[17502]
May 12, 2004
TO: EQUITY MARKETS ADVISORY COMMITTEE No. 21-04
SEC RULES COMMITTEE No. 44-04
RE: DRAFT INSTITUTE LETTER ON SEC PROPOSED REGULATION NMS
As we previously informed you,1 the Securities and Exchange Commission has
published for comment proposed Regulation NMS.2 Regulation NMS consists of four proposals
– the trade-through proposal, the market access proposal, the subpenny quoting proposal and
the market data proposal – which, collectively, are intended to enhance and modernize the
regulatory structure of the U.S. equity markets. The Institute has prepared a draft comment
letter on Regulation NMS. The most significant aspects of the draft letter are summarized
below and a copy of the draft letter is attached.
Comments on Regulation NMS are due to the SEC no later than May 24, 2004. We
have scheduled a conference call to discuss the Institute’s draft comment letter for Monday,
May 17 at 1:30 pm Eastern. The dial-in number for the call will be 888-889-6350 and the
passcode for the call will be 19354. If you would like to participate on the call, please contact
Monica Carter-Johnson by phone at 202-326-5823 or by e-mail at mcarter@ici.org. In the
meantime, if you have any comments on the draft letter, please contact the undersigned by
phone at 202-371-5408 or by e-mail at aburstein@ici.org.
I. Trade-Through Proposal
The trade-through proposal would create a uniform rule that would require an “order
execution facility,” national securities exchange and national securities association market, with
regard to the trading of “NMS Stocks,” to establish, maintain, and enforce policies and
procedures reasonably designed to prevent the purchase or sale of an NMS Stock at a price that
is inferior to a better price displayed on another market.
The draft letter supports the establishment of a uniform trade-through rule for all
market centers. The letter states that a uniform trade-through rule, by preventing one market
1 Memorandum to Equity Markets Advisory Committee No. 6-04 and SEC Rules Committee No. 23-04, dated March
12, 2004 [17206].
2 Securities Exchange Act Release No. 49325 (February 26, 2004), 69 FR 11126 (March 9, 2004).
2
from executing an order at a price that is inferior to a better price displayed on another market,
should encourage the display of limit orders, which in turn can improve the price discovery
process and contribute to increased market liquidity and depth.3
The draft letter makes several recommendations regarding the scope of the proposed
trade-through rule. Specifically, the draft letter supports the application of a uniform trade-
through rule to all securities (currently, only exchange-listed securities, and not those listed on
Nasdaq, are subject to a trade-through rule). In addition, in response to a request for comment
on whether broker-dealer orders should be included within the scope of the rule, the draft letter
states that the scope of the rule should not be determined by the market participant on whose
behalf an order was placed and that broker-dealer orders therefore should be included. Finally,
the proposed trade-through rule would apply only to the best bid and offer of any order
execution facility and would not apply to other limit orders or quotes that are also priced better
than the order being executed. The draft letter states that in order to truly promote order
interaction in the markets, all limit orders should be protected and that such an expansion of the
rule would further encourage the placement of limit orders and, in turn, significantly increase
market liquidity and depth.
The Commission also requests comment on whether the policies and procedures
requirement is reasonably designed to prevent the execution of trade-throughs or whether the
Commission should instead, or in addition, explicitly prohibit trade-throughs absent an
exception. The draft letter states that while explicitly prohibiting trade throughs may raise
concerns regarding holding a market responsible for a trade-through it could not have
reasonably avoided, relying solely on a market establishing its own policies and procedures to
prevent trade-throughs may not be sufficient to prevent them from occurring and may result in
the formation of non-uniform trade-through procedures across markets. The draft letter
therefore recommends that the Commission explicitly prohibit trade-throughs but include
certain exceptions to the rule in order to address concerns regarding unavoidable trade-
throughs.4
While the draft letter supports the proposed trade-through rule, it states that it is
extremely important that the execution of orders entered into a market not be delayed by
mandating that those orders be routed to a less efficient market where there is no guarantee that
the orders will even be executed. The draft letter therefore supports the proposed exception to
the trade-through rule that permits an “automated” market to trade through a better priced
displayed bid or offer on a “non-automated” market.
At the same time, the draft letter recommends that the Commission provide a stronger
definition of what constitutes an “automated” market. Specifically, the draft letter recommends
that the proposed definition of an “automated” market be amended in two ways: (1) the
3 In order to ensure that a market that sends an order to another market under the trade-through rule can execute
against that better priced order quickly and with certainty, the draft letter recommends that prior to implementing a
trade-through rule, the Commission should first ensure that effective linkages and access standards between markets
are in place to support such a rule.
4 The draft letter states that an effective trade-through rule also will require methods to “satisfy” the order that was
traded-through and recommends that markets be required to establish policies and procedures for making an
investor “whole” if a trade-through occurs.
3
Commission should establish minimum performance standards with respect to response times
and the times required to update or “refresh” a quote and (2) in order to be considered an
“automated” market, a market should be required to provide automatic execution to its entire
limit order book and not only to their best bid and offer.5
The trade-through rule’s other exception, the “opt-out” exception, would permit a
person for whose account an order is entered to “opt-out” of the protections of the trade-
through rule by providing informed consent to the execution of their orders, on an order-by-
order basis, in one market without regard to the possibility of obtaining a better price in another
market.
The draft letter states that if the Commission strengthens its definition of an
“automated” market as per the Institute’s recommendations, and creates strong linkages and
access between automated markets, then the opt-out exception is unnecessary and the Institute
would not support such an exception to the trade-through rule. The draft letter states that an
ideal market structure should not provide the ability for any market participant to ignore better
priced orders in the market. In addition, the opt-out exception is inconsistent with the principle
of price protection for limit orders and therefore would negatively impact investors’ use of limit
orders, would undermine investor confidence in the markets and would be antithetical to the
goals of the trade-through proposal.6
The draft letter states that if the Commission determines, however, that an opt-out
exception is necessary, the ability to opt-out should be extremely limited in scope. As
proposed, the opt-out exception would permit a customer for the customer’s account as well as
a broker-dealer for its own account to affirmatively opt-out of the trade-through rule’s
protections with regard to a specific order. The draft letter recommends that the Commission
narrow the scope of the opt-out exception to include only those orders entered by a customer
for the customer’s account.
II. Market Access Proposal
The market access proposal would establish rules that would modernize the terms of
access to quotations and the execution of orders in the national market system. Specifically, the
proposal would require market centers to permit all market participants access to their limit
order books, at least indirectly, on a non-discriminatory basis; would limit any fees charged by
market centers and broker-dealers for access to their quotations to a de minimis amount; and
would require SROs to establish rules to reduce the incidence of intermarket locked and crossed
quotations.
5 The automated market exception only would permit an “automated” market to trade through a “non-automated”
market up to a “trade-through limit amount.” Specifically, depending on the bid or offer of a stock, the allowable
trade-through amount varies from one cent to five cents. The draft letter recommends that the Commission eliminate
the proposed trade-through limit amount and permit an “automated” market to trade through a “non-automated”
market for an unlimited amount.
6 If, however, the Commission adopts the definition of an “automated” market as proposed (i.e., with no minimum
standards for the execution of orders and update of quotes, and requiring automation only at the best bid and offer),
then the draft letter states that an “opt-out” exception may be necessary.
4
The draft letter supports the creation of minimum access standards that would provide
market participants with non-discriminatory access to the best prices for a security, no matter
where those prices are displayed, and that would reduce the current barriers to intermarket
access. The draft letter states that fair and efficient access to the securities markets is critical to
the efficient execution of orders as well as to an effective trade-through rule.7
The draft letter also states that a de minimis fee standard is a logical approach to
addressing concerns regarding ECN access fees. Specifically, the draft letter states that the
proposed access fee standard would promote a common quoting convention and facilitate the
ready comparison of quotes across the national market system.8
Finally, the draft letter supports proposals that would require every SRO to establish
and enforce rules requiring its members to avoid locking or crossing the quotations of quoting
market centers and quoting market participants and to prohibit members from engaging in a
pattern or practice of locking or crossing the quotations in any security. The draft letter states
that locked and crossed markets can have a negative impact on the securities markets and can
be a sign of an inefficient market structure. In addition, locked and crossed markets may create
confusion for investors, as it is unclear under such circumstances what is the true value of a
stock.9
III. Subpenny Quoting Proposal
The subpenny quoting proposal would prohibit market participants from accepting,
ranking, or displaying orders, quotes, or indications of interest in a pricing increment less than a
penny. The draft letter strongly supports the subpenny quoting proposal.
The draft letter states that the proposal would address concerns that have been raised
regarding quoting securities in subpenny increments. For example, while the move to pricing
in whole pennies has enhanced the ability of investors to more fully understand the prices at
which securities are quoted, quoting securities in subpennies would make it more difficult for
investors (as well as market participants executing orders for investors) to understand these
prices. In addition, displaying consolidated quotes in subpenny increments would further
reduce the displayed quote size and overall depth of the markets. The reduction in market
transparency and depth that would occur in a subpenny environment also would adversely
affect liquidity, especially for mutual funds and other institutional investors that need to
execute relatively large-sized orders. Finally, permitting the entry of orders and the quoting of
securities in subpennies would increase instances of “stepping ahead” of limit orders by
7 The draft letter also supports the flexible approach proposed by the Commission that seeks to ensure proper access
through linkages established by the markets and not through government-imposed linkages.
8 Under the proposed rule, an SRO’s order interaction facility would be allowed to charge a maximum fee of $0.001
per share for access to its market. Market makers, specialists, ATSs, and other broker-dealers that display
attributable quotes through SROs also would be permitted to charge a maximum fee of $0.001 per share for access to
their quotes, and would be permitted to charge this access fee in addition to any access fee that the SRO also imposes
on the transaction, with the accumulation of fees limited to no more than $0.002 per share in any transaction.
9 The draft letter also supports the proposal to lower the "fair access" threshold in Regulation ATS from twenty
percent to five percent and states that lowering the threshold should encourage fair competition between ATSs with
significant internal trading volume.
5
allowing a trader to gain priority over another trader by bidding as little as $0.001 more for the
same security with almost no risk of loss.
The draft letter also supports the aspect of the proposed rule that would permit an
exchange or association to report or “print” a trade in a subpenny increment and that would not
per se prohibit an exchange or association from printing a trade that was the result of a mid-
point or volume-weighted pricing algorithm, as long as the exchange or association or its
members did not otherwise violate the proposed rule with respect to the trading interest that
resulted in the execution. The draft letter states that it should not be problematic for executions
to take place in subpenny increments where the prices for these executions are determined
through the application of a passive algorithm, as is the case where a trade is executed on a
crossing network at the mid-point of a bid and offer.
IV. Market Data Proposal
The market data proposal would amend the rules and joint industry plans for
disseminating market information to the public. Most significantly, the proposal would modify
the formulas for allocating market data revenues to reward those market centers whose quotes
reflect the best prices for the largest sizes and thereby contribute the most to public price
discovery.
The draft letter supports the revisions to the allocation of market data revenue,
specifically, revisions that would discourage practices that currently exist solely to generate
increased revenue. The draft letter states that the issues raised by market data are very
important to the effective functioning of the markets as it is pursuant to these joint industry
plans that market participants obtain real-time access to consolidated information regarding the
best quotes for, and trades in, stocks. Thus, such information is an important means of
enhancing the transparency of the buying and selling interest in a security, for addressing the
fragmentation of buying and selling interest among different market centers, and for facilitating
the best execution of customers' orders by their broker-dealers.
The draft letter also supports other changes made to the joint industry plans under the
market data proposal, specifically: (1) the amendment to the joint industry plans that would
broaden participation in their governance and could help assure that the views of interested
parties other than SROs have an opportunity to be heard on plan matters; (2) amendments
relating to the independent distribution of market information that would permit individual
market centers to have the freedom to distribute their own market data independently; and (3)
the proposed rule to require SROs to act jointly pursuant to one or more national market system
plans to disseminate consolidated information for NMS Stocks.
Ari Burstein
Associate Counsel
Attachment (in .pdf format)