consolidated market data, however, is unlikely
to affect the wholesalers' and retail brokers' evaluation of best
execution because the Commission understands that wholesalers already
would be expected, under FINRA
[[Page 141]]
guidance,\113\ to use a more complete set of quotation information
(i.e., proprietary data feeds) than will be available in the expanded
MDI data when evaluating best execution today, and retail brokers use
wholesalers as executing brokers to obtain the best terms reasonably
available.
---------------------------------------------------------------------------
\112\ Id. at 18605 (footnotes omitted).
\113\ The MDI Adopting Release referred to this FINRA guidance
concerning the relevance of proprietary data feeds to a broker-
dealer's best execution efforts under FINRA rules. Id. at 18605 n.
94 (quoting FINRA Notice to Members 15-46, Guidance on Best
Execution Obligations in Equity, Options and Fixed Income Markets at
3 n. 12 (Nov. 2015), available at <a href="https://www.finra.org/rules-guidance/notices/15-46">https://www.finra.org/rules-guidance/notices/15-46</a> (``FINRA Notice 15-46''). The relevant
portion of FINRA Notice 15-46 provides the following guidance on
compliance with FINRA Rule 5310: ``[A] firm that regularly accesses
proprietary data feeds, in addition to the consolidated SIP feed,
for its proprietary trading, would be expected to also be using
these data feeds to determine the best market under prevailing
market conditions when handling customer orders to meet its best
execution obligations.''
---------------------------------------------------------------------------
The MDI Adopting Release also stated that ``as a result of the new
round lot definition and the inclusion of odd-lot quotations in core
data, retail investors will be able to see, and more readily access,
better-priced quotations.'' \114\ Such information will, depending on
the fees yet to be determined for such information (as stated above),
enable those retail investors that purchase such information (or for
those retail investors whose broker-dealers purchase it for them) to
see and more readily access better-priced quotations than the current
NBBO disseminated by the SIPs. To do so, retail investors will need to
direct their own orders to the particular trading center that is
displaying a better-priced quotation. As stated in the MDI Adopting
Release, however, most retail investors rely on their broker-dealers
for execution of their orders, and the additional quotation information
will likely be used by more sophisticated retail investors that are
able to process quotation information and self-direct their
orders.\115\
---------------------------------------------------------------------------
\114\ Id. at 18601.
\115\ See, e.g., id. at 18753 (``the Commission believes, as
suggested by commenters, that retail brokers may allow some
sophisticated retail investors to directly utilize the expanded
content of core data and realize the benefits discussed below'').
---------------------------------------------------------------------------
The MDI Adopting Release also stated that ``through the addition of
depth of book data and auction information in core data, the scope of
NMS information will, to a greater extent, allow some market
participants to trade in a more informed, competitive, and efficient
manner.'' \116\ The phrase ``some market participants'' as discussed
above, refers to those market participants that currently rely on SIP
data for trading and not the proprietary data feeds. For the marketable
orders of individual investors that currently are routed to
wholesalers, the expansion of depth of book data in consolidated market
data will not affect the information used for their execution because
the Commission understands that wholesalers currently use proprietary
data feeds for evaluating the best execution of their orders, which
include more information than the expanded consolidated market data of
the MDI Rules.
---------------------------------------------------------------------------
\116\ Id. at 18601.
---------------------------------------------------------------------------
An aspect of the MDI Rules that will affect the public evaluation
of wholesaler order execution quality is smaller round lot sizes for
quotations in NMS stocks with prices greater than $250 per share. These
quotations determine the NBBO, and smaller round lot sizes can lead to
narrower NBBO spreads. As discussed in section II above, the NBBO is a
benchmark used to assess the market for an NMS stock, as well as to
retrospectively assess the level of execution quality for an order.
Accordingly, although implementation of the MDI Rules will not increase
the information available to wholesalers in proprietary data feeds,
changes in the round lot definition could narrow the NBBO as a public
benchmark for the execution quality of the marketable orders of
individual investors.
The Commission does not believe, however, the smaller round lot
sizes for NMS stocks with prices that exceed $250 per share will
substantially affect the need for Proposed Rule 615 in terms of
improved order execution quality for the marketable orders of
individual investors. In particular, Proposed Rule 615 would encompass
all NMS stocks, while the new round lot definition will encompass a
much smaller range of NMS stocks and trading volume. In the MDI
Adopting Release, for example, Table 3 and Table 4 set out the range of
stocks and volume estimated to be affected by the new round lot
definition. This information is summarized below:
----------------------------------------------------------------------------------------------------------------
% Average % Average
Round lot tier Number of NMS daily share daily dollar % Instances of
stocks volume volume smaller NBBO
----------------------------------------------------------------------------------------------------------------
$0-$250......................................... 9,023 97.12 71.93 n/a
$250.01-$1,000.................................. 117 2.79 23.24 26.6
$1,000.01-$10,000............................... 16 0.09 4.82 47.7
$10,000+........................................ 1 0.00 0.02 n/a
----------------------------------------------------------------------------------------------------------------
First, as stated in the MDI Adopting Release, ``most stocks,
approximately 98.5%, will remain unaffected'' by the new round lot
definition.\117\ The 98.5% of unaffected NMS stocks with prices of $250
or less represented 97.12% of total NMS stock share volume and 71.93%
of total NMS stock dollar volume. Thus, the great majority of NMS
stocks and their volume would not be affected by the narrowing of the
NBBO benchmark that will result from the new round lot definition in
the MDI Rules.\118\
---------------------------------------------------------------------------
\117\ MDI Adopting Release, supra note 81, 86 FR at 18743 (Table
4).
\118\ Id. at 18753 (``Even though the new round lot definition
would expand information on odd-lots that may be priced better than
the current NBBO in some stocks, most stocks would not be affected
by the new round lot definition.'') (footnotes omitted).
---------------------------------------------------------------------------
Second, for the estimated 1.5% of high-priced NMS stocks (over
$250) that will be affected by the reduction in round lot sizes, the
Commission estimated that most of the dollar volume (23.24% of total
NMS stock dollar volume) will occur within the $250.01-$1,000 tier, but
in this tier, the NBBO spread will be reduced for only 26.6% of the
trading day.\119\ For the remaining 73.4% of the trading day in these
NMS stocks, the NBBO spread in these NMS stocks will be
unaffected.\120\ Accordingly, even for the 1.5% of NMS stocks that will
be affected by the revised round lot definition, NBBO spreads were
estimated to remain unaffected for the most of the trading day.
---------------------------------------------------------------------------
\119\ Id. at 18743 (Table 3).
\120\ Id. (Table 4). For NMS stocks with prices of $1000.01 to
$10,000, which represented 4.82% of trading volume, the Commission
estimated that, taking into account the new round lot definition,
the NBBO spread would be reduced to some extent for 47.7% of the
trading day. Id. (Tables 3-4).
---------------------------------------------------------------------------
This conclusion is consistent with statements in the MDI Adopting
Release. For example, the MDI Adopting Release states that ``the size
of the change in the NBBO spread, conditional
[[Page 142]]
on the NBBO being smaller, will also be substantial.'' \121\ The phrase
``conditional on the NBBO being smaller'' \122\ means that the
reduction in size of the half spread is limited to the 1.5% of stocks
and their volume that, as discussed above, will be affected by the new
odd lot definition. As a result, there will be a significant reduction
in half spread of the NBBO for those stocks, but this reduction is
conditional on the minority of the trading day for 1.5% of NMS stocks
when NBBO spreads actually will be affected by the new round lot
definition.
---------------------------------------------------------------------------
\121\ Id. at 18744.
\122\ Similarly, the following statement in the MDI Adopting
Release is conditional on those instances where the NBBO spread is
smaller: ``The Commission believes that, in particular, for
securities with a significant amount of dollar trading volume, there
will be significant changes to (tightening of) the quoted spread
displayed under the new round lot definition.'' Id. at 18743.
---------------------------------------------------------------------------
Third and finally, the NBBO as a benchmark for order execution
quality does not, as discussed in section II.C above, reflect the
availability of prices better than round lot displayed quotations. Such
better prices include displayed odd lot quotations and undisplayed
orders at national securities exchanges, as well as the availability of
NBBO price improvement at wholesalers that is enabled by the low
adverse selection costs of the marketable orders of individual
investors. In the MDI Adopting Release, the Commission considered
whether a narrowing of the NBBO spread would affect the order execution
quality of retail investors.\123\ While it stated that a narrowing of
the NBBO spread would, by definition, reduce the level of NBBO price
improvement if execution prices for retail investors remained the
same,\124\ the Commission stated that ``retail investors might or might
not'' experience an improvement in execution quality, ``as measured by
execution prices,'' from wholesalers.\125\ The Commission stated that a
retail broker commented that retail investors would not receive better
execution prices under the new round lot sizes because wholesalers
already offer price improvement to retail investors that exceeds the
potential improvements in the NBBO from the new round lot size.\126\
Another commenter stated that all investors, including retail
investors, would experience reduced execution costs from a tighter NBBO
no matter where the execution took place.\127\ The Commission concluded
that it was ``uncertain'' whether the execution quality that retail
investors receive from wholesalers would change if the NBBO spread
narrows because the effect ``would depend on how the change in the NBBO
compared to the current price improvement offered by wholesalers,'' as
well as on ``changes in the degree of price improvement wholesalers
will offer in stocks with tighter NBBOs, which is uncertain.'' \128\
---------------------------------------------------------------------------
\123\ Id. at 18747 (section addressing ``effects of
internalization on retail order flow'').
\124\ Id. (``it may become more difficult for the retail
execution business of wholesalers to provide price improvement and
other execution quality metrics at levels similar to those provided
under the 100 share round lot definition today'').
\125\ Id.
\126\ Id.
\127\ Id.
\128\ Id.
---------------------------------------------------------------------------
As stated above, the Commission understands that wholesalers
already would be expected, under FINRA guidance, to use proprietary
data feeds, which contain a fuller set of quotations than will be
included in the new round lot definition, when, among other things,
evaluating best execution. Consequently, the new round lot definition
will not change the quotation data used by wholesalers to determine
prices for executing the orders of individual investors, but rather
will change the NBBO as benchmark for analysis of order execution
quality at wholesalers.\129\ Moreover, narrowing the NBBO as a
benchmark for execution quality of wholesalers will affect all
wholesalers equally. For example, if the average NBO for an NMS stock
declined by two cents, the NBO as a benchmark would reduce the
calculation of NBBO price improvement by two cents for all wholesalers
and therefore leave them in the same relative position when compared to
each other. The Commission does not believe that implementation of the
new round lot definition in the MDI Rules will substantially affect the
need for Proposed Rule 615 in terms of an improvement in the order
execution quality of the marketable orders of individual investors.
---------------------------------------------------------------------------
\129\ Id. at 18745 (``the new round lot definition will also
improve transaction cost analysis and best execution analysis in
higher priced stocks, which are benchmarked against the NBBO'').
---------------------------------------------------------------------------
2. Rules Addressing Order Handling and Execution
Broker-dealers owe their customers a duty of best execution when
handling and executing customer orders.\130\ This duty of best
execution derives from common law agency principles and fiduciary
obligations, and is incorporated in SRO rules and enforced through the
antifraud provisions of the Federal securities laws.\131\ The
Commission has stated that ``the duty of best execution generally
requires broker-dealers to execute customers' trades at the most
favorable terms reasonably available under the circumstances, i.e., at
the best reasonably available price.'' \132\ Broker-dealers should
periodically assess the quality of competing markets to assure that
order flow is directed to the markets providing the most beneficial
terms for their customer orders.\133\ In doing so, broker-dealers must
take into account price improvement opportunities, and whether
different markets may be more suitable for different types of orders or
particular securities.\134\
---------------------------------------------------------------------------
\130\ The Commission also is proposing a new rule addressing the
best execution obligations of broker-dealers. See Securities
Exchange Act Release No. 96496 (Dec. 14, 2022) (File No. S7-32-22)
(Regulation Best Execution) (``Regulation Best Execution
Proposal''). The Commission encourages commenters to review that
proposal to determine whether it might affect their comments on this
proposal.
\131\ See MDI Adopting Release, supra note 81, 86 FR at 18605.
In addition, FINRA has codified a duty of best execution in its
rules, requiring a broker-dealer to ``use reasonable diligence to
ascertain the best market for the subject security and buy or sell
in such market so that the resultant price to the customer is as
favorable as possible under prevailing market conditions.'' FINRA
Rule 5310, ``Best Execution and Interpositioning.''
\132\ See MDI Adopting Release, supra note 81, 86 FR at 18605
(quoting Regulation NMS Adopting Release, supra note 78, 70 FR at
37538); see also Geman v. SEC, 334 F.3d 1183, 1186 (10th Cir. 2003)
(quoting Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135
F.3d 266, 270 (3d Cir. 1998)) (``[T]he duty of best execution
requires that a broker-dealer seek to obtain for its customer orders
the most favorable terms reasonably available under the
circumstances.''); and Kurz v. Fidelity Management & Research Co.,
556 F.3d 639, 640 (7th Cir. 2009) (describing the ``duty of best
execution'' as ``getting the optimal combination of price, speed,
and liquidity for a securities trade'').
\133\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37538.
\134\ See id.
---------------------------------------------------------------------------
After the enactment of section 11A in 1975, which included as an
objective the practicability of brokers' executing investor orders in
the best market,\135\ the Commission adopted rules that prescribe
requirements for the handling and execution of orders in NMS stocks in
certain contexts. These rules were often designed, at least in part, to
promote best execution of investors' orders. Three rules in Regulation
NMS, discussed below, specifically address the handling and execution
of orders in NMS stocks--17 CFR 242.604 (``Rule 604,'' also known as
the ``Limit Order Display Rule''), 17 CFR 242.611 (``Rule 611,'' also
known as the ``Order Protection Rule''), and 17 CFR 242.612 (``Rule
612,'' also known as the ``Sub-Penny Rule'').
---------------------------------------------------------------------------
\135\ Section 11A(a)(1)(C)(iv) of the Exchange Act; see also
supra note 57 and accompanying text.
---------------------------------------------------------------------------
[[Page 143]]
a. Limit Order Display Rule
The Limit Order Display Rule was originally adopted in 1996 as Rule
11Ac1-4 and redesignated as Rule 604 with the adoption of Regulation
NMS in 2005.\136\ It establishes minimum display requirements for
customer limit orders that are not executed immediately, which, as
discussed in section II.C above, can be referred to as ``non-
marketable'' limit orders. In contrast to marketable limit orders, non-
marketable limit orders cannot be executed immediately at the NBBO.
Rule 604 requires specialists and OTC market makers 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 quotation.\137\ Specialists
and OTC market makers also must increase the size of their quotation
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 quotation and that quotation is
equal to the NBBO.\138\
---------------------------------------------------------------------------
\136\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37570. Modifications included conforming terms to those adopted with
Regulation NMS, such as changing references from ``covered
security'' to ``NMS stock.'' Id. at 37572.
\137\ Rule 604(b)(1) provides exceptions for, among other
things, orders executed immediately upon receipt and odd lot orders.
\138\ See Securities Exchange Act Release No. 37619A (Sep. 6,
1996), 61 FR 48290, 48290 (Sep. 12, 1996) (Order Execution
Obligations) (adopting final rules to require the display of
customer limit orders and amending a rule governing publication of
quotations) (``1996 Order Handling Release''); Rule 604(a).
---------------------------------------------------------------------------
In adopting Rule 604, the Commission observed that the enhanced
transparency of such orders would increase the likelihood that customer
limit orders would be executed because contra-side market participants
would have a more accurate picture of trading interest in a given
security, and that the increased visibility would enable market
participants to interact directly with limit orders, rather than rely
on the participation of a dealer for execution.\139\ The Commission
also stated that the display requirement (together with other
amendments being made at the time) would help ensure the disclosure of
customer and market maker buying and selling interest that had, prior
to adoption of Rule 604, been hidden from many market
participants.\140\
---------------------------------------------------------------------------
\139\ See 1996 Order Handling Release, supra note 138, 61 FR at
48293.
\140\ Id. at 48292. The Commission also adopted amendments 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''). Id. at 48292. Also,
at the same time it adopted the Limit Order Display Rule in 1996,
the Commission deferred action on a proposed rule to address the
handling of customer market orders of less than block size, referred
to as the ``Price Improvement Rule.'' Id. at 48322. This proposed
rule would have required specialists and OTC market makers to
provide their customer market orders an opportunity for price
improvement. The proposal included a non-exclusive safe harbor to
satisfy the price improvement obligation that included exposing the
customer order for 30 seconds at an improved price in a published
quotation. The proposal sought to improve opportunities in auction
and dealer markets for market orders to interact directly with other
market orders and public limit orders, consistent with the goals of
an NMS. Id.
---------------------------------------------------------------------------
b. Order Protection Rule
In 2005, the Commission adopted the Order Protection Rule as Rule
611 of Regulation NMS. Rule 611(a) applies to ``trading centers,''
which is defined broadly in Rule 600(b)(95) as a national securities
exchange or national securities association that operates an SRO
trading facility, an ATS, an exchange market maker, an OTC market
maker, or any other broker or dealer that executes orders internally by
trading as principal or crossing orders as agent.
Rule 611(a)(1) requires trading centers to implement written
policies and procedures reasonably designed to prevent trade-throughs--
the execution of an order at a price that is inferior to the price of a
``protected quotation.'' \141\ To be protected, a quotation must be
immediately and automatically accessible up to its full displayed size,
must be the best-priced quotation (highest bid to buy and lowest offer
to sell) in round lot sizes of an exchange or FINRA, and must be
disseminated in consolidated market data.\142\ Accordingly, Rule 611
provides for intermarket price protection only of an exchange's or
FINRA's best bid and offer (``BBO''). It does not establish time
priority among the same-priced quotations at different trading centers,
nor does it protect ``depth-of-book'' quotations (quotations with
prices outside an exchange's or FINRA's BBO) or odd lot quotations
(quotations with sizes of less than one round lot).
---------------------------------------------------------------------------
\141\ Rule 600(b)(70) defines ``protected bid'' or ``protected
offer'' as a quotation in an NMS stock that: (i) is displayed by an
automated trading center; (ii) is disseminated pursuant to an
effective NMS plan; and (iii) is an automated quotation that is the
best bid or best offer of a national securities exchange, or the
best bid or best offer of a national securities association.
\142\ Rule 600(b)(71) defines ``protected quotation'' as a
protected bid or a protected offer. As stated in section II.B.1
above, no FINRA member currently uses the ADF, its facility for
displaying quotations, to disseminate quotations in consolidated
market data. Today, only exchanges display protected quotations
under Rule 611.
---------------------------------------------------------------------------
In adopting Rule 611, the Commission stated that strong intermarket
price protection offers greater assurance, on an order-by-order basis,
to investors who submit market orders that their orders in fact will be
executed at the best readily available prices, which can be difficult
for investors, particularly individual investors, to monitor.\143\ One
of the Commission's concerns when adopting Rule 611 was the
internalization of individual investor orders by broker-dealers. The
Commission observed that the great majority of internalized trades are
the small trades of individual investors, and that, in 2003, nearly 1
out of every 30 of these trades, of which there are millions, appears
to have been executed at a price inferior to an automated and
accessible quotation.\144\ The Commission stated that Nasdaq's data
submitted in response to the Rule 611 proposal appeared to indicate a
need for regulatory action to reinforce the fundamental principle of
best price for all NMS stocks.\145\
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\143\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37505.
\144\ Id. at 37508.
\145\ Id. In response to the Commission's proposal to adopt
Regulation NMS, The Nasdaq Stock Market, Inc. (n.k.a. Nasdaq)
submitted data to show that the trade-through rates for Nasdaq
stocks in some trading centers had dropped from the Fall of 2003 to
the Fall of 2004, and that the reduction during that time was a
result of fewer independently operating ECNs. The Commission stated
``[i]t is unlikely that ECN consolidation could have caused such a
major reduction in trade-through rates at securities dealers when
they execute their customer orders internally.'' Id. (footnote
omitted).
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c. Sub-Penny Rule
Also in 2005, the Commission adopted the Sub-Penny Rule as Rule 612
of Regulation NMS to establish a minimum pricing increment for NMS
stocks. Specifically, paragraph (a) of Rule 612 provides that no
national securities exchange, national securities association, ATS,
vendor, or broker or dealer shall display, rank, or accept from any
person a bid or offer, an order, or an indication of interest in any
NMS stock priced in an increment smaller than $0.01 if that bid or
offer, order, or indication of interest is priced equal to or greater
than $1.00 per share.\146\ Rule 612 does not, however, prohibit a sub-
penny trade by a wholesaler or other internalizing broker-dealer, as
long as the trade did not result from an impermissible sub-penny
quotation,
[[Page 144]]
order, or indication of interest.\147\ For example, Rule 612 does not
prevent wholesalers, after they receive an order from a broker, from
choosing to execute that order in a transaction at a sub-penny price.
This includes a trade executed at a price that is a sub-penny increment
better than the best displayed quotation in consolidated market
data.\148\ This sub-penny trading exception is not available to market
participants on exchanges and ATSs,\149\ in contrast, because those
trading centers operate by accepting, matching, and executing orders
from market participants. Exchanges and ATSs, with limited exceptions,
may only execute orders at a sub-penny price if the price is the NBBO
midpoint.\150\ Also, exchanges with retail liquidity programs
(``RLPs'') have been granted an exemption from Rule 612 to provide
executions in tenths of a penny.\151\ The Commission has granted
exemptions for these programs to promote competition between exchanges
and OTC market makers (which, as discussed above, includes
wholesalers).\152\ As discussed in section VII below, however, the
great majority of marketable orders of individual investors continue to
be routed first to wholesalers.
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\146\ 17 CFR 242.612(a). Paragraph (b) of Rule 612 sets forth a
minimum increment of $0.0001 for prices less than $1.00 per share.
\147\ The Commission also is proposing to amend Rule 612
regarding sub-penny trading. See Minimum Pricing Increments
Proposal, supra note 98. The Commission encourages commenters to
review that proposal to determine whether it might affect their
comments on this proposing release.
\148\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37556 (the Commission stated that sub-penny executions due to price
improvement are generally beneficial to retail investors).
\149\ The regulatory framework for ATSs is discussed in section
III.B.3 below.
\150\ Neither Rule 612 nor any other Commission rule or
interpretation states that exchanges and ATSs may execute midpoint
orders at a sub-penny amount (e.g., if the NBBO is 10.00-10.01 to
execute at the mid-point price of 10.005). However, the Commission
has stated that Rule 612 will not prohibit a sub-penny execution
resulting from a midpoint or volume-weighted algorithm or from price
improvement, so long as the execution did not result from an
impermissible sub-penny order or quotation. Regulation NMS Adopting
Release, supra note 78, 70 FR at 37556. Undisplayed ``floating''
midpoint orders (i.e., orders that re-price when the exchange BBO
changes), for example, are permissible under Rule 612, and the
Commission has approved numerous rule proposals by national
securities exchanges for their use. See, e.g., Securities Exchange
Act Release Nos. 89563 (Aug. 14, 2020), 85 FR 51510 (Aug. 20, 2020)
(SR-PEARL-2020-03) (order approving proposed rule change by MIAX
PEARL to establish rules governing the trading of equity securities,
including a midpoint peg order type); and 78101 (June 17, 2016), 81
FR 41142 (June 23, 2016) (File No. 10-222) (order approving IEX's
registration as a national securities exchange, including the
exchange's inclusion of a midpoint pegged order type in its
rulebook).
\151\ Several exchanges operate RLPs. These are programs for
retail orders seeking liquidity that allow market participants to
supply liquidity to such retail orders by submitting undisplayed
orders priced at least $0.001 better than the exchange's protected
best bid or offer. Each program results from a Commission approval
of a proposed rule change made on Form 19b-4 combined with a
conditional exemption, pursuant to section 36 of the Exchange Act,
from Rule 612 to enable the exchange to accept and rank (but not
display) the sub-penny orders. See, e.g., Securities Exchange Act
Release Nos. 85160 (Feb. 15, 2019), 84 FR 5754 (Feb. 22, 2019) (SR-
NYSE-2018-28) (approving the NYSE RLP on a permanent basis and
granting the exchange a limited exemption from the Sub-Penny Rule to
operate the program); 86194 (June 25, 2019), 84 FR 31385 (July 1,
2019) (SR-BX-2019-011) (approving Nasdaq BX's retail price
improvement program on a permanent basis and granting the exchange a
limited exemption from the Sub-Penny Rule to operate the program).
\152\ Id. See also Securities Exchange Act Release No. 73702
(Nov. 28, 2014), 79 FR 72049 (Dec. 4, 2014) (SR-BX-2014-048)
(approving Nasdaq BX's (f/k/a NASDAQ OMX BX Inc.) establishment of
its retail price improvement program on a pilot basis). In granting
the original exemption from Rule 612, the Commission stated that the
vast majority of ``marketable retail orders'' are internalized by
OTC market makers, and that retail investors can benefit from such
arrangements to the extent that OTC market makers offer them price
improvement over the NBBO. This price improvement is typically
offered in sub-penny amounts. The Commission explained that OTC
market makers typically select a sub-penny price for a trade without
quoting at that exact amount or accepting orders from retail
customers seeking that exact price; and that exchanges--and exchange
member firms that submit orders and quotations to exchanges--cannot
compete for ``marketable retail order flow'' on the same basis,
because it would be impractical for exchange electronic systems to
generate sub-penny executions without exchange liquidity providers
or retail brokerage firms having first submitted sub-penny orders or
quotations, which the Sub-Penny Rule expressly prohibits. The
Commission explained that the limited exemption granted to operate
the retail price improvement program should promote competition
between exchanges and OTC market makers in a manner reasonably
designed to minimize the problems that the Commission identified
when adopting the Sub-Penny Rule. Id. at 72053.
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3. Rules Addressing Access to Trading Centers
As stated above, access to trading centers and their services is a
critically important component of the NMS as a means to link trading
centers together in a unified system. For example, the Regulation NMS
rules addressing the display of quotations, the display of customer
limit orders, and protection of customer orders cannot achieve their
objectives if market participants do not have fair and efficient means
to access those trading centers that display quotations and execute
orders.\153\
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\153\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37538. The rules discussed in this section address requirements
that apply to trading centers providing access to their services.
Exchange Act Rule 15c3-5, in contrast, addresses access, but in the
context of risk management controls for broker-dealers with market
access.
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For purposes of assessing access requirements in today's NMS,
trading centers for NMS stocks can be divided into three distinct
regulatory categories: national securities exchanges, NMS Stock ATSs,
and internalizing broker-dealers (including wholesalers). As discussed
below, the statutory access requirements and the Commission's access
rules currently apply to exchanges and ATSs, as well as to FINRA
members that display quotations in consolidated market data through
FINRA's ADF (of which there currently are none). In contrast, broker-
dealers that do not display quotations in consolidated market data and
that trade outside of an ATS, such as wholesalers, are not subject to
any fair access requirements under the Exchange Act or Commission
rules. While subject to Commission and SRO rules for broker-dealers,
internalizing broker-dealers are not prohibited from restricting access
to their trading mechanisms and the investor orders that they
internalize. An internalizing broker-dealer is not required, for
example, to provide other market participants, including institutional
investors and liquidity providers on exchanges, with any opportunity to
compete to provide the best prices to the individual investor orders
that the broker-dealer executes internally.
a. Access Rules for National Securities Exchanges
As stated in section III.A above, the Exchange Act directly
requires national securities exchanges to provide fair access in four
contexts.\154\ Section 6(b)(2) specifies that exchange rules must allow
``any'' broker-dealer registered with the Commission, unless subject to
a specified disqualification, to become a member of the exchange.
Section 6(b)(4) requires that exchange rules provide for the
``equitable'' allocation of ``reasonable'' dues, fees, and other
charges among members, issuers, and other persons using exchange
facilities. Section 6(b)(5) broadly requires that exchange rules be
designed, among other things, to remove impediments to and perfect the
mechanism of a free and open market and an NMS, and that exchange rules
are not designed to permit unfair discrimination between customers,
issuers, brokers, or dealers. And section 6(b)(8) requires that
exchange rules do not impose any burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act.
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\154\ See supra notes 61-66 and accompanying text.
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In addition to these broad statutory requirements for all national
securities exchanges, the Commission has adopted 17 CFR 242.610 (``Rule
610'') of Regulation NMS, which addresses access to displayed
quotations.
[[Page 145]]
Specifically, Rule 610(a) prohibits any national securities exchange
that operates an SRO trading facility \155\ from imposing unfairly
discriminatory terms that would prevent or inhibit any person from
obtaining efficient access through a member of the national securities
exchange to the quotations in an NMS stock displayed through its SRO
trading facility. This provision is designed to prohibit national
securities exchanges from limiting ``piggyback access'' as a means by
which non-members obtain access to exchange quotations through the
services of an exchange member.\156\ Piggyback access, for example,
allows non-members to obtain access to a national securities exchange's
quotations without the need to obtain (and pay for) direct connectivity
to the exchange.
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\155\ Rule 600(b)(89) defines an ``SRO trading facility'' as a
facility operated by or on behalf of a national securities exchange
or a national securities association that executes orders in a
security or presents orders to members for execution.
\156\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37539. Rule 610(c) also limits the fees that can be charged for
accessing an exchange's best-priced displayed quotations, and Rule
610(d) addresses locking and crossing quotations.
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b. Access Rules for NMS Stock ATSs
In 1998, the Commission initiated a new regulatory regime for ATSs
with the adoption of Regulation ATS.\157\ An ATS is a trading system
that falls within the definition of exchange in Section 3(b)(1) of the
Exchange Act, but is exempted from such definition by Rule 3a1-1 under
the Exchange Act if the trading system complies with Regulation
ATS.\158\ For an NMS Stock ATS,\159\ Regulation ATS requires, among
other things, that the NMS Stock ATS must register with the Commission
as a broker-dealer and must file a Form ATS-N, a publicly available
document that includes detailed disclosures about the NMS Stock ATS's
operations.
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\157\ See Regulation ATS Adopting Release, 63 FR 70844, supra
note 27. ``Regulation ATS'' consists of 17 CFR 242.300 through
242.304 (``Rule 300'' through ``Rule 304'' under the Exchange Act).
\158\ 17 CFR 240.3a1-1.
\159\ In 2018, the Commission amended Regulation ATS with
respect to the requirements that apply to NMS Stock ATSs. Securities
Exchange Act Release No. 83663 (July 18, 2018), 83 FR 38768 (Aug. 7,
2018) (``ATS-N Adopting Release'').
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In addition, Regulation ATS includes two separate types of access
requirements that potentially can apply to an NMS Stock ATS. First,
Rule 301(b)(3) imposes order display and execution access requirements
on an NMS Stock ATS that displays orders to any person and had 5% or
more of average daily volume reported in an NMS stock during four of
the preceding six calendar months. Similar to Rule 610, the ``execution
access'' requirement of Rule 301(b)(3) is limited to access to
displayed quotations in consolidated market data. As stated above in
section III.B.1, FINRA's ADF is a facility for broker-dealers
(including ATSs) to display quotations in consolidated market data.
Currently, no NMS Stock ATS that displays quotations uses the ADF to
display its quotations in consolidated market data, and no NMS Stock
ATS is subject to the execution access requirement of Rule 301(b)(3).
Second, Rule 301(b)(5) imposes ``fair access'' requirements with
respect to an NMS stock in which the NMS Stock ATS had 5% or more of
the average daily volume reported during four of the preceding six
calendar months. This fair access requirement requires an NMS Stock ATS
(1) to establish written standards for granting access to trading on
its systems, (2) to not unreasonably prohibit or limit any person in
respect to access to services offered by such ATS by applying the
written access standards in an unfair or discriminatory manner, (3) to
maintain records of grants, denials, and limitations of access, and (4)
to report the information required by Form ATS-R on grants, denials,
and limitations of access. When it adopted Regulation ATS, the
Commission emphasized that the fair access requirements of Rule
301(b)(5) apply to a far broader range of services than the ``execution
access'' requirements of Rule 301(b)(3), which are limited to access to
quotations. Specifically, the Commission stated that although it was
adopting rules to require ATSs with significant trading volume to
publicly display their best bid and offer and provide equal access to
those orders, direct participation in ATSs offers benefits in addition
to execution against the best bid and offer. The Commission gave as an
example that direct participants could enter limit orders into the
system, rather than just execute against existing orders on a fill-or-
kill basis,\160\ and that direct participants could view all orders,
not just the best bid or offer, which provides important information
about the depth of interest in a particular security. The Commission
further observed that some ATSs also allowed direct participants to
enter ``reserve'' orders which hide the full size of an order from
view. Because of these advantages to direct participants in an ATS,
access to the best bid and offer through an SRO provided an incomplete
substitute. Therefore, the Commission adopted rules to require most
ATSs that have a significant percentage of overall trading volume in a
particular security to comply with fair access standards.\161\
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\160\ A fill-or-kill order is an order with instructions to
cancel the order if it cannot be executed in its full size.
\161\ Regulation ATS Adopting Release, supra note 27, 63 FR at
70872 (footnote omitted).
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In sum, the fair access requirements of Rule 301(b)(5) encompass
all of the trading services of an NMS Stock ATS. When adopting these
requirements, the Commission emphasized that an ``alternative trading
system must apply [fair access] standards fairly and is prohibited from
unreasonably prohibiting or limiting any person with respect to trading
in any equity securities.'' \162\
---------------------------------------------------------------------------
\162\ See id. at 70873.
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Currently, only a single NMS Stock ATS discloses on its Form ATS-N
that it is subject to these fair access requirements for securities
that are available for trading on its platform.\163\ NMS Stock ATSs
that are not subject to fair access requirements are not prohibited
from unfairly discriminating with respect to the trading services they
offer broker-dealers and other market participants.
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\163\ See supra note 29 and accompanying text.
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c. Access Rules for ADF Participants
As stated in section III.B.2 above, Rule 611 protects the best-
priced displayed quotations of FINRA members that use the ADF to
display quotations in consolidated market data (though no FINRA member
currently uses the ADF to do so). In adopting Rule 611, the Commission
recognized that assuring fair and efficient access to FINRA members
displaying quotations in the ADF would be essential, given that other
market participants were required by rule to not trade through such
quotations.\164\ The ADF falls within the definition of an ``SRO
display-only facility'' in Rule 600(b)(88) because it merely displays
the quotations of its participants and neither executes orders itself
nor presents orders to ADF participants for execution. Instead, market
participants must obtain their own means of access to ADF participants
to trade with ADF protected quotations. Accordingly, the Commission
adopted Rule 610(b) to promote such access to ADF participants.\165\
Rule 610(b)(2) imposes
[[Page 146]]
the same piggyback access requirement that applies to exchanges under
Rule 610(a), thereby assuring that market participants can obtain
indirect access to an ATS's or broker-dealer's quotations in the ADF.
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\164\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37540 (discussing Rule 610, which addresses means of access to
quotations). The Regulation NMS Adopting Release refers to National
Association of Securities Dealers (``NASD'') members. NASD was the
predecessor association to what today is FINRA.
\165\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37502-03; see also id. at 37539-43.
---------------------------------------------------------------------------
In addition, however, Rule 610(b)(1) imposes an access requirement
that is particularly tailored to address concerns presented by FINRA
members (including NMS Stock ATSs) displaying quotations in the ADF.
Specifically, Rule 610(b)(1) requires that any trading center that
displays quotations in NMS stocks through an SRO display-only facility
must provide a level and cost of access to such quotations that is
substantially equivalent to the level and cost of access to quotations
displayed by SRO trading facilities (such as national securities
exchanges). The Commission emphasized that the phrase ``level and cost
of access'' would encompass both (1) the policies, procedures, and
standards that govern access to quotations of the trading center, and
(2) the connectivity through which market participants can obtain
access and the cost of such connectivity.\166\ The Commission further
stated that trading centers that choose to display quotations in an SRO
display-only facility would be required to bear the responsibility of
establishing the necessary connections to afford fair and efficient
access to their quotations, and the nature and cost of these
connections for market participants seeking to access the trading
center's quotations would need to be substantially equivalent to the
nature and cost of connections to SRO trading facilities.\167\
---------------------------------------------------------------------------
\166\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37549.
\167\ Id.
---------------------------------------------------------------------------
In addition to these heightened access requirements for FINRA
members (including NMS Stock ATSs) that display quotations in the ADF,
the Commission stated that FINRA, as the self-regulatory authority
responsible for enforcing compliance by ADF participants with the
requirements of the Exchange Act, would need to evaluate the
connectivity of ADF participants to determine whether they meet the
requirements of Rule 610(b)(1).\168\ The Commission also stated that
the addition of a new ADF participant would constitute a material
aspect of the operation of FINRA's facilities, and thus require the
filing of a proposed rule change pursuant to section 19(b) of the
Exchange Act that would offer an opportunity for public notice and
comment.\169\
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\168\ Id.
\169\ Id.
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4. Disclosure of Order Routing Practices and Order Execution Statistics
Rule 606 of Regulation NMS requires broker-dealers to publish
quarterly reports on their routing of customer orders in NMS stocks,
and Rule 605 of Regulation NMS requires market centers to make data
files publicly available on a monthly basis that include a variety of
statistics on their execution of orders in NMS stocks.\170\ When it
originally adopted the two rules in 2000, the Commission stated that,
by increasing the visibility of order execution and routing practices,
the rules were ``intended to empower market forces with the means to
achieve a more competitive and efficient [NMS] for public investors.''
\171\
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\170\ The rules that the Commission originally adopted were
designated as Rule 11Ac1-6 and Rule 11Ac1-5. The Commission re-
designated Rule 11Ac1-6 as Rule 606 and Rule 11Ac1-5 as Rule 605
when it adopted Regulation NMS in 2005. Regulation NMS Adopting
Release, supra note 78, 70 FR at 37538. The term ``market center,''
as defined in Rule 600(b)(46) of Regulation NMS, is somewhat
narrower than trading center. Market centers include, for example,
national securities exchanges, ATSs, and OTC market makers
(including wholesalers), but do not include the broad catch-all
category of trading center that encompasses any broker-dealer that
executes orders internally as principal or agent.
\171\ Securities Exchange Act Release No. 43590 (Nov. 17, 2000),
65 FR 75414, 75427 (Dec. 1, 2000). The Commission enhanced the order
routing disclosure requirements of Rule 606 when it amended the rule
in 2018. Securities Exchange Act Release No. 84528 (Nov. 2, 2018),
83 FR 58338 (Nov. 19, 2018).
---------------------------------------------------------------------------
Rule 606 requires broker-dealers to disclose, among other things,
the percentage of non-directed customer orders routed to different
trading centers, as well as the financial inducements offered by these
trading centers to attract order flow.\172\ Information must be
provided for four types of orders--market orders, marketable limit
orders, non-marketable limit orders, and other orders. The enhanced
disclosures include a requirement to disclose net aggregate amounts of
PFOF received from trading centers or amounts paid to them (such as
transaction fees on exchanges), both as a total dollar amount and an
amount per 100 shares.
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\172\ A ``non-directed order'' is defined in Rule 600(b)(56) of
Regulation NMS to mean any order from a customer other than a
directed order, and a ``directed order'' is defined in Rule
600(b)(27) of Regulation NMS to mean an order from a customer that
the customer specifically instructed the broker-dealer to route to a
particular venue for execution.
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Rule 605 requires market centers to disclose standardized
statistics about the execution quality they achieve for ``covered
orders,'' as defined in Rule 600(b)(22) of Regulation NMS.\173\ In
general, the definition of covered orders excludes order types for
which the customer requests special handling that could detract from
the goal of achieving comparable statistics for similar order types
across different market centers. Unlike the Rule 606 disclosures, the
Rule 605 data files are not designed to be human-readable and instead
consist of a large volume of detailed statistics for each of the NMS
stocks in which a market center receives covered orders. The data files
are published in a format that is designed to be downloaded and
processed with analysis software, such as a spreadsheet program, which
then can be used to generate summary reports for viewing.
---------------------------------------------------------------------------
\173\ Rule 605(a)(1). The Commission also is proposing to amend
the order execution quality disclosures required by Rule 605. See
Securities Exchange Act Release No. 96493 (Dec. 14, 2022) (File No.
S7-29-22) (Disclosure of Order Execution Information). The
Commission encourages commenters to review that proposal to
determine whether it might affect their comments on this proposing
release.
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IV. Description of Proposed Rule 615
A. Overview of Order Competition Requirement
Paragraph (a) of Proposed Rule 615 sets forth the rule's core
competition requirement. It states that a restricted competition
trading center shall not execute a segmented order internally \174\
until after a broker-dealer has exposed such order to competition at a
specified limit price in a qualified auction operated by an open
competition trading center. As discussed below in this section IV: (1)
segmented order, open competition trading center, restricted
competition trading center, and qualified auction are new terms
proposed to be defined in Rule 600(b) of Regulation NMS; (2) certain
exceptions to the order competition requirement are set forth in
paragraph (b) of Proposed Rule 615; (3) the requirements for a
qualified auction are specified in paragraph (c) of Proposed Rule 615;
and (4) the requirements with respect to segmented orders that would be
imposed on open competition trading centers, originating brokers, all
broker-dealers, and national securities exchanges are set forth in
paragraphs (d) through (g) of Proposed Rule 615.
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\174\ The applicability of paragraph (a) of Proposed Rule 615 to
``internally'' executed transactions is designed to accommodate the
practice of some trading centers that both execute orders internally
and obtain executions of orders externally by seeking liquidity at
other trading centers. Cf. Rule 600(b)(95) of Regulation NMS
(definition of ``trading center'' includes ``any other broker or
dealer that executes orders internally by trading as principal or
crossing orders as agent'').
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The term ``segmented order,'' as proposed to be defined in Proposed
Rule 600(b)(91) of Regulation NMS, is a
[[Page 147]]
key term determining the scope of Proposed Rule 615 and is designed to
encompass those orders of individual investors with relatively low
adverse selection costs.\175\ In addition, paragraphs (b)(2) and (b)(3)
of Proposed Rule 615 would provide exceptions for larger orders
($200,000 or more) and orders that are executed at favorable prices for
individual investors (orders executed at the NBBO midpoint or better);
paragraph (b)(4) would provide an exception for limit orders that have
a limit price that is equal to or more favorable for the segmented
order than the NBBO midpoint (i.e., non-marketable segmented orders
with a limit price that is equal to or lower than the midpoint for buy
orders and equal to or higher than the NBBO midpoint for sell orders);
and paragraph (b)(5) would provide an exception for orders sized less
than one share and for the fractional component, if any, of a segmented
order if no qualified auction is available to execute the fractional
share or fractional component.\176\
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\175\ As discussed in IV.B.1 below, the proposed definition of
``segmented order'' would exclude very active traders whose orders
are likely to impose a much higher level of adverse selection costs
on liquidity providers than the less-active accounts that are more
typical of individual investors. This is done by limiting the
proposed definition of ``segmented orders'' to orders for accounts
in which the average daily number of trades executed in NMS stocks
was less than 40 in each of the six preceding calendar months.
\176\ As discussed in section IV.B.1 below, the proposed
definition of ``segmented order'' does not include a limit price
component. Compliance with the order competition requirement for
limit orders would vary depending on the relation of any limit price
and an execution price to the NBBO. For example, segmented orders
that have a limit price, or are executed at a price, equal to or
more favorable for the segmented order than the NBBO midpoint or
better, would have an exception under paragraph (b)(3) or (b)(4) of
Proposed Rule 615(b). Segmented orders with a limit price beyond the
NBBO midpoint (higher for segmented orders to buy and lower for
segmented orders to sell) could still qualify for the exception in
Proposed Rule 615(b)(3) if they were executed at the NBBO midpoint
or better (i.e., such an order would have been executed at a more
favorable price for the segmented order than its limit price).
---------------------------------------------------------------------------
The purpose of the order competition requirement is to expose
segmented orders to competition to provide the best prices on an order-
by-order basis and thereby minimize the transaction costs incurred by
individual investors when they use marketable orders. Proposed Rule 615
would allow flexibility for broker-dealers, wholesalers, and other
restricted competition trading centers in how they comply with the
rule. A broker-dealer could choose, subject to its best execution
responsibilities as discussed further below, to route a segmented order
directly to a qualified auction, to an open competition trading center,
or to a national securities exchange. Alternatively, a broker-dealer
could route such segmented order to another destination, such as a
routing broker-dealer, a wholesaler, or other restricted competition
trading center, which, in turn, could route the segmented order to a
qualified auction, to an open competition trading center, or to a
national securities exchange.
For illustrative purposes, the following is one example of how a
segmented order could be handled and executed in compliance with
Proposed Rule 615. Assume that a broker-dealer routed a customer's
segmented order to a wholesaler. The wholesaler that received the
segmented order could select a price at which it was willing to execute
a segmented order internally. Before executing internally, however, the
wholesaler would be required to submit the segmented order to a
qualified auction with a specified limit price. As discussed further
below, the specified limit price is not a price at which the wholesaler
is guaranteeing to execute (i.e., it is not a ``reserve'' price or a
``backstop'' of the segmented order).\177\ Rather, the specified limit
price would inform auction responders on how to price their orders and
also, if the segmented order did not receive an execution in the
qualified auction, would be the price (or better) at which the
wholesaler or other restricted competition trading center subsequently
could execute the segmented order as soon as reasonably possible.
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\177\ If the segmented order is not executed in the qualified
auction, however, the wholesaler could choose to execute the
segmented order internally at the specified limit price or better.
---------------------------------------------------------------------------
The wholesaler that submitted the segmented order to a qualified
auction would have a choice of whether to participate in the qualified
auction by submitting its own auction response. The wholesaler could,
for example, use its selected price for execution of the segmented
order as the specified limit price in the qualified auction or,
alternatively, the wholesaler could pick a less aggressive price as the
specified limit price for the qualified auction and participate in the
qualified auction by submitting an auction response with its more
aggressive selected price. The open competition trading center
operating the qualified auction would widely disseminate an auction
message, which would include the specified limit price, in consolidated
market data that would invite auction responses. During the qualified
auction, the full range of market participants with the technological
capability of responding to a fast (sub-second) auction, such as
exchange market makers and institutional investors through their
broker-dealers' smart order routers (``SORs''), would have an
opportunity to compete to provide the best price for the segmented
order by submitting auction responses. If all or part of the segmented
order could be executed in the qualified auction at the specified limit
price or better, the open competition trading center operating the
qualified auction would execute the segmented order pursuant to the
execution priority rules set by the open competition trading center
running the qualified auction, consistent with the execution priority
requirements of Proposed Rule 615(c)(5). If the segmented order did not
receive a full execution in the qualified auction, the unexecuted
order, or unexecuted portion thereof, would be canceled back to the
wholesaler, who could, as soon as reasonably possible, execute the
segmented order, or unexecuted portion thereof, internally at a price
that was equal to or better for the segmented order than the specified
limit price. As discussed below, the wholesaler would not, however, be
required to execute the unexecuted segmented order or unexecuted
portion of the segmented order at the specified limit price. Any
unexecuted segmented order, or any unexecuted portion thereof, would
continue to be subject to the order competition requirements of
Proposed Rule 615(a).
Given the absence of a ``reserve price'' or ``backstop''
requirement, a segmented order would not have certainty of an execution
in a qualified auction at a price equal to the NBBO or better, but the
marketable orders of individual investors orders today also do not have
certainty of execution for orders routed to wholesalers. As shown in
Table 7 in section VII.B.4 below, 1.67% of marketable order shares in
NMS stocks (and 3.61% of marketable order shares in non-S&P 500 stocks)
receive executions at prices that are outside the NBBO at the time the
wholesaler received the order. This low percentage of orders executed
outside the NBBO when routed to wholesalers is consistent with the low
probability that the NBBO will move away from individual investor
orders in the very short time period of a qualified auction.\178\ For
the reasons discussed in section VII.C.2.b.i below, the Commission does
not believe that
[[Page 148]]
segmented orders would have significantly greater risk of inferior
execution prices under Proposed Rule 615 than currently provided by
wholesalers, but the variability of execution prices could increase.
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\178\ See infra section VII.C.2.b.i (the fade probability of the
NBBO prices goes from an average of 1.8% at 25 milliseconds after an
internalized individual investor order, to 2.8% at 100 milliseconds,
and to 4.6% at 300 milliseconds).
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In sum, Proposed Rule 615 would allow segmented orders to continue
to be executed internally by a wholesaler or other restricted
competition trading center, but not until after the execution price had
been exposed to order-by-order competition in a fair and open qualified
auction. In addition, qualified auctions would give the trading
interest of other investors, particularly institutional investors, an
opportunity to interact directly (without the participation of a
dealer) with, and thus execute against, the marketable orders of
individual investors. When investor orders are able to interact
directly at a fully competitive price without the intermediation of a
wholesaler or other dealer, two investors (both the buyer and the
seller) are able to benefit mutually from a single trade, thereby
promoting the NMS objective that, consistent with the objectives of
economically efficient execution of securities transactions and the
practicability of brokers executing investors' orders in the best
market, investors' orders have an opportunity to be executed without
the participation of a dealer.\179\
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\179\ See Section 11A(a)(1)(C)(v) of the Exchange Act.
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Proposed Rule 615 does not limit the types of broker-dealers that
would be permitted to submit segmented orders for execution in a
qualified auction. For example, a retail broker that currently routes
segmented orders directly to a wholesaler could instead route such
orders directly to a qualified auction with a specified limit price
selected by the retail broker. Such specified limit price would need to
be consistent with its best execution responsibilities and the terms of
the order as set by the customer. If the segmented order did not
receive an execution in the auction at the specified limit price, the
retail broker could, as soon as reasonably possible, route the
segmented order to a wholesaler with a representation that the
segmented order had cleared (i.e., not received an execution in) a
qualified auction at that price. The wholesaler then could, in
compliance with Proposed Rule 615, as soon as reasonably possible,
execute the segmented order internally at the specified limit price or
better.
If a segmented order did not receive an execution in a qualified
auction (regardless of whether submitted to the auction by a retail
broker, a wholesaler, or other broker-dealer), a wholesaler that
received such order following the conclusion of a qualified auction
would not be required by Proposed Rule 615 to execute the order
internally. If a wholesaler chose not to execute the order internally
following the conclusion of a qualified auction, the segmented order,
as with all segmented orders, would need to be further handled in
compliance with Proposed Rule 615. For example, (1) the wholesaler
could return the order to the retail broker or other broker-dealer for
further handling (such as resubmission to a qualified auction with a
revised specified limit price); (2) the wholesaler itself could
resubmit the segmented order to a qualified auction with a revised
specified limit price; \180\ or (3) the wholesaler could route the
order directly to an open competition trading center or national
securities exchange (as national securities exchanges are not
restricted competition trading centers subject to Proposed Rule 615(a))
for an immediate execution on its continuous order book. The decision
on how to handle segmented orders that clear qualified auctions without
executions also would be governed by the relevant best execution
responsibilities of retail brokers and wholesalers.
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\180\ The revised specified limit price set by the wholesaler
would have to be consistent with the terms of the order, such as the
limit price set by the customer, if any, as well as with the
wholesaler's best execution responsibilities.
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As indicated in the above example and subject to relevant best
execution responsibilities, a broker-dealer responsible for obtaining
the execution of a segmented order has the option of routing the order
directly to the continuous order book \181\ of an open competition
trading center or national securities exchange for execution, without
exposure in a qualified auction. The definition of restricted
competition trading center would exclude all open competition trading
centers and all national securities exchanges.\182\ They would be
excluded because both of these types of trading centers either are not
permitted by the Exchange Act currently, or would not be permitted by
Proposed Rule 615, to unfairly restrict access to their continuous
order books.\183\ Consequently, segmented orders routed directly to the
continuous order books of open competition trading centers and national
securities exchanges would be subject to competition to provide the
best prices on an order-by-order basis, and thus would not be
isolated.\184\
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\181\ See infra section IV.B.2 (discussing the proposed
definition of ``continuous order book'').
\182\ See Proposed Rule 600(b)(87) and discussion in section
IV.B.3 below.
\183\ Section III.B.2 above discusses the Exchange Act
provisions that currently prohibit a national securities exchange
from unfairly restricting access. Section IV.B.2 below discusses the
proposed access requirement for any open competition trading center
that is not a national securities exchange (i.e., an NMS Stock ATS).
In many cases, an open competition trading center also would be a
national securities exchange. As discussed in section IV.B.2 below,
however, some national securities exchanges would not meet the
definition of an open competition trading center.
\184\ As discussed in sections IV.D and IV.G below, open
competition trading centers and national securities exchanges would
not be allowed to operate a mechanism limited, in whole or in part,
to segmented orders, including RLPs, barring an exception from
Proposed Rule 615. See infra notes 258, 259 and accompanying text.
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Importantly, however, all relevant broker-dealer best execution
responsibilities would govern the extent to which segmented orders
could be routed to an open competition trading center or national
securities exchange without first clearing a qualified auction. As
discussed in section III.B.2 above, best execution generally requires a
broker-dealer to obtain the best terms reasonably available for
customer orders. Because liquidity providers can profitably offer
better prices to segmented orders of individual investors with low
adverse selection costs as compared to the prices they can offer other
types of order flow, trading mechanisms that offer such segmentation,
as would a qualified auction, are quite likely to obtain better prices
for segmented orders than other trading mechanisms, such as the
continuous order book of an open competition trading center or national
securities exchange, that commingle all types of order flow.\185\ A
broker-dealer would need to consider the opportunity for better prices
in its best execution analysis.
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\185\ See, e.g., infra section VII.C.1.b (discussing anticipated
benefits of improved execution quality for retail orders exposed in
qualified auctions).
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There may be market conditions when a best execution analysis could
indicate that a broker-dealer should route segmented orders directly to
the continuous order book of an open competition trading center or
national securities exchange. One example could be a ``fast market''--
when publicly quoted prices are moving rapidly away when a broker-
dealer receives a marketable order (that is, rapidly up in price for
orders to buy or rapidly down in price for orders to sell). In these
market conditions, the broker-dealer could determine that best prices
could be obtained by immediately attempting to execute segmented orders
against the NBBO on an open competition trading center or national
securities exchange,
[[Page 149]]
rather than first submitting segmented orders to qualified auctions
when market conditions suggest that auction would be unlikely to
generate better prices than the NBBO. Proposed Rule 615 is designed to
give broker-dealers sufficient flexibility to obtain best execution of
individual investor orders in the full range of market conditions.
B. Coverage of Proposed Rule 615
1. Definition of Segmented Order
The term ``segmented order,'' as proposed to be defined in Proposed
Rule 600(b)(91) \186\ of Regulation NMS, would have two parts. First,
the order for an NMS stock must be for an account of a natural person,
or an account held in legal form on behalf of a natural person or group
of related family members. Second, for such an account, the average
daily number of trades executed in NMS stocks must be less than 40 in
each of the preceding six calendar months. The intent of the proposed
definition is to encompass the marketable orders of individual
investors with expected low adverse selection costs that retail brokers
currently route to wholesalers for handling and execution. These orders
already are segmented in practice.
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\186\ Rule 600(b) of Regulation NMS sets forth defined terms.
Rule 600(b) would be amended to insert new defined terms used in
Proposed Rule 615, and existing defined terms would be renumbered
accordingly. Cross references to Rule 600(b) throughout the rules
and regulations under the Exchange Act would also be amended to
reflect the new numbering.
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The proposed definition's limitation to ``natural persons'' draws
on the approach in existing rules designed to identify the orders of
individual investors. For example, the definition of ``retail
customer'' in the Commission's Regulation Best Interest (``Regulation
BI'') is limited to a ``natural person.'' \187\ Moreover, several
national securities exchanges operate programs for trading ``retail''
orders that are limited to accounts of natural persons or certain
accounts on behalf of natural persons.\188\ The proposed definition of
segmented order is closely related to these rules,\189\ as well as to
FINRA's fee schedule for Nasdaq's Trade Repository Facility.\190\
Patterning the definition of segmented order on existing SRO rules is
designed to leverage market knowledge and to facilitate compliance with
Proposed Rule 615. This would help reduce the costs of compliance
because broker-dealers would already be familiar with identifying
orders as for the accounts of natural persons, or for related accounts,
in these other contexts. In addition to the accounts of natural persons
themselves, the definition would, again consistent with SRO rules,
cover accounts held in legal form on behalf of natural persons or
groups of related family members.
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\187\ 17 CFR 240.15l 1(b)(1) (defining ``retail customer'' as,
among other things, as a natural person who receives a
recommendation of any securities transaction from a broker-dealer
and uses the recommendation primarily for personal, family, or
household purposes). Proposed Rule 615 does not incorporate all of
the definition of ``retail customer'' in Regulation BI, because that
definition is limited to when there is a recommendation to a retail
customer. Proposed Rule 615, in contrast, is designed to promote
competition for individual investor orders, regardless of whether
such investor is self-directed. Moreover, Proposed Rule 615 is
focused on limiting the extent to which an account may generate
orders with a high level of adverse selection costs. As discussed
below, Proposed Rule 615 includes a trading activity threshold
designed to address this policy concern. The definition of ``retail
investor'' for purposes of 17 CFR 249.641 (``Form CRS'')
(Relationship Summary for Brokers and Dealers Providing Services to
Retail Investors) is also limited to ``natural persons'' and defines
``retail investor'' as a natural person, or the legal representative
of such natural person, who seeks to receive or receives services
primarily for personal, family or household purposes. In the context
of Form CRS, the term ``retail investor'' is used in connection with
disclosures to prospective customers, and as in the context of
Regulation BI, relates to the relationship between an investor and a
financial professional. See Securities Exchange Act Release No.
86031 (June 5, 2019), 84 FR 33318, 33345 (July 12, 2019) (adopting
Regulation Best Interest: The Broker-Dealer Standard of Conduct)
(''Regulation BI Adopting Release''). Because Proposed Rule 615 is
intended to improve competition for individual investor orders, and
is not related to the relationship between an investor and a
financial professional, the Commission is not proposing to include
the phrase ``primarily for personal, family, or household purposes''
in the definition of segmented order. For purposes of Proposed Rule
615, limiting segmented orders to orders for the accounts of natural
persons, and specifically those with less than 40 trades in NMS
stocks in each of the preceding 6 months, is intended to address
adverse selection costs and is not related to the purposes for which
a natural persons may be seeking the services of a broker-dealer.
\188\ See supra note 151 (generally describing exchange RLPs).
\189\ E.g., IEX Rule 11.190(b)(15) (providing, among other
things, that ``[a] Retail order must reflect trading interest of a
natural person'' and that ``[a]n order from a retail customer can
include orders submitted on behalf of accounts that are held in a
corporate legal form--such as an Individual Retirement Account,
Corporation, or a Limited Liability Company--that have been
established for the benefit of an individual or group of related
family members, provided that the order is submitted by an
individual.''); and Nasdaq, Equity 7, section 118 (defining a
``Designated Retail Order'' as originating from a ``natural person''
and explaining that ``[a]n order from a `natural person' can include
orders on behalf of accounts that are held in a corporate legal
form--such as an Individual Retirement Account, Corporation, or a
Limited Liability Company--that has been established for the benefit
of an individual or group of related family members, provided that
the order is submitted by an individual'').
\190\ FINRA Rule 7620A (defining a ``Retail Order'' as
originating from a ``natural person'' and explaining that ``[a]n
order from a `natural person' can include orders on behalf of
accounts that are held in a corporate legal form, such as an
Individual Retirement Account, Corporation, or a Limited Liability
Corporation that has been established for the benefit of an
individual or group of related family members, provided that the
order is submitted by an individual'').
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For purposes of the definition of ``segmented order,'' a ``group of
related family members'' would be defined broadly to include a group of
natural persons with any of the following relationships: child,
stepchild, grandchild, great grandchild, parent, stepparent,
grandparent, great grandparent, domestic partner, spouse, sibling,
stepbrother, stepsister, niece, nephew, aunt, uncle, mother-in-law,
father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-
in-law, including adoptive and foster relationships; and any other
natural person (other than a tenant or employee) sharing a household
with any of the foregoing natural persons.\191\ This definition is
designed to be broad so as not to restrict the types of arrangements
that may be set up to benefit family groups, including individual
retirement accounts, corporations, and limited liability companies for
the benefit of related family members.\192\
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\191\ Proposed Rule 600(b)(91)(iii).
\192\ Given the proposed broad definition of ``group of related
family members'' in Proposed Rule 600(b)(91), an account held in
legal form on behalf of a group of related family members could
include some accounts with an extensive portfolio of NMS stocks. The
second prong of the definition of segmented order, however, would
exclude accounts with average daily trades of 40 or more and likely
would exclude many accounts with large portfolios.
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The second part of the proposed definition of segmented orders
focuses on the frequency of trading in an account. It would limit the
average daily number of trades executed in NMS stocks in an account to
less than 40 for each of the six preceding calendar months. This part
of the proposed definition would exclude very active traders whose
orders are likely to impose a much higher level of adverse selection
costs on liquidity providers than the less-active accounts that are
more typical of individual investors. For example, very active traders
may use sophisticated trading tools, such as application programming
interfaces (APIs) and computer algorithms, to submit their orders.
These tools can enable highly active trading strategies that impose
much higher adverse selection costs on liquidity providers than the
manual placement of orders by a natural person. Rather than prohibiting
any opportunity for investors to use potentially beneficial trading
tools,\193\ however, the proposed
[[Page 150]]
definition specifies a maximum level of trading activity as a means to
limit the level of adverse selection costs.
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\193\ Some SRO rules, for example, prohibit the use of any
computerized technology for submitting retail orders. See, e.g.,
NYSE Rule 7.44(a)(3) (defining ``retail order'' in the context of
NYSE's RLP to require that ``the order does not originate from a
trading algorithm or any other computerized methodology'').
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The proposed level is supported by an analysis of the distribution
of order activity across accounts reported to the Consolidated Audit
Trail as being held for the benefit of an ``Individual Customer'' for
the first six months of 2022.\194\ Across this period, slightly more
than 99.9% of Individual Customer accounts originated, on an average
daily basis, 40 or fewer orders associated with a trade. The median
number of daily-average orders associated with a trade from accounts at
or below this threshold was less than one.\195\ The median number of
daily-average orders associated with a trade from accounts above this
threshold was approximately 68.\196\ Accordingly, the thr
[…truncated; see source link]Indexed from Federal Register on January 3, 2023.
This is legal information, not legal advice. Laws vary by jurisdiction and change frequently. Always verify current law with official sources and consult a licensed attorney in your jurisdiction for advice on your specific situation.