75414 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

1The two rules, 17 CFR 240.11Ac1–5 and 17 CFR

240.1Ac1–6, were proposed for public comment in

Securities Exchange Act Release No. 43084 (July 28,

2000), 65 FR 48406 (‘‘Proposing Release’’). Section

11A of the Securities Exchange Act of 1934, 15

U.S.C. 78k–1, grants the Commission authority to

promulgate rules necessary or appropriate to assure

the fairness and usefulness of information on

securities transactions and to assure that brokerdealers transmit orders in a manner consistent with

the establishment and operation of a national

market system. The principal national market

system objectives set forth in section 11A(a)(1)

include the efficient execution of securities

transactions, fair competition among market

participants, the public availability of information

on securities transactions, and the best execution of

investor orders. The rules adopted today should

significantly further these objectives.

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 240

[Release No. 34–43590; File No. S7–16–00]

RIN 3235–AH95

Disclosure of Order Execution and

Routing Practices

AGENCY: Securities and Exchange

Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange

Commission is adopting two rules to

improve public disclosure of order

execution and routing practices. Under

Rule 11Ac1–5, market centers that trade

national market system securities will

be required to make available to the

public monthly electronic reports that

include uniform statistical measures of

execution quality. Under Rule 11Ac1–6,

broker-dealers that route customer

orders in equity and option securities

will be required to make publicly

available quarterly reports that, among

other things, identify the venues to

which customer orders are routed for

execution. In addition, broker-dealers

will be required to disclose to

customers, on request, the venues to

which their individual orders were

routed. By making visible the execution

quality of the securities markets, the

rules are intended to spur more vigorous

competition among market participants

to provide the best possible prices for

investor orders.

DATES: Effective date: January 30, 2001.

Compliance dates: For specific phasein dates for compliance with the rules,

see section V of this release. In addition,

the national securities exchanges and

the national securities association

subject to § 240.11Ac1–5(b)(2) shall

comply with that provision by

submitting a national market system

plan to the Commission by no later than

February 15, 2001.

FOR FURTHER INFORMATION CONTACT:

Susie Cho, Attorney, at (202) 942–0748,

Division of Market Regulation,

Securities and Exchange Commission,

450 Fifth Street, NW., Washington, DC

20549–1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

II. Disclosure as Minimum Step Necessary to

Address Market Fragmentation

III. Rule 11Ac1–5—Disclosure of Order

Execution Information

A. Comments on the Disclosure Approach

of the Proposed Rule

1. Emphasis on Execution Price and Speed

2. Usefulness to Investors of Execution

Quality Information

3. Risk of Meritless Litigation

B. Scope of Rule

1. Market Center

2. Covered Order

a. Immediate-Or-Cancel Orders

b. Market Opening Orders

3. National Market System Securities

C. Required Information

1. Information Required for All Types of

Orders

2. Information Required for Market and

Marketable Limit Orders

D. Procedures for Making Reports

Available to the Public

IV. Rule 11Ac1–6—Disclosure of Order

Routing Information

A. Scope of Rule

B. Quarterly Reports

C. Customer Requests for Information

V. Effective Dates and Phase-In of

Compliance Dates

VI. Paperwork Reduction Act

A. Comments on Collection of Information

Requirements

B. Total Annual Reporting and

Recordkeeping Burdens

VII. Cost-Benefit Analysis

A. Costs and Benefits of Rule 11Ac1–5

1. Benefits

2. Costs

B. Costs and Benefits of Rule 11Ac1–6

1. Benefits

2. Costs

VIII. Consideration of Burden on Competition

and Promotion of Efficiency,

Competition, and Capital Formation

IX. Final Regulatory Flexibility Analysis

A. Need for the Rules

B. Significant Issues Raised by Public

Comment

C. Small Entities Subject to the Rules

1. Small Entities Affected by Rule 11Ac1–

5

2. Small Entities Affected by Rule 11Ac1–

6

D. Projected Reporting, Recordkeeping and

other Compliance Requirements

1. Reporting Requirements under Rule

11Ac1–5

2. Reporting Requirements under Rule

11Ac1–6

E. Agency Action to Minimize Effect on

Small Entities

1. Rule 11Ac1–5

2. Rule 11Ac1–6

X. Statutory Authority

Text of Rules

I. Introduction

The Securities and Exchange

Commission (‘‘Commission’’) is

adopting two rules to increase the

visibility of execution quality of the U.S.

securities markets for public investors.1

Market centers that execute investor

orders will be required to make monthly

disclosures of basic information

concerning their quality of executions.

Broker-dealers will be required to

disclose the identity of the market

centers to which they route orders on

behalf of customers. Taken together, the

rules should significantly improve the

opportunity for public investors to

evaluate what happens to their orders

after they submit them to a brokerdealer for execution.

The rules arise out of the

Commission’s extended inquiry into

market fragmentation—the trading of

orders in multiple locations without

interaction among those orders. In

today’s markets, investor order flow in

the same security can be divided among

many different ‘‘market centers’’—e.g.,

exchanges, over-the-counter (‘‘OTC’’)

market makers, and electronic

communications networks (‘‘ECNs’’).

The primary structural component

linking these market centers in the

national market system is the

consolidated public quote. Pursuant to

Commission rules, the best displayed

bid and offer for each equity security are

collected from all significant market

centers and disseminated to the public

on a real-time basis. This centralized

source of information, however, may

convey an inaccurate impression of the

significant extent to which the quality of

order execution can vary across

different market centers. At some

market centers, for example, as many as

50% of certain orders, particularly

market orders for small sizes (less than

500 shares), are executed at prices better

than the public quotes. Similarly, for

investors seeking to use limit orders to

obtain better prices than the public

quotes, there can be wide variations

among market centers in the

opportunity for such orders to be

executed.

At present, few market centers

provide detailed public disclosure

concerning their execution quality. Rule

11Ac1–5 will assure that all market

centers publicly disclose, on a monthly

basis, basic standardized information

concerning their handling and

execution of orders. Such information

will include, for example, how market

orders in various size categories are

executed relative to the public quotes.

Also, investors for the first time will be

informed not just about quoted spreads,

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75415

2Source: NASD Economic Research Dept.,

www.nasdaq.marketdata.com (visited Oct. 31,

2000). It is doubtful that the emergence of agency

market centers operated by ECNs has significantly

worsened fragmentation in the market for Nasdaq

securities. Since the creation of the Nasdaq market

in the 1970’s, order flow in such securities always

has been fragmented among a significant number of

market makers.

3Source: NYSE. In addition, the American Stock

Exchange LLC (‘‘Amex’’) accounted for 69.9% of

share volume in Amex equities during September

2000. Source: Amex.

4Securities Exchange Act Release No. 42450 (Feb.

28, 2000), 65 FR 10577. The Commission

subsequently approved the rescission of Rule 390,

in part because the rule had tended to restrict the

competitive opportunities in listed securities of

ECNs that operate agency markets. Securities

Exchange Act Release No. 42758 (May 5, 2000), 65

FR 30175. It emphasized, however, that its desire

to clear away any regulatory barriers to competition

should not be interpreted as an indication of

whether the ECNs would or should attractive a

significant amount of listed market share. That will

be determined by competition. The Commission

also emphasized that its criticism of Rule 390

should not be interpreted as criticism of the quality

of the NYSE’s market, noting that studies repeatedly

had demonstrated its high quality of execution and

important public price discovery function. Id. at

note 28 and accompanying text.

5These dealer practices are discussed in section

IV.A.2 of the Fragmentation Release.

6Securities Exchange Act Release No. 43084 (July

28, 2000), 65 FR 48406.

7Section IV.A.1 of the Fragmentation Release

discusses the various ways in which investors seek

to obtain the best prices, including the use of

market orders by investors seeking liquidity and the

use of limit orders by investors supplying liquidity.

In addition, it discusses the alternatives used by

large investors to interact with smaller orders (often

by offering better prices for such orders) without

being forced to display their full trading interest,

which might move the market significantly against

them.

8An opportunity for investor orders to be

executed without the participation of a dealer is,

subject to efficiency and best execution objectives,

one of the five principal objectives for a national

market system. Exchange Act section

11A(a)(1)(C)(v), 15 U.S.C. 78k–1(a)(1)(C)(v).

but also about effective spreads—the

spreads actually paid by investors

whose orders are routed to a particular

market center. In addition, market

centers will disclose the extent to which

they provide to investors using limit

orders executions at prices better than

the public quotes.

To complement the improved public

disclosure of execution quality by

market centers, the Commission also is

adopting a rule to improve disclosure of

order routing by broker-dealers. Under

Rule 11Ac1–6, broker-dealers that route

orders as agent on behalf of their

customers will be required to disclose,

on a quarterly basis, the identity of the

market centers to which they route a

significant percentage of their orders.

Broker-dealers also will be required to

disclose the nature of their relationships

with such market centers, including any

internalization or payment for order

flow arrangements, that could represent

a conflict of interest between the brokerdealer and its customers. In the past,

such information has been available, if

at all, only by individual customer

request on a transaction-by-transaction

basis. As a result, there has been very

little opportunity for the public to

evaluate the routing practices of a

broker-dealer as a whole.

In a fragmented market structure with

many different market centers trading

the same security, the order routing

decision is critically important, both to

the individual investor whose order is

routed and to the efficiency of the

market structure as a whole. The

decision must be well-informed and

fully subject to competitive forces.

Currently, given the lack of comparable

public information on execution quality,

retail investors may conclude that the

most rational strategy is simply to opt

for a broker-dealer that offers the lowest

commission and a fast execution. As a

result, there may be limited

opportunities for market participants to

compete on their ability to obtain the

best prices for these investor orders. By

increasing the visibility of order

execution and routing practices, the

rules adopted today are intended to

empower market forces with the means

to achieve a more competitive and

efficient national market system for

public investors.

II. Disclosure as Minimum Step

Necessary to Address Market

Fragmentation

The Commission is adopting Rule

11Ac1–5 and Rule 11Ac1–6 primarily to

address the serious problems that can

arise from market fragmentation. For

most stocks actively traded in the U.S.

markets, there are a variety of market

centers from which to choose in

determining where to route orders for

execution. Particularly for equity

securities qualified for inclusion in the

Nasdaq Stock Market, Inc. (‘‘Nasdaq’’),

trading is widely dispersed among many

different market centers. These include

a large number of securities dealers that

act as Nasdaq market makers. In

September 2000, there were an average

of 59 market makers per issue in the top

1% of Nasdaq stocks by dollar trading

volume, 29 market makers per issue in

the next 9% of stocks, and an overall

average of 13 market makers per issue.

In addition, eight ECNs operate agency

markets, which together accounted for

25.8% of Nasdaq share volume in

September 2000.2 For exchange-listed

equities, in contrast, the primary

exchanges still retain a high percentage

of order flow. In September 2000, for

example, the New York Stock Exchange,

Inc. (‘‘NYSE’’) accounted for 83.3% of

share volume in NYSE equities.3

The Commission initiated its formal

inquiry into market fragmentation in

December 1999 when the NYSE

submitted a proposed rule change to

rescind Rule 390, its rule restricting offboard trading by NYSE members. In

February 2000, the Commission issued

a release that published the NYSE’s

proposal for public comment and also

requested comment on a wide range of

issues relating to market fragmentation

(‘‘Fragmentation Release’’).4 It noted

that the rescission of off-board trading

rules raised at least the potential for

increased fragmentation of the market

for exchange-listed stocks. The

Commission particularly highlighted its

concerns that dealer practices such as

internalization and payment for order

flow have contributed to the isolation of

investor limit orders and to less

vigorous quote competition.5

Among the commenters responding to

the Fragmentation Release, the investors

(both institutional and retail) were

unanimous in their view that

fragmentation was a problem that the

Commission needed to address. Many

securities industry participants, in

contrast, believed that fragmentation

merely was an inevitable adjunct of

competition among market centers, and

that such competition produces many

benefits for investors. Although the

comments reflected wide disagreement

about a number of potential options for

Commission action that would have

addressed market fragmentation most

directly, the majority of commenters

supported some form of increased

disclosure by market centers and brokerdealers concerning their execution

quality and order routing practices. In

July 2000, the Commission issued a

release proposing Rule 11Ac1–5 and

Rule 11Ac1–6 to implement this option

(‘‘Proposing Release’’).6

In considering the issue of

fragmentation, the overriding objective

of the Commission’s inquiry has been

quite pragmatic—to assure that

investors receive the best possible prices

for their orders.7 For example, do

investors who seek liquidity by

submitting market orders pay the lowest

possible effective spread, or liquidity

premium, for their orders? Similarly, do

investors who supply liquidity by

submitting limit orders have the best

possible opportunity for their orders to

be executed? The Commission believes

that vigorous competition among buyers

and sellers in an individual security,

particularly through an opportunity for

their orders to interact directly,8 is the

only reliable means to achieve the best

prices for investors. To the extent that

75416 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

9See Report by Commissioner Laura S. Unger,

On-Line Brokerage: Keeping Apace of Cyberspace

40–41 (Nov. 1999) (available at http://www.sec.gov).

One of the recommendations in Commissioner

Unger’s Report was that the Commission should

consider requiring market centers to make publicly

available certain uniform information on execution

quality and requiring broker-dealers to provide their

customers with plain English information about the

execution quality available at different market

centers, order handling practices, and the brokerdealer’s receipt of inducements for order flow. Id.

at 45. In addition, one of the largest broker-dealers

noted in its comment letter on the Fragmentation

Release that even it had been frustrated in its own

attempts to obtain useful order execution data from

certain markets. Letter from Lon Gorman, Vice

Chairman and President, Capital Markets & Trading

Group, Charles Schwab & Co., to Jonathan G. Katz,

Secretary, SEC, dated July 5, 2000, at 7.

10This estimate is described in the cost-benefit

discussion in section VII.A.1 below.

11The practice of preferencing, under which

orders are directed to a particular exchange

specialist that is entitled to take priority in

execution over same-priced orders entered prior in

time, is quite similar to internalization by OTC

market makers.

12The Preferencing Report specifically noted (p.

172) that preferencing programs would require

reconsideration if ‘‘a significant increase in the

amount of preferencing activity as a percentage of

overall national market system activity’’ resulted in

the decline of execution quality on the national

market system.

13Commenters on the Proposing Release correctly

noted that the Preferencing Report found higher fill

rates for non-marketable limit orders on the regional

exchanges than on the NYSE. Letter from Jeffrey T.

Brown, Vice President Regulation and General

Counsel, Cincinnati Stock Exchange, to Jonathan G.

Katz, Secretary, SEC, dated Sept. 25, 2000, at 9

(‘‘CSE Letter’’); Letter from Richard Brueckner,

Chief Operating Officer, Pershing Division of

Donaldson, Lufkin & Jenrette Securities

Corporation, to Jonathan Katz, Secretary, SEC, dated

Sept. 29, 2000, at 3 (‘‘Pershing Letter’’). The fill

rates are reported in Tables V–17 and V–18 of the

Preferencing Study. Only a small number of nonmarketable limit orders, however, were routed to

the regional exchanges, even when evaluated as a

percentage of total order flow (and therefore

adjusting for the much smaller share volume of the

regional exchanges). See Preferencing Report, Table

V–2 (regional exchanges’ non-marketable limit

orders represented 11.5% to 17.3% of their total

order executions compared to 45.7% of NYSE

executions). Indeed, the Preferencing Study found

that four of the five largest broker-dealer

participants in the CSE preferencing program (all

that were examined) generally did not use the CSE’s

limit order book, but preferred either to place limit

orders on their proprietary limit order books or to

route the limit orders to the primary market.

Preferencing Report at 114.

14Preferencing Report, Table V–7. In addition,

Table V–11 indicates that, when compared for same

stocks and order sizes, the NYSE average price

improvement rate for small market orders was 45%

to 180% higher than that of the regional exchanges.

Analogous results were reflected in other tables (V–

12, V–14, V–15, V–16) that were adjusted for

trading in the same stocks and order sizes. Most of

the tables in the Preferencing Report, however,

compared NYSE trading for one week in all of its

stocks with regional exchange trading for four

weeks in a smaller number of NYSE stocks. They

therefore did not attempt to capture distinctions

between trading in comparable stocks during the

same time period, as will be facilitated by the

monthly market center reports to be made available

under Rule 11Ac1–5.

substantial fragmentation of order flow

stands in the way of such competition,

the harm that results is not merely

theoretical. Rather, investors are forced

to incur higher transaction costs, and

the efficiency of the U.S. markets is

diminished.

The Commission’s concerns about

fragmentation and order interaction

should not be construed as meaning that

it fails to recognize the essential

importance of competition among

market centers, which almost by

definition entails some fragmentation of

order flow. The Commission repeatedly

has emphasized the substantial benefits

to investors of such competition,

including innovative trading services,

lower trading fees, and faster

executions. Accordingly, the relevant

issue in addressing fragmentation is not

whether the objective of order

interaction should be pursued to the

exclusion of market center competition,

but how best to secure the benefits of

both market center competition and

order interaction. Although these two

objectives may not be entirely

congruous, they both serve to further the

interests of investors and therefore must

be reconciled in the structure of the

national market system.

Determining how best to assure an

appropriate balance between market

center competition and order interaction

is unquestionably a difficult task.

Nevertheless, the Commission’s yearlong inquiry has led it to conclude that

increased public disclosure of execution

quality and order routing practices is a

minimum step necessary to address

fragmentation. There currently is little

or no publicly available information that

would enable investors to compare and

evaluate execution quality among

different market centers and order

routing practices among broker-dealers.

Some market centers make order

execution information privately

available to independent companies,

which then prepare reports on

execution quality that are sold to brokerdealers. Other market centers provide

reports on execution quality directly to

broker-dealers or to their members. The

information in these reports generally

has not been publicly disseminated.

Moreover, some broker-dealers have

reported difficulty in obtaining useful

information on execution quality from

market centers. For example,

participants in a Commission

roundtable on the on-line brokerage

industry indicated that not all market

centers were willing to make order

execution information available and,

even when such information was made

available, not all of it was useful or in

a form that allowed for cross-market

comparisons.9

Consequently, most investors have

few tools with which to assess the

execution quality of different market

centers and the order routing practices

of different broker-dealers. Execution

quality can, however, vary significantly

across different market centers trading

the same security. If improved

disclosure leads to the tightening of

effective spreads across market centers,

the savings to investors could be quite

substantial. For example, the

Commission staff has estimated that

investors who submit market orders for

Nasdaq securities could save $110

million in annual trading costs if market

centers that currently execute such

orders at effective spreads wider than

the median for all Nasdaq market

centers improved their effective spreads

to the median.10 The variation of

execution quality across market centers

also has been shown by previous

analyses of trading. In 1997, for

example, the Commission issued a

Report on the Practice of Preferencing

that analyzed trading in the listed equity

markets (‘‘Preferencing Report’’). The

sole objective of the Preferencing Report

was to evaluate the impact of two

preferencing programs that had been

formally implemented by the Cincinnati

Stock Exchange (‘‘CSE’’) and Boston

Stock Exchange.11 In this limited

context, the Preferencing Report found

that the programs had not had an

adverse effect on the national market

system as a whole (particularly given

that the programs were quite limited

and represented only a small fraction of

listed order flow).12 When NYSE trading

was compared directly with trading on

the regional exchanges, however, and

such comparisons were made on an

‘‘apples-to-apples’’ basis (i.e.,

categorized by trading in the same

stocks and by orders of the same size),

the Preferencing Report found

significant variations in executions

across market centers.13 For example,

the effective spreads on the regional

exchanges for small market orders were

20% to 39% higher than those on the

NYSE.14

In addition to public analyses of

equity market trading, the Commission

staff is aware of similar data obtained

during the examination process

indicating that execution quality can

vary across market centers. In 1999, for

example, the Commission’s Office of

Compliance Inspections and

Examinations (‘‘OCIE’’) conducted

examinations of 21 broker-dealers for

compliance with the firms’

responsibility to examine regularly and

rigorously the execution quality likely

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75417

15See, e.g., Letter from Craig S. Tyle, General

Counsel, Investment Company Institute, to Jonathan

G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 1

(‘‘ICI Letter’’); Letter from Robin Roger, Managing

Director and Counsel, Morgan Stanley Dean Witter

& Co., to Jonathan G. Katz, Secretary, SEC, dated

Sept. 25, 2000, at 1 (‘‘Morgan Stanley Letter’’);

Letter from Mary A. Burnes, Principal, OTC

Trading, Edward D. Jones & Co., to Jonathan G.

Katz, Secretary, SEC, dated Sept. 19, 2000, at 1

(‘‘Edward Jones Letter’’); Letter from Robert C.

Gasser, Managing Director, J.P. Morgan Securities

Inc., to Jonathan Katz, Secretary, SEC, dated Oct. 5,

2000, at 2 (‘‘J.P. Morgan Letter’’).

16The comment letters and a comprehensive

summary of comments have been placed in Public

File No. S7–16–00, which is available for inspection

in the Commission’s Public Reference Room.

17See, e.g., ICI Letter, note 15 above, at 2; Letter

from James E. Buck, Senior Vice President &

Secretary, NYSE, to Jonathan G. Katz, Secretary,

SEC, dated Oct. 17, 2000, at 1 (‘‘NYSE Letter’’);

Letter from Thomas Peterffy, Chairman, and David

M. Battan, Vice President and General Counsel,

Interactive Brokers LLC, to Jonathan G. Katz,

Secretary, SEC, dated Sept. 22, 2000, at 2

(‘‘Interactive Brokers Letter’’); Letter from Michael

T. Dorsey, Senior Vice President and General

Counsel, Knight Trading Group, Inc., to Jonathan G.

Katz, Secretary, SEC, dated Oct. 25, 2000, at 2

(‘‘Knight Trading Letter’’); Letter from William R.

Harts, Managing Director, Salomon Smith Barney

Inc., to Jonathan G. Katz, Secretary, SEC, dated Nov.

3, 2000, at 1 (‘‘Salomon Smith Barney Letter’’);

Letter from Andrew A. Davis, Chairman and CEO,

The Rock Island Company, and William R. Surman,

Senior Vice President—Equity, Rock Island

Securities, Inc., to Jonathan G. Katz, Secretary, SEC,

dated Sept. 8, 2000, at 2 (‘‘Rock Island Letter’’);

Letter from Alan R. Shapiro, President, and Howard

Kohos, Executive Vice President, Transaction

Auditing Group, Inc., to Jonathan G. Katz,

Secretary, SEC, dated Sept. 22, 2000, at 8 (‘‘TAG

Letter’’).

18Letter from Marshall E. Blume, Howard Butcher

III Professor of Financial Management, The

Wharton School, University of Pennsylvania, to

Jonathan G. Katz, Secretary, SEC, dated Sept. 7,

2000, at 1 (‘‘Blume Letter’’).

19Letter from Meng-yuan Wang, Executive

Director of EMM, UBS Warburg, to Jonathan G.

Katz, Secretary, SEC, dated Sept. 25, 2000, at 1.

20CSE Letter, note 13 above, at 9; Blume Letter,

note 18 above, at 1; Letter from Cameron Smith,

General Counsel, Island ECN, to Jonathan Katz,

Secretary, SEC, dated Sept. 27, 2000, at 9 (‘‘Island

Letter’’). The Proposing Release requested comment

Continued

to be obtained from different market

centers. In the course of these

examinations, OCIE found that the firms

had obtained private analyses of trading

from independent companies showing

marked differences in execution quality

among market centers trading the same

security, as well as across securities

traded in different market structures.

The Commission anticipates that the

two rules adopted today could provoke

more vigorous competition on execution

quality and order routing performance.

The rules will reveal if broker-dealers

are routing a significant volume of

orders to market centers that execute

orders at prices substantially inferior to

those available at other market centers

trading the same security. This

improved visibility, in turn, could shift

order flow to those market centers that

consistently generate the best prices for

investors. Finally, by facilitating

comparisons among securities traded in

different market structures, the

disclosures required by the rules may

bring competitive forces more directly

to bear on broader market structure

issues, such as by prompting investors

and issuers to choose markets with more

efficient structures.

Nevertheless, the Commission shares

the concerns of many commenters

responding to both the Fragmentation

Release and the Proposing Release that

improved disclosure alone might not

prove sufficient to address all of the

problems that can arise from substantial

market fragmentation.15 Accordingly,

the Commission intends to monitor

closely the effects of the disclosure rules

on trading in the coming months. The

Commission also plans to monitor the

pending move to decimal trading in

actively-traded equities, which

potentially could address fragmentation

concerns by enabling more vigorous

competition on quoted price. After

assessing the impact of the rules and

decimals, it will consider whether

additional action is necessary to address

market fragmentation and further the

Exchange Act’s objectives for a national

market system.

III. Rule 11Ac1–5—Disclosure of Order

Execution Information

The Commission has decided to adopt

Rule 11Ac1–5 substantially as it was

proposed, subject to certain technical

modifications. The Rule will require

market centers to prepare and make

available to the public monthly reports

in electronic form that categorize their

order executions and include statistical

measures of execution quality. To

facilitate comparisons across market

centers, the Rule adopts basic measures

of execution quality (such as effective

spread, rate of price improvement and

disimprovement, fill rates, and speed of

execution) and sets forth specific

instructions on how the measures are to

be calculated. The statistical

information will be categorized by

individual security, by five types of

order (e.g., market and inside-the-quote

limit), and four order sizes (e.g., 100–

499 shares and 500–1999 shares). As a

result, users of the market center reports

will have great flexibility in determining

how to summarize and analyze

statistical information. Users of the data

will be able to analyze order executions

for a particular security or for any

particular group of securities, as well as

for any size or type of orders across

those groups of securities.

A. Comments on the Disclosure

Approach of the Proposed Rule

The Commission received 51

comment letters on the disclosure of

order execution practices reflected in

the proposed rule.16 A majority of letters

were supportive of the objective of

improved disclosure, although several

expressed serious reservations regarding

the implementation of this objective in

the proposed rule. Those who supported

the rule’s approach noted the current

lack of useful, public information with

which to compare execution quality

among market centers. They believed

that the information required by the rule

would help address this problem.17 The

Investment Company Institute, for

example, noted that ‘‘[c]urrently, it can

be very difficult to obtain significant

and meaningful data on the execution

quality of market centers. In the absence

of such data, it is difficult to compare

execution quality across markets.’’

Interactive Brokers believed that the

rule ‘‘will be a major step forward in

improving investor awareness of the real

costs they pay, both in time and money,

for trade execution.’’ Others noted that

improved disclosure could benefit

investors by acting as a spur to

competition. Knight Trading Group

believed that the proposed rules ‘‘will

serve to enhance investor protection and

further competition for retail orders by

enabling investors and their fiduciaries

to evaluate more effectively the market

centers to which their orders are

routed.’’ Salomon Smith Barney noted

that ‘‘an educated investor will force

firms and market centers to compete

vigorously with each other for customer

order flow and improve the quality of

executions and our capital markets.’’

Marshall E. Blume stated that ‘‘[t]hrough

disclosure, investors will learn which

markets provide better execution, and

competition, not the SEC, will

determine which markets will

thrive.’’ 18 Another commenter agreed,

noting that ‘‘transparency and

disclosure are the foundation of fair

competition.’’ 19

Although fully supporting the

objective of improved disclosure of

order execution practices, five

commenters expressed reservations

regarding the implementation of this

objective in the proposed rule. Three

suggested that the Commission should

require much more detailed disclosure

of individual orders and transactions,

rather than the rule’s approach of

aggregating such data into statistical

categories on a stock-by-stock basis.20

75418 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

on disclosure of ‘‘raw data’’ as an alternative. The

Commission is not adopting the alternative. If a

market center believes, however, that the basic

statistical measures included in the Rule do not

adequately reflect the complexity of its order flow

and execution quality, it also could make its raw

data publicly available as a means to promote

greater understanding of its performance.

21Letter from Mark B. Sutton, Chairman, Market

Structure Committee, Securities Industry

Association, to Jonathan G. Katz, Secretary, SEC,

dated Sept. 26, 2000, at 1 (‘‘SIA Market Structure

Committee Letter’’; Letter from Lon Gorman, Vice

Chairman, Charles Schwab & Co., to Jonathan G.

Katz, Secretary, SEC, dated Sept. 28, 2000, at 1–2

(‘‘Schwab Letter’’).

22See, e.g., Morgan Stanley Letter, note 15 above,

at 1; Letter from Junius W. Peake, Monfort

Distinguished Professor of Finance, Kenneth W.

Monfort College of Business, to Jonathan G. Katz,

Secretary, SEC, dated Sept. 6, 2000, at 3 (‘‘Peake

Letter’’).

23See, e.g., Pershing Letter, note 13 above, at 1

(‘‘The Commission seems to be trying to create a

quantitative definition of best execution.’’); SIA

Market Structure Committee Letter, note 21 above,

at 3 (the proposed rules ‘‘elevate price and speed

over other, less easily quantifiable, measures that

may be important to certain investors in assessing

execution quality’’); Schwab Letter, note 21 above,

at 9 (‘‘by focusing on price and speed, the

Commission is explicitly endorsing these elements

and implicitly indicating that all others are not

relevant in the determination of best execution’’).

24See, e.g., Securities Exchange Act Release No.

37619A (Sept. 6, 1996), 61 FR 48290 (‘‘Order

Handling Rules Release’’), at section III.C.2.

Two other commenters expressed

reservations about the usefulness of

many statistical categories included in

the proposed rule, and also noted the

need for additional categories that were

not included.21

The commenters that opposed the

disclosure approach of the proposed

rule did so for varying reasons. Five of

the commenters were opposed to the

approach primarily because they

believed the Commission should

address fragmentation by mandating a

unified national linkage system with

price/time priority.22 The reasons

identified by other commenters opposed

to the disclosure approach can be

divided into three major categories: (1)

The proposed rule would overemphasize quantitative factors,

particularly execution price and speed,

in obtaining best execution of investor

orders; (2) the information on execution

quality required by the proposed rule

would be too complex and not very

useful to investors; and (3) the statistical

disclosures required by the proposed

rule would greatly increase the risk of

meritless private litigation. These issues

are discussed below.

1. Emphasis on Execution Price and

Speed

Many of the commenters opposing the

disclosure approach of the proposed

rule, as well those criticizing the rule’s

implementation of a disclosure

approach, believed that it would overemphasize the quantitative factors of

execution price and speed in obtaining

the best execution of investor orders.23

The Commission agrees with these

commenters that execution price and

speed are not the sole relevant factors in

obtaining best execution of investor

orders. It repeatedly has noted that other

factors may be relevant, such as (1) the

size of the order, (2) the trading

characteristics of the security involved,

(3) the availability of accurate

information affecting choices as to the

most favorable market center for

execution and the availability of

technological aids to process such

information, and (4) the cost and

difficulty associated with achieving an

execution in a particular market center.

Rule 11Ac1–5 does not address, much

less alter, the existing legal standards

that apply to a broker-dealer’s duty of

best execution.

For example, the Commission

previously has stated that a brokerdealer must regularly and rigorously

evaluate the quality of execution it

obtains for customers’ orders.24 This

responsibility is not changed by Rule

11Ac1–5. Indeed, the monthly market

center reports will encompass all the

orders received by a market center from

any number of different broker-dealers.

In contrast, a broker-dealer is

responsible only for the execution

quality of its own customers’ orders. If

a market center’s overall statistics do

not reflect the quality of execution of

the orders of the broker-dealer’s

customers, the broker-dealer

appropriately should consider this

disparity in meeting its duty of best

execution. In sum, the rules adopted

today do not define, either explicitly or

implicitly, a broker-dealer’s duty of best

execution.

The Commission strongly believes,

however, that most investors care a great

deal about the quality of prices at which

their orders are executed, and that an

opportunity for more vigorous

competition among market participants

to provide the best quality of execution

will enhance the efficiency of the

national market system. Rule 11Ac1–5

is needed, not because price is the only

important factor in routing orders, but

because there currently is little or no

public information that would allow

investors to assess a broker-dealer’s

handling of its customer orders. For

example, the Rule will allow investors

to monitor the extent to which, in

choosing execution venues, there are, in

fact, systematic trade-offs that must be

made between price and other factors,

and the amount of those trade-offs. For

example, if the best prices are

consistently produced by one of the

leading market centers with cuttingedge, highly-reliable trading systems,

there would be little, if any, trade-off

between price and systems reliability.

Similarly, the rules will help customer

weigh the trade-off between a market

center that provided immediate

executions at the quote, and a market

center that executed orders on average

in under 30 seconds, but that

consistently generated prices resulting

in average effective spreads that were a

significant amount per share better than

those paid by investors at other market

centers. Currently, however, investors

have little or no information that would

allow them to evaluate how their

broker-dealer has responded to such

trade-offs. Rule 11Ac1–5 is intended to

remedy this glaring absence of public

information.

The Rule’s disclosure of the average

spreads at which investor orders are

executed should not be construed as

meaning that only price

‘‘improvement’’—defined as the

execution of an order at a price better

than the public quote at the time the

market center received the order—is

important. Price improvement is likely

to be important to many small investors

because small orders are the most likely,

at least at some market centers, to

receive significantly better prices than

the public quotes. The Rule does not,

however, focus solely on orders that

receive price improvement. It requires

the same types and degree of disclosure

for orders that are executed at the quotes

and at prices outside the quotes.

Moreover, many commenters

mistakenly believed that Rule 11Ac1–5

focused on price ‘‘improvement’’ to the

exclusion of other important aspects of

execution that relate to price,

particularly the amount of liquidity

available at different market centers.

However, liquidity and price are

integrally related. Liquidity reflects the

extent to which larger size orders can be

executed at prices that are equal to or

not far away from the quotes when the

order is submitted. To measure the

amount of liquidity available at different

market centers, Rule 11Ac1–5 requires

separate disclosures concerning the

extent to which orders are executed at

prices better than the quotes, equal to

the quotes, and outside the quotes. Each

of these disclosures will be categorized

by the following order sizes: 100–499,

500–1999, 2000–4999, and 5000 or more

shares. Thus, these categories of

information enable the comparison of

the performance of market centers in

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75419

25See, e.g., Morgan Stanley Letter, note 15 above,

at 12–13; Pershing Letter, note 13 above, at 2; Letter

from Robert H. Forney, President and Chief

Executive Officer, Chicago Stock Exchange, to

Jonathan G. Katz, Secretary, SEC, dated Oct. 5,

2000, at 9 (‘‘CHX Letter’’); Letter from Lanny A.

Schwartz, Executive Vice President and General

Counsel, Philadelphia Stock Exchange, Inc., to

Jonathan G. Katz, Secretary, SEC, dated Sept. 22,

2000, at 1 (‘‘Phlx Letter’’).

26For example, the quoted spread and the

effective spread are analogous to the manufacturer’s

suggested retail price (‘‘MSRP’’) for a product and

the varying prices actually charged at different

stores. The first reflects the price that might be

charged; the second reflects the price actually

charged, which could be better or worse than the

first, and often is. The Commission similarly

believes that investors, with proper explanation,

can grasp the concept underlying average realized

spread. This statistic is calculated by comparing the

execution price of an order with the public quotes

as they stand five minutes after the time of

execution. As discussed further in section III.C.1

below, it measures the extent to which a market

center receives order flow that is difficult to

handle—either because it arrives during times when

the markets are stressed or it comes from informed

traders. It highlights those market centers that are

willing to accept such difficult order flow, a

praiseworthy quality that the Commission does not

want the Rule’s disclosure requirements to

discourage.

27 If interested, however, investors with access to

the Internet and capable of using widely-available

office application software could readily download

and analyze a market center’s monthly execution

quality report. Private vendors also may offer

services that enable individual investors to access

and review market center reports.

28A commenter suggested that, without an

independent verification requirement, some market

centers might produce reports that were materially

misleading. Morgan Stanley Letter, note 15 above,

at 17. The Commission does not believe that an

independent verification requirement is necessary

at this time. Market centers subject to Rule 11Ac1–

5 will be regulated entities that have met the

integrity and competence standards of the Exchange

Act. In addition, all market centers will be subject

to inspection by the Commission. If registered as a

broker-dealer, they also will be subject to inspection

by their respective self-regulatory organizations

(‘‘SROs’’). The Exchange Act grants the Commission

and SROs ample enforcement powers to deal with

any market center that makes materially misleading

disclosures concerning its execution quality.

29SIA Market Structure Committee Letter, note 21

above, at 5; Letter from Bruce E. Coolidge of

Wilmer, Cutler & Pickering, to Jonathan G. Katz,

Secretary, SEC, dated Oct. 10, 2000; Letter from

Continued

executing larger orders at prices equal to

the public quotes. Moreover, one

particular measure included in the

Rule—the average effective spread—will

capture the net effect of all executions

in an order size. For example, a market

center’s average effective spread for

market orders of 2000–4999 shares in a

security will reflect the share-weighted

average of the executions it provided for

all of those orders. Thus, if a market

center gave only a few orders price

improvement, but executed most orders

at prices outside the quotes, its average

effective spread would be higher than

the average effective spread reported by

a market center that executed a high

percentage of orders at prices equal to

the public quotes.

The Commission also wishes to

emphasize that Rule 11Ac1–5 is

intended to establish a baseline level of

disclosure that all market centers must

meet in order to facilitate cross-market

comparisons of execution quality. It

does not preclude market centers from

disclosing whatever additional

information concerning their order

execution practices that they believe

would more fully convey the quality of

their services.

2. Usefulness to Investors of Execution

Quality Information

Commenters opposed to the proposed

rule also questioned the usefulness to

investors of the information on

execution quality that would be

included in the market center reports. In

particular, they believed that the

information was too complex for

investors to understand, that the reports

would overwhelm investors with

statistical data, and that, as a result,

investors would be vulnerable to being

misled by those willing to ‘‘spin’’ the

data to serve their own self interest.25

As an initial matter, the Commission

disagrees with the notion that investors

are incapable of understanding the

fundamental principles of execution

quality reflected in Rule 11Ac1–5.26

Investors’ current lack of familiarity

with the statistical measures, rather than

their inherent complexity, may

contribute to an impression that the

measures are complex. To date, very few

market centers have made any public

disclosures concerning their execution

quality, such as their effective spread

and rate of price improvement for

different types of orders. The quoted

spread, in contrast, has been widely

disseminated pursuant to Commission

rules and that is what investors have

come to know. Given the enormous

appetite of investors in recent years for

better information about the markets

(fueled largely by improved technology

and lower communication costs), the

Commission anticipates that many

investors will come to appreciate the

important distinction between quoted

prices and the prices they actually

receive. Nearly every statistical measure

included in Rule 11Ac1–5, each of

which is based on execution price and

speed of execution, is straightforward in

principle.

Commenters correctly observed,

however, that a large volume of

statistical data will be disclosed in the

monthly execution quality reports. As

discussed in the Proposing Release, the

large volume of statistics reflects a

deliberate decision by the Commission

to avoid the dangers of overly-general

statistics. Assigning a single ‘‘execution

quality’’ score to market centers, for

example, would hide major differences

in execution quality, potentially

creating far more problems that it

solved. Instead, Rule 11Ac1–5, taking

advantage of improved and more

efficient information technology,

requires electronic disclosure of basic

order execution information that is

categorized on a stock-by-stock basis.

After this basic information is disclosed

by all market centers in a uniform

manner, market participants and other

interested parties will be able to

determine the most appropriate classes

of stocks and orders to use in comparing

execution quality across market centers.

Given the large volume of data that

will be included in the reports, most

individual investors likely would not

obtain and digest the reports

themselves.27 The Commission

anticipates that independent analysts,

consultants, broker-dealers, the

financial press, and market centers will

analyze the information and produce

summaries that respond to the needs of

investors. Some commenters expressed

discomfort with the varied and

unstructured analysis that might arise

once execution quality statistics become

available to the public. However, many

market participants will have an interest

in clearly communicating to investors

the salient information in ways that

investors can understand. In time,

investors should be able to assess the

credibility of these analyses and use

them in evaluating execution

performance. Indeed, one of the most

serious problems investors currently

face with respect to choosing a broker is

assessing the quality of order routing

and execution services provided by

various broker-dealers. After the rules

adopted today become effective,

competitive forces can be brought to

bear on broker-dealers both with respect

to the explicit trading costs associated

with brokerage commissions and the

implicit trading costs associated with

execution quality. The Commission

believes that investors ultimately will be

the beneficiaries of this expanded

competition.28

3. Risk of Meritless Litigation

Several commenters expressed

concern that the required disclosures of

order execution and routing practices

would greatly increase the risk of

private securities litigation alleging that

broker-dealers failed to meet their duty

of best execution.29 The Commission

75420 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

Roger D. Blanc of Wilkie Farr & Gallagher, to

Jonathan G. Katz, Secretary, SEC, dated Oct. 5,

2000, at 10 (‘‘Wilkie Farr & Gallagher Letter’’);

Schwab Letter, note 21 above, at 13–17; Morgan

Stanley Letter, note 15 above, at 17; Letter from the

Regulatory Studies Program of the Mercatus Center

at George Mason University, to Jonathan G. Katz,

Secretary, SEC, dated Sept. 22, 2000, at 14

(‘‘Mercatus Center Letter’’). But see Knight Trading

Letter, note 17 above, at 12–14.

30For this reason, broker-dealers will be able to

explain in their disclosures to customers the full

range of factors that influenced their order routing

decisions.

31Exchange Act Section 11A(a)(2). See also Guice

v. Charles Schwab & Co., 674 N.E.2d 282 (N.Y.

1996), cert. denied, 520 U.S. 1118 (1997).

32Exchange Act Section 11A(a)(1)(C)(iv).

33Similarly, the Commission has noted that ‘‘in

evaluating its procedures for handling limit orders,

the broker-dealer must take into account any

material differences in execution quality.’’ Order

Handling Rules Release, note 24 above, at section

III.C.2 (emphasis added).

34See id. at section III.C.2.

35A national securities exchange is an exchange

registered under Section 6 of the Exchange Act. An

exchange exempted from registration pursuant to

Section 5 of the Exchange Act therefore is not

included within the Rule’s definition of market

center.

expresses no opinion on some of the

broader criticisms of private litigation

made by these commenters. It is

concerned, however, about comments

that the required disclosures,

particularly the detailed statistical

information required by Rule 11Ac1–5,

could be subject to misinterpretation

that might pose a risk of meritless

litigation. The Commission wishes to

make clear its views as to the limits of

these data in evaluating a brokerdealer’s compliance with its legal duty

of best execution. Both Rule 11Ac1–5

and Rule 11Ac1–6 are designed to

require disclosure pursuant to Section

11A of the Exchange Act. They are not

antifraud rules, nor do they create new

duties under the antifraud provisions of

the federal securities laws. The rules

themselves create neither express nor

implied private rights of action.

Furthermore, Rule 11Ac1–5 and Rule

11Ac1–6 do not address and therefore

do not change the existing legal

standards that govern a broker-dealer’s

duty of best execution. The market

center reports will provide statistical

disclosures regarding certain of the

factors relevant to a broker-dealer’s

order routing decision, but these factors

alone are not determinative of whether

the broker-dealer achieved best

execution.

Rule 11Ac1–5 and Rule 11Ac1–6 are

designed to generate uniform, general

purpose statistics that will prompt more

vigorous competition on execution

quality. The information that will be

generated as a result of these rules will

not, by itself, be sufficient to support

conclusions regarding a broker-dealer’s

compliance with its legal responsibility

to obtain the best execution of customer

orders. Any such conclusions would

require a more in-depth analysis of the

broker-dealer’s order routing practices

than will be available from the

disclosures required by the rules.

For example, as discussed in section

III.A.1 above, the execution quality

statistics included in Rule 11Ac1–5 do

not encompass every factor that may be

relevant in determining whether a

broker-dealer has obtained best

execution. In addition, the statistics in

a market center’s reports typically will

reflect orders received from a number of

different routing broker-dealers. Legal

conclusions about any one brokerdealer’s routing practices require an

assessment of additional information

concerning how that broker-dealer’s

customer orders were executed.

Moreover, under Rule 11Ac1–6, a

broker-dealer’s quarterly report will

provide a general overview of its order

routing practices. The information on

where orders were routed during the

quarter will be broken out only by the

listing status of the security—NYSE,

Nasdaq, Amex/other, and options.

Within these categories, a broker-dealer

may have varied its routing of different

types of orders, or orders in different

securities, so as to obtain results that

would not be evident from the general

statistics presented in the market center

reports.

In sum, while the order execution and

routing disclosures will represent a

significant step forward in the quality of

information that is currently publicly

available, they alone will not provide a

reliable basis to assess a broker-dealer’s

compliance with its duty of best

execution. Therefore, the resulting

statistics, by themselves, do not

demonstrate whether or not brokerdealers have complied with their legal

duties to their customers,30 and to

conclude otherwise would be contrary

to the Commission’s prior statements,

discussed below, about the duty of best

execution. Furthermore, the

Commission believes that the possibility

of multiple, inconsistent standards in

interpreting this information in relation

to various state law claims could tend

to frustrate the statutory objective of

establishing and monitoring the

development of a national market

system 31 and would undermine the

Commission’s effort to assure the

practicability of brokers achieving best

execution.32

The Commission previously has

expressed three conclusions

inconsistent with an overly-simplistic

determination that a broker-dealer

breached the duty of best execution.

First, a broker-dealer is required to seek

to obtain the most favorable terms

reasonably available under the

circumstances for a transaction (which

may not in every case necessarily be the

best price that might be available).33

Second, the duty of best execution does

not necessarily require broker-dealers

with a large volume of orders to

determine individually where to route

each order. Third, a broker-dealer does

not violate its best execution obligation

solely because it receives payment for

order flow or trades as principal with

customer orders.34

To emphasize these points, we have

added a ‘‘Preliminary Note’’ to Rule

11Ac1–5. It provides as follows:

Section 240.11Ac1–5 requires market

centers to make available standardized,

monthly reports of statistical information

concerning their order executions. This

information is presented in accordance with

uniform standards that are based on broad

assumptions about order execution and

routing practices. The information will

provide a starting point to promote visibility

and competition on the part of market centers

and broker-dealers, particularly on the factors

of execution price and speed. The disclosures

required by this Section do not encompass all

of the factors that may be important to

investors in evaluating the order routing

services of a broker-dealer. In addition, any

particular market center’s statistics will

encompass varying types of orders routed by

different broker-dealers on behalf of

customers with a wide range of objectives.

Accordingly, the statistical information

required by this Section alone does not create

a reliable basis to address whether any

particular broker-dealer failed to obtain the

most favorable terms reasonably available

under the circumstances for customer orders.

The Commission believes that this

clear statement will substantially

address the danger of meritless litigation

that might impose significant indirect

costs on broker-dealers.

B. Scope of Rule

Paragraph (b)(1) of Rule 11Ac1–5

provides that every market center shall

make available for each calendar month

an electronic report on the covered

orders in national market system

securities that it received for execution

from any person. Thus, the Rule is

limited in scope to market centers,

covered orders, and national market

system securities.

1. Market Center

Paragraph (a)(14) of the Rule defines

the term ‘‘market center’’ as any

exchange market maker, OTC market

maker, alternative trading system,

national securities exchange,35 or

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75421

36When a market center receives an order for

execution, the order must be included in its

statistical disclosures of execution quality even if

the order is routed to another venue for execution.

See section III.C.1 below.

37 Indeed, the Commission anticipates that many

SROs may, on behalf of their members, assume

substantially all responsibility for complying with

the Rule. Such an assumption of responsibility

would be an acceptable way for an SRO and its

members to meet the Rule’s requirements.

38The Commission’s staff will be available to

provide interpretive guidance to market centers on

how orders should be reported under the Rule.

39See Division of Market Regulation, SEC, Report

on Electronic Communications Networks and AfterHours Trading (June 2000), at 29 (for the 15 largest

capitalization stocks in the Nasdaq 100 index,

average quoted spread, average effective spread, and

trade price volatility increased significantly after

the close of regular trading hours). 40The Proposing Release requested comment on

orders received when the consolidated BBO is

locked or crossed. One commenter suggested that

such orders be excluded, as well as orders received

during ‘‘fast’’ markets. TAG Letter, note 17 above,

at 4. The adopted Rule continues to encompass

such orders. Its statistical measures can all be

calculated during periods when markets are locked,

crossed, and fast. Moreover, one of the important

characteristics of a market center is its ability to

handle orders well during difficult market

conditions.

41The full title of the Nasdaq Plan is ‘‘Joint SelfRegulatory Plan Governing the Collection,

Consolidation, and Dissemination of Quotation and

Transaction Information for Exchange-Listed

Nasdaq/National Market System Securities and for

Nasdaq/National Market System Securities Traded

on an Unlisted Trading Privilege Basis.’’

42One commenter requested clarification

concerning orders that are not sent to a market

center for prompt execution, as are traditional

market orders, or that are not priced orders. Letter

from P. Mats Goebels, Senior Vice President &

General Counsel, ITG, Inc., to Jonathan G. Katz,

Secretary, SEC, dated Sept. 29, 2000, at 5. Such

orders would not fall within the definition of

‘‘covered order’’ in subparagraph (a)(8), which

applies only to market orders and limit orders.

national securities association. This

definition is intended to cover entities

that hold themselves out as willing to

accept and execute orders in national

market system securities. In addition,

the language in paragraph (b)(1) that a

market center must report on orders that

it ‘‘received for execution from any

person’’ is intended to assign the

disclosure obligation to the entity that is

expected to control whether and when

an order will be executed.36

The Commission anticipates that the

reporting entity for the vast majority of

orders will be an exchange specialist,

OTC market maker, or ATS. Although

specialists and market makers

frequently operate under the auspices of

an SRO (and such an SRO likely will

greatly assist its members in meeting the

disclosure requirements of the Rule),37

the responsibility for executing orders

generally is handled by the individual

firms, and execution quality may vary

significantly among them. This is

particularly true where an exchange has

multiple market makers in a security. It

therefore is appropriate for the monthly

reports to reflect these potential

differences. In some cases, however,

orders may be executed through a

facility operated by an SRO without a

member significantly controlling the

order executions. Examples may include

(1) the Small Order Execution System

(‘‘SOES’’) operated by Nasdaq, and (2)

floor brokers who receive orders on the

floor of an exchange and obtain an

execution of the orders with little

participation by a specialist. The

definition of market center includes

exchanges and associations to cover

these situations.38

2. Covered Order

The definition of ‘‘covered order’’ in

paragraph (a)(8) of Rule 11Ac1–5

contains several conditions and

exclusions that are intended to limit its

scope to those orders that provide a

basis for meaningful and comparable

statistical measures of execution quality.

First, the Rule applies only to market

orders or limit orders that are received

by a market center during regular

trading hours and, if executed, executed

during such time. The term ‘‘regular

trading hours’’ is defined in paragraph

(a)(19) of the Rule to mean between 9:30

a.m. and 4:00 p.m. Eastern Time, or

such other time as is set forth in the

procedures established pursuant to

paragraph (b)(2) of the Rule. There are

substantial differences in the nature of

the market between regular trading

hours and after-hours, and orders

executed at these times should not be

blended together in the same statistics.39

In addition, covered orders must be

received during the time that a

consolidated BBO is being

disseminated.40 This restriction is

necessary because nearly all of the

statistical measures included in the Rule

depend on the availability of a

consolidated BBO at the time of order

receipt. The term ‘‘consolidated best bid

and offer’’ is defined in paragraph (a)(7)

as the highest firm bid and the lowest

firm offer for a security that is

calculated and disseminated on a

current and continuous basis pursuant

to an effective national market system

plan. The two plans that currently

provide for the calculation and

dissemination of a consolidated best bid

and offer for national market system

securities are the Consolidated

Quotation Plan for listed equities and

the Nasdaq/National Market System

Plan for Nasdaq equities.41

The definition of covered order

excludes any orders for which the

customer requested special handling for

execution and that, if not excluded,

could skew general statistical measures

of execution quality. Types of orders

specifically excluded from the Rule

include, but are not limited to, orders to

be executed at a market opening or

closing price, stop orders, orders such as

short sales that must be executed on a

particular tick or bid, orders submitted

on a ‘‘not held’’ basis, orders for other

than regular settlement, and orders to be

executed at prices unrelated to the

market price at the time of execution.

All of these exclusions are retained from

the proposed rule. In addition, the Rule

as adopted now specifically excludes

all-or-none orders on the basis that they

often may be more difficult to execute

than orders without a substantial

minimum quantity requirement.42

Two types of orders warrant further

discussion. The first type—immediateor-cancel orders—is included in the

Rule. The second—orders to be

executed at a market opening price—is

excluded for operational reasons,

notwithstanding the significant issues of

quality of disclosure for investors

submitting these orders, particularly in

Nasdaq securities.

a. Immediate-Or-Cancel Orders. The

Commission has determined that

‘‘immediate-or-cancel’’ orders should be

included in Rule 11Ac1–5. Immediateor-cancel orders are immediately subject

to execution under normal conditions.

These orders are functionally nearly the

same as orders that are submitted and

cancelled almost immediately

thereafter, which are included in the

Rule. If not executed, they simply will

be included in the statistic for a market

center’s cancelled orders under

subparagraph (b)(1)(i)(C) of the Rule.

Moreover, ECNs trading Nasdaq

securities receive a substantial number

of immediate-or-cancel orders,

particularly those that are marketable

limit orders. Thus, including these

orders may be important to accurately

assess the quality of these ECNs, and

statistics that reflect the execution

quality of these orders in ECNs may be

of significant interest to investors.

b. Market Opening Orders. The

Proposing Release requested comment

on the appropriateness of excluding

orders that are to be executed at a

market opening price. Several

commenters believed that such orders

should be included in the Rule. Edward

D. Jones & Co., for example, observed

that approximately 10–20% of its order

flow typically was executed at the

opening and that it would be useful,

particularly for Nasdaq securities, to

segregate opening orders into a separate

statistic. The Investment Company

Institute stated that ‘‘the quality of

75422 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

43The market centers that offer these improved

prices for opening orders may, however, exclude

them from their payment for order flow schedules,

thereby potentially reducing the payments to

broker-dealers that obtain these better prices for

their customers.

44Rule 11Aa2–1 incorporates the definition of

‘‘reported security’’ that is used in Exchange Act

Rule 11Aa3–1—any security for which transaction

reports are made available pursuant to a reporting

plan approved under Rule 11Aa3–1. Only

exchange-listed equities and Nasdaq National

Market equities currently fall within this definition. 45See NASD Economic Research Dept.,

http://www.marketdata.nasdaq.com (visited June

27, 2000).

46 Interactive Brokers Letter, Note 17 above, at 4.

47Letter from Thomas A. Bond, Chicago Board

Options Exchange, to Jonathan G. Katz, Secretary,

SEC, dated Oct. 9, 2000 at 3 (‘‘CBOE Letter’’).

execution of market opening orders in

the Nasdaq market has been an issue of

significant concern to market

participants’’ and that ‘‘information on

the quality of execution at the opening

would assist market participants in

determining how to trade securities at

the opening of the market.’’

The Commission fully shares the

concerns of commenters over the need

for improved information on the quality

of execution of opening orders in

Nasdaq securities. In this respect, the

market for Nasdaq securities differs

significantly from the market for

exchange-listed securities, where the

primary exchange generates and

disseminates a single opening price.

Moreover, it is the Commission’s

understanding that it is industry

practice in the listed markets to provide

investors with this single opening price

for opening orders that are executed

away from the primary exchange. In the

market for Nasdaq securities, in

contrast, it appears to be the common

practice of many market centers to

execute opening orders to buy at the

quoted offer and opening orders to sell

at the quoted bid, thereby charging a

liquidity premium for a large volume of

orders that effectively cross each other

at a single point in time.

The Commission is aware that several

important market centers trading

Nasdaq securities have begun to offer

services that give investors an

opportunity to avoid paying a liquidity

premium on opening orders. Such

services can include, for example, ‘‘midpoint pricing,’’ pursuant to which both

buy and sell orders are executed at the

midpoint of the opening quoted bid and

offer.43

The Commission is concerned that

many investors may not be fully aware

of the significant distinction between

Nasdaq and listed securities with

respect to the execution of opening

orders. The Commission also is

concerned that many investors may not

be aware of the differing services offered

by market centers for execution of

opening orders in Nasdaq securities,

and their impact on execution quality.

Without question, including a separate

category for opening orders in the Rule

11Ac1–5 statistics would highlight the

differences in quality of execution of

opening orders across market centers.

Nevertheless, the Commission is

reluctant to expand the quantity of the

Rule’s continuing and marketwide

disclosure requirements to address an

issue that is limited to a specific

segment of the equities markets.

Including additional statistics for

opening orders in market center reports

alone would increase the size of the

reports by 20%. All market centers, both

those trading listed and Nasdaq

securities, would be required to include

the opening order information, even

though it would be nearly the same for

all market centers offering a single price

execution of these orders. In addition,

Nasdaq is actively considering new

opening procedures that could reduce

disparities in execution quality.

Instead of substantially expanding the

quantity of statistics required by the

Rule to address this issue, the

Commission believes that the markets

and broker-dealers handling customer

orders should be given a further

opportunity to improve execution

quality at the opening in Nasdaq

securities. Market centers generally

inform broker-dealers in advance how

they will execute opening orders.

Broker-dealers are subject to a best

execution duty in executing customer

orders at the opening, and should take

into account the alternative methods in

determining how to obtain best

execution for their customer orders.

Broker-dealers are encouraged to

communicate clearly to customers the

choices available for execution of

opening orders, as well as the brokerdealer’s policy for obtaining best

execution of such orders. If necessary in

the future, the Commission will

consider requiring statistical disclosure

of order execution quality at the

opening.

3. National Market System Securities

Rule 11Ac1–5 applies only to

securities that are designated as national

market system securities under

Exchange Act Rule 11Aa2–1. Currently,

this designation applies to exchangelisted equities and equities included in

the National Market tier of Nasdaq.44 It

does not apply to Nasdaq SmallCap

securities, Over-the-Counter Bulletin

Board securities, and exchange-listed

options. SmallCap stocks tend to be

inactively traded and, as a group,

generate less than 5% of the dollar

volume on Nasdaq while making up

nearly 25% of Nasdaq companies.45

Given the relatively light dollar amount

of trading in these and Bulletin Board

securities, the Commission believes at

this time that the value of statistical

measures of trading may not justify the

costs to produce the information. After

gaining experience with the Rule’s

operation, it will consider whether the

scope of the Rule should be expanded.

The Proposing Release requested

comment on whether Rule 11Ac1–5

should apply to orders for listed

options. Interactive Brokers LLC

strongly believed that the Rule should

apply to options trading.46 The Chicago

Board Options Exchange (‘‘CBOE’’), in

contrast, did not think that the Rule’s

disclosure approach was appropriate for

options trading, although it did express

support for the objective of improved

disclosure in general.47 The

Commission continues to believe that

there is a need for improved disclosure

of execution quality in the options

markets, particularly now that there is

widespread trading of options on

multiple exchanges and expanding

payment for options order flow.

Nevertheless, potentially difficult issues

would have to be addressed before

options could be included within Rule

11Ac1–5. For example, a consolidated

BBO is not, at this time, calculated and

disseminated for options trading. A

consolidated BBO is an essential

element for nearly every statistical

measure in the Rule, such as calculating

price improvement and classifying types

of limit orders (e.g., inside-the-quote

and at-the-quote limit orders). Although

each exchange potentially could

calculate its own consolidated BBO, the

calculations might vary at times and fail

to provide a uniform basis for

comparable statistics. In addition,

categorization of orders on a securityby-security basis would be much less

practical for the options markets, where

there may be hundreds of series of

options for one underlying security. The

Commission’s Office of Economic

Analysis and OCIE currently are

preparing a report on payment for order

flow in the options markets. The report

necessarily will address the quality of

execution of options orders. After the

report is completed, the Commission

will consider whether additional action

is needed to improve the quality of

disclosure of execution quality in the

options markets.

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75423

48Phlx Letter, note 25 above, at 4; CSE Letter,

note 13 above, at 6–7; Schwab Letter, note 21 above,

at 10–11.

49A commenter suggested that the Rule should

exclude cancelled orders in calculations of

execution quality measures. Letter from Richard G.

Ketchum, National Association of Securities

Dealers, Inc., to Jonathan G. Katz, Secretary, SEC,

dated Oct. 17, 2000, at 3. In fact, the Rule does not

specify whether cancelled orders should or should

not be included in calculating measures such as

price improvement rates for market orders and fill

rates for limit orders. Instead, market centers will

disclose the number of cancelled shares, and

analysts are free to use or exclude cancelled orders

in performing their calculations as they think most

appropriate.

50 Interactive Brokers Letter, note 17 above, at 3–

4.

51The overall fill rates for such orders can be

calculated by comparing the number of shares

executed with the total number of shares received.

Such overall fill rates for non-marketable limit

orders can be difficult to interpret because of the

problem of cancelled orders. An aggressive user of

non-marketable limit orders frequently will submit

orders with limit prices at or inside the current

consolidated BBO. If market prices move away from

the order, the order submitter may cancel and

resubmit the order at a new limit price that reflects

the changing consolidated BBO. Consequently, the

same person potentially may cancel and resubmit

an order several times to maintain the

aggressiveness of the limit price. These

cancellations can make it difficult to evaluate

overall fill rates and cancellation rates.

C. Required Information

Paragraph (b)(1) of Rule 11Ac1–5

requires market center reports to be

categorized by individual security, order

type, and order size. These categories

are defined in paragraphs (a)(4) through

(a)(6) of the Rule. The five types of

orders are market, marketable limit,

inside-the-quote limit, at-the-quote

limit, and near-the-quote limit. The four

buckets of order size are 100–499, 500–

1999, 2000–4999, and 5000 or more

shares. With this degree of

categorization, a market center will, for

example, produce statistical information

for the subcategory of market orders for

100–499 shares in an individual stock.

Several commenters criticized the

categories specified in the proposed

rule.48 The Commission has decided to

retain the categories at this time,

although experience with the Rule may

indicate ways in which they could be

improved in the future. The categories

are intended to strike a balance between

(1) sufficient aggregation of orders to

produce statistics that are meaningful,

and (2) sufficient differentiation of

orders to facilitate fair comparisons of

execution quality across market centers.

If a market center believes that the

categories do not fully reflect its order

flow and execution practices, it is

encouraged to make any additional

information publicly available that it

believes would be helpful to investors.

1. Information Required for All Types of

Orders

For each subcategory of security/order

type/order size, paragraph (b)(1)(i)

specifies eleven columns of information

that must be provided. The first five

columns provide general information on

the orders received by a market center

in a subcategory and the disposition of

those orders. The first column is ‘‘the

number of covered orders.’’ The second,

however, is ‘‘the cumulative number of

shares of covered orders’; and thereafter

all statistics required by the Rule are

expressed either in number of shares or

in share-weighted amounts. The Rule

uses share-based statistics primarily to

deal with those situations in which a

single order receives less than a full

execution or more than one partial

execution.

The Rule requires disclosure of the

number of shares cancelled prior to

execution,49 and the number of shares

executed at both the receiving market

center and at any other venue (after

being routed elsewhere by the receiving

market center). Thereafter, all statistical

measures of order execution for a

market center will encompass both

orders that were executed at the

receiving market center and orders that

were executed elsewhere. In calculating

its statistics, a market center will use the

time it received the order and the

consolidated BBO at the time it received

the order, not the time and consolidated

BBO when the venue to which an order

was forwarded received the order. The

Commission believes that a market

center should be held accountable for

all orders that it receives for execution

and should not be given an opportunity

to exclude difficult orders from its

statistical measures of execution quality

by routing them to other venues. In

addition, from the perspective of the

customer who submitted the order, the

fact that a market center chooses to

route the order elsewhere does not

reduce the customer’s interest in a fast

execution that reflects the consolidated

BBO as close to the time of order

submission as possible. Consequently,

in evaluating the quality of order

routing and execution services, it is

important for customers to know how a

market center handles all orders that it

receives, not just those it chooses to

execute.

The term ‘‘time of order receipt’’ is

defined in paragraph (a)(21) of the Rule

as the time (to the second) that an order

was received by a market center for

execution. The definition is intended to

identify the time that an order reaches

the control of the market center that is

expected, at least initially, to execute

the order. In many cases, a broker-dealer

may receive an order from a customer in

a security for which the broker-dealer

also is an OTC market maker or an

exchange specialist. In such cases, the

market center will be considered to have

received an order for execution only

when the order is transmitted to the

department of the firm responsible for

making a market in the security.

A commenter noted the danger that a

market center might attempt to

manipulate the time of receipt for its

order flow. It stated, for example, that ‘‘a

market maker executing captive market

orders pursuant to an internalization or

payment for order flow arrangement

who has agreed to ‘‘step up and match’’

the NBBO can create for itself a free

option by monitoring market

movements before and/or after receipt of

any order and assigning as an execution

price for that order whatever ‘‘NBBO’’ is

most favorable to the market maker

during the brief option period.’’ 50 The

Commission agrees that it is critically

important for market centers to assign a

time of receipt (including seconds) to

orders in a prompt, consistent, and nonmanipulatory manner. The

Commission’s inspections of market

centers will include a review for

compliance with this standard, and

failure to meet the standard would be a

serious violation of the Rule.

The next five columns required by

paragraph (b)(1)(i) of the Rule ask for the

number of shares that were executed

within specified periods of time after

order receipt (such as ‘‘from 0 to 9

seconds’’ and ‘‘from 10 to 29 seconds’’).

Although required for all types of

orders, the Commission anticipates that

this information will be most useful for

evaluating the execution of nonmarketable limit orders. These statistics

are intended to provide useful

comparisons to the overall fill rates for

non-marketable limit orders.51

Particularly for inside-the-quote and atthe-quote limit orders, the submitter of

the order reasonably may expect that the

order should be executed relatively

quickly, and information on the

likelihood that such an order will be

executed with 10 seconds, 30 seconds,

and so on, at different market centers

may be helpful in guiding the order

routing decision.

The final column of information

required for all types of orders is the

average realized spread. The term

‘‘average realized spread’’ is defined in

paragraph (a)(3) of the Rule and is

calculated by comparing the execution

price of an order with the midpoint of

the consolidated BBO as it stands five

minutes after the time of order

75424 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

52The proposed rule incorporated a 30-minute

time period for calculating average realized spread.

Several commenters suggested that, given the

volatility of stock prices, five minutes would be a

more appropriate time period and would generate

more useful information. ICI Letter, note 15 above,

at 4; Rock Island Letter, note 17 above, at 2. The

Commission agrees and has incorporated a fiveminute time period in the Rule as adopted.

53See, e.g., NYSE Letter, note 17 above, at 9–10;

NASD Letter, note 49 above, at 4–5; SIA Market

Structure Committee Letter, note 21 above, at 4.

54For example, if local traders at a particular

market center display a great deal of expertise in

deciding when to step ahead of displayed limit

orders, the average realized spread for those limit

orders would be comparatively high (they would

almost always be executed only when the market

was moving significantly against them).

execution.52 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. In other words, a low average

realized spread indicates that the market

center was providing liquidity even

though prices were moving against it for

reasons such as news or market

volatility.

Many commenters questioned the

usefulness of this statistic and

recommended that it be eliminated.53

The Commission believes, however, that

the average realized spread is an

essential measure for evaluating a

market center’s order execution

practices and so we have retained the

measure in the Rule. Most importantly,

marketwide disclosure of realized

spreads will help address a potentially

serious incentive problem that could

arise during ‘‘stressed’’ markets (i.e.,

when prices are moving quickly). A

market center of ‘‘last resort’’—one that

executes a greater proportion of orders

when the market is stressed—generally

will post wider effective spreads during

those periods, even though the realized

spread may remain quite low or

negative (because prices are moving

rapidly against those providing liquidity

during the stressed period). Thus,

marketwide disclosure of realized

spreads can help identify those market

centers willing to supply liquidity

during difficult times. If average

realized spread were not included in the

Rule, it might create an incentive for

market centers to avoid trading in times

of stress, leading to a drop in liquidity

at the very time when it is most needed.

In addition, for market orders (as well

as marketable limit orders), average

realized spread can measure the extent

to which ‘‘informed’’ and ‘‘uninformed’’

orders are routed to different market

centers. Informed orders are those

submitted by persons with better

information than is generally available

in the market. They therefore represent

a substantial risk to liquidity providers

that take the other side of these

informed trades. In contrast, orders

submitted by persons without an

information advantage (often small

orders) present less risk to liquidity

providers and in theory should receive

the most favorable effective spreads

available in the market. Market centers

may attempt to identify and secure a

substantial flow of uninformed orders,

while avoiding, and perhaps even

rejecting, informed orders. The average

realized spread statistic for market and

marketable limit orders can highlight

the extent to which market centers

receive uninformed orders (as indicated

by higher realized spreads than other

market centers), thereby potentially

helping to spur more vigorous

competition to provide the best prices to

these orders to the benefit of many retail

investors. Other market centers, for

example, may seek to obtain such

profitable order flow by offering to

execute the orders at narrower effective

spreads (which also would result in

narrower realized spreads for these

orders).

Finally, average realized spread can

generate useful information for nonmarketable limit orders. The most

significant risk of using such orders is

that they will not be executed and will

miss the market. The likelihood of

execution can vary depending on the

extent to which traders that are able to

see all the orders (such as specialists,

floor traders, and OTC market makers)

are able to step in front of displayed

limit orders by improving on the limit

price as market orders arrive on the

other side of the market. This can lead

to another type of trading cost for limit

orders that is commonly referred to as

‘‘adverse selection’’—the greater

likelihood that limit orders will be

executed when the market is moving

significantly against them. The

frequency with which local traders step

in front of limit orders can heighten the

cost of adverse selection for limit order

investors. This ‘‘last mover’’ advantage

for local trading interest can be

substantial, and the average realized

spread can indicate the extent to which

it affects the execution costs of limit

orders.54

For market centers that comply with

Rule 11Ac1–5 by comparing their order

data with a record of the consolidated

quote stream (the method commonly

used today to prepare analyses of

execution quality), calculating the

statistic is not significantly more

burdensome than calculating the Rule’s

other statistics. As with effective spread

(discussed below), execution prices are

compared with a record of the

consolidated quote stream. Effective

spread is calculated using the quotes at

the time of order receipt; realized spread

is calculated using the quotes five

minutes after the time of order

execution.

2. Information Required for Market and

Marketable Limit Orders

Subparagraph (b)(1)(ii) of Rule

11Ac1–5 specifies an additional nine

columns of information for

subcategories of market orders and

marketable limit orders. These columns

are intended to help evaluate how well

these orders are executed by comparing

their execution prices with the

consolidated BBO at the time of order

receipt. The time of order receipt is used

rather than the time of order execution

primarily based on an understanding

that customers, at least for purposes of

evaluating execution quality, generally

expect orders to be executed at prices

that reflect, as closely as possible, the

displayed quotes at the time they submit

their orders. The earliest time at which

a market center can be held responsible

for executing an order is the time of

receipt.

The first of these columns is the

average ‘‘effective’’ spread (in contrast

to the average ‘‘realized’’ spread that

was discussed above). Average effective

spread is defined in paragraph (a)(2) of

the Rule and is calculated by comparing

the execution price of an order with the

midpoint of the consolidated BBO at the

time of order receipt. The larger the

effective spread, the higher the

transaction costs for market and

marketable limit orders in that security.

The average effective spread is a

comprehensive statistic that summarizes

the extent to which market and

marketable limit orders are given price

improvement, executed at the quotes,

and executed outside the quotes. As

such, it is a useful single measure of the

overall liquidity premium paid by those

submitting market and marketable limit

orders to a market center.

The final eight columns of

information required for market and

marketable limit orders essentially break

out the major determinants of execution

quality that are summarized in the

average effective spread. They also are

intended to provide a substantial basis

to weigh any potential trade-offs

between execution speed and execution

price. Orders are classified based on

whether they were ‘‘executed with price

improvement,’’ ‘‘executed at the quote,’’

or ‘‘executed outside the quote,’’ as

defined in paragraphs (a)(10) through

(a)(12). For shares executed with price

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75425

55See, e.g., TAG Letter, note 17 above, at 5;

Edward Jones Letter, note 15 above, at 3.

56See, e.g., NASD Letter, note 49 above, at 5;

Schwab Letter, note 21 above, at 9–10.

57Section 11A(a)(3)(B) of the Exchange Act

authorizes the Commission, by rule or order, to

require SROs to act jointly with respect to matters

as to which they share authority in planning,

developing, operating, or regulating the national

market system.

improvement and shares executed

outside the quote, market centers will

disclose the number of shares, the

average amount per share of price

improvement or price disimprovement,

and the average speed of execution. For

shares executed at the quote, market

centers will disclose the number of

shares and the average speed of

execution. Not only will these statistics

help broker-dealers and investors

evaluate where to find the fastest

executions at the best prices, they also

will indicate the extent to which market

centers are able to execute larger orders

at prices equal to or better than the

quotes. They thereby indicate the

volume of liquidity available at different

market centers.

Many commenters suggested

including an additional statistic for

‘‘size improvement’’ or ‘‘liquidity

enhancement’’ in the Rule. These

measures generally are calculated by

comparing the size of order executions

at the quotes with the size associated

with the consolidated BBO at the time

of order receipt. The Commission did

not add this type of measure to the Rule,

primarily because of its desire to

minimize as much as possible the

complexity and quantity of statistics to

be disclosed. As discussed in section

III.A.1 above, Rule 11Ac1–5 already

includes several measures that will

reflect the extent to which a market

center is able to execute larger orders at

prices equal to the public quotes, such

as the average effective spread and

number of shares executed at the quotes

for larger sizes of orders. Moreover, the

size associated with the consolidated

BBO may not provide a useful basis on

which to compare execution quality

among market centers. For example,

consolidated size varies substantially

between Nasdaq and listed securities.

For listed securities, the quoted size

nearly always reflects the quotes of the

primary exchanges and generally is

much larger than the size associated

with the public quotes for Nasdaq

securities.

The Proposing Release requested

comment on the usefulness of all the

basic measures of execution quality

included in the proposed rule, as well

as on any alternative measures that

commenters might suggest. For nonmarketable limit orders, the Proposing

Release specifically mentioned (1) the

length of time that an order remained on

a market center’s order book while the

limit price was at the consolidated BBO

or better, and (2) the number of trades

or share volume printed on the

consolidated tape at prices equal to or

less favorable than the limit order price.

Several commenters expressed support

for including these alternatives in the

Rule.55 In addition, commenters

suggested many other statistical

measures of execution quality that could

be included.56 At this time, however,

the Commission has decided not to

expand the volume of statistics required

by the Rule. Many of the suggested

alternatives would have substantially

increased the complexity of the Rule.

For simplicity reasons, the Commission

therefore has retained the basic

measures that were included in the

proposal. Market centers are

encouraged, however, to make publicly

available any additional measures of

execution quality that they believe will

be helpful to broker-dealers and

investors, particularly if they are

concerned that the Rule’s basic

measures do not adequately capture the

complexity of their order flow and

executions.

D. Procedures for Making Reports

Available to the Public

In light of the large volume of data the

monthly order execution reports

necessarily will include, they must be

made available by market centers in

electronic form rather than in writing.

Consequently, paragraph (b)(2) of Rule

11Ac1–5 directs the SROs to act jointly

in establishing procedures for market

centers to follow in making their

monthly reports available to the public

in a readily accessible, uniform, and

usable electronic format.57 Given that

the reports will be made available each

month by a large number of market

centers, the Commission’s primary

concern is that interested parties have

the ability to access the reports easily

and efficiently. Thus, for example, it

will be helpful for all the reports to be

prepared in a compatible electronic

format, and for users to have ready

access to the locations where reports

can be obtained. The volume of data

included in the monthly reports, while

large in written form, will not be large

when compared with many electronic

files commonly made available to the

public over the Internet.

Rule 11Ac1–5 will be effective 60

days after publication of this release in

the Federal Register. Market centers

must comply with the Rule according to

the phase-in schedule set forth in

section V below. The SROs are directed

to prepare and submit a joint national

market system plan to the Commission

for approval under Exchange Act Rule

11Aa3–2 by no later than February 15,

2001. At that point, public comment

will be invited on the proposed plan

prior to Commission approval. Many of

the more detailed issues relating both to

the format of the reports and to the

means of access to the reports can

perhaps more appropriately be

addressed in the context of approval of

a joint plan.

In the event that a joint-SRO plan has

not been approved by the Commission

prior to the compliance date of the Rule,

paragraph (b)(2) also provides that

market centers shall prepare their

reports in a consistent, usable, and

machine-readable electronic format, and

make such reports available for

downloading from an Internet web site

that is free and readily accessible to the

public. This backstop requirement will

assure that valuable information on

order execution quality will be made

available to the public without undue

delay. If necessary, the Commission will

take additional action to specify in more

detail a uniform format and means of

dissemination for the monthly market

center reports.

Paragraph (b)(3) of Rule 11Ac1–5

requires market centers to make their

reports available within one month after

the end of the month addressed in the

report. Market centers must make their

reports available without charge. If a

market center believes that its particular

circumstances warrant an exemption

from the provisions of the Rule, it may

request an unconditional or conditional

exemption pursuant to paragraph (c) of

the Rule, which has been added to the

proposed rule. Such an exemption will

be granted if the Commission finds that

it is necessary or appropriate in the

public interest, and is consistent with

the protection of investors.

IV. Rule 11Ac1–6—Disclosure of Order

Routing Information

The Commission is adopting Rule

11Ac1–6 with significant changes from

the proposed rule. Primarily in response

to concerns of commenters, it has

substantially cut back the amount of

information that broker-dealers will be

required to disclose concerning their

order routing practices. The majority of

commenters supported disclosures that

would enable investors to better

understand where orders are routed for

execution and the relationships between

75426 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

58See, e.g., Letter from Edward J. Nicoll,

Chairman and CEO, Datek Online Holdings Corp.,

to Jonathan G. Katz, Secretary, SEC, dated Sept. 25,

2000, at 1 (‘‘Datek Letter’’); Letter from James H.

Lee, President Momentum Securities, LLC, to

Jonathan G. Katz, Secretary, SEC, dated Oct. 11,

2000, at 5; ICI Letter, note 15 above, at 5.

59NASD Letter, note 49 above, at 4; CHX Letter,

note 25 above, at 11; Edward Jones Letter, note 15

above, at 4.

60Morgan Stanley Letter, note 15 above, at 15;

Schwab Letter, note 21 above, at 3–4; Wilkie Farr

& Gallagher Letter, note 29 above, at 3.

61To include Nasdaq SmallCap equities,

paragraph (a)(1)(i) of Rule 11Ac1–6 incorporates the

language of current Rule 11Ac1–1(a)(1)—‘‘any other

security for which a transaction report, last sale

data or quotation information is disseminated

through an automated quotation system as

described in Section 3(a)(51)(A)(ii) of the Act.’’ This

language covers SmallCap equities, but excludes

equities quoted on the OTC Bulletin Board operated

by the NASD. To include option securities,

paragraph (a)(1)(ii) of the Rule includes ‘‘any option

contract traded on a national securities exchange for

which last sale reports and quotation information

are made available pursuant to a national market

system plan.’’ This language includes any option

securities for which market information is

disseminated on a real-time basis pursuant to the

national market system plan administered by the

Options Price Reporting Authority (‘‘OPRA’’).

62 In addition, a new paragraph (d) has been

included in the Rule explicitly providing that the

Commission may exempt any person, security, or

transaction, or any class or classes of persons,

securities, or transactions, from any provision or

provisions of Rule 11Ac1–6. Such an exemption

will be granted if the Commission determines that

it is necessary or appropriate in the public interest,

and is consistent with the protection of investors.

broker-dealers and trading venues.58

Several, however, expressed concern

about the length and usefulness of some

of the disclosure requirements included

in the proposed rule.59 In addition, a

number of other commenters generally

questioned the value of the required

disclosures.60 As discussed in section II

above, the Commission believes that

quarterly reports identifying the venues

to which broker-dealers routed their

customer orders and discussing

potential conflicts of interest will be

useful to investors. To maintain the

brevity and reduce the compliance

burdens of the reports, it has decided to

delete several provisions from the

proposed rule that would have required

potentially long and complex

explanations of order routing choices of

broker-dealers.

Under Rule 11Ac1–6 as adopted, a

broker-dealer that routes orders on

behalf of customers will be required to

prepare quarterly reports that disclose

the identity of the venues to which it

routed orders for execution. The reports

also will disclose the nature of the

broker-dealer’s relationship with those

venues, including the existence of any

internalization or payment for order

flow arrangements. Finally, brokerdealers will be required to disclose, on

customer request, where they routed a

customer’s individual orders for

execution.

In a significant change from the rule

as proposed, a broker-dealer will not be

required to prepare a narrative section

for the reports that discusses and

analyzes its order routing practices. The

Commission agrees with commenters

that such a requirement could result in

reports that were overly long and

complex. In addition, a broker-dealer

will not be required to identify every

venue to which it routed any orders.

Instead, only the most significant

venues—the top ten and any others that

received 5% or more of the brokerdealer’s orders—must be disclosed. The

primary purpose of the Rule as adopted

is simply to assure public disclosure of

the significant venues to which a

broker-dealer routes its customer’s

orders and to facilitate an evaluation of

potential conflicts of interest between

the broker-dealer and its customers.

When combined with the information to

be made available by market centers

under Rule 11Ac1–5, the quarterly

reports should provide a much clearer

picture of a broker-dealer’s order routing

practices than has previously been

available to the public.

A. Scope of Rule

The scope of Rule 11Ac1–6 is broader

than the scope of proposed Rule 11Ac1–

5. First, Rule 11Ac1–6 covers a wider

range of securities. The definition of

‘‘covered security’’ in paragraph (a)(1)

includes not only national market

system securities (i.e., exchange-listed

equities and Nasdaq National Market

equities), but also Nasdaq SmallCap

equities and listed options.61 Second,

the Rule applies to all broker-dealers

that route orders on behalf of their

customers. The term ‘‘customer order’’

is defined as any order to buy or sell a

covered security that is not for the

account of a broker-dealer. It excludes,

however, any order for a quantity of a

security having a market value of at

least $50,000 for a covered security that

is an option contract and a market value

of at least $200,000 for any other

covered security. Large orders are

excluded in recognition of the fact that

a general overview of order routing

practices is more useful for smaller

orders that tend to be homogenous.62

Finally, Rule 11Ac1–6 applies to all

types of orders (e.g., pre-opening orders

and short sale orders), but brokerdealers must give an overview of their

routing practices only for ‘‘non-directed

orders.’’ Paragraph (a)(5) defines a nondirected order as any customer order

other than a directed order. Paragraph

(a)(3) defines a directed order as a

customer order that the customer

specifically instructs the broker-dealer

to route to a particular venue for

execution. Consequently, all customer

orders are non-directed orders in the

absence of specific customer

instructions on where they are to be

routed.

B. Quarterly Reports

Paragraph (b)(1) of the Rule 11Ac1–6

requires broker-dealers to make publicly

available for each calendar quarter a

report on its routing of non-directed

orders in covered securities. The term

‘‘make publicly available’’ is defined to

require broker-dealers to do three

steps—post on a free Internet web site,

furnish a written copy on request, and

notify customers at least annually that a

written copy will be furnished on

request. The Commission expects that

the broker-dealer quarterly reports on

order routing will be of direct interest to

investors, and so is requiring that

broker-dealers make them readily

available via the Internet. In addition, a

primarily Internet method of

dissemination will ease the burden of

compliance on broker-dealers by

reducing paperwork and costs. The

reports must be provided on request for

customers that may lack Internet access.

Paragraph (b)(2) requires that a

quarterly report be made publicly

available within one month after the

end of the quarter addressed in the

report. A longer two-month period was

included in the proposed rule to allow

broker-dealers an opportunity to

evaluate the monthly market center

reports under Rule 11Ac1–5 prior to

preparing their narrative discussion and

analysis of order routing practices.

Because this narrative disclosure has

been eliminated from the Rule as

adopted, the lag-period between end-ofquarter and report dissemination has

been shortened to one month to provide

more timely disclosures to the public.

Rule 11Ac1–6 as adopted requires

that a quarterly report be divided into

four separate sections for four different

types of covered securities—one for

equity securities listed on the NYSE,

one for equity securities qualified for

inclusion in Nasdaq, one for equity

securities listed on the Amex or any

other national securities exchange, and

one for options. These sections reflect

potentially significant differences in

routing practices for the four types of

securities and should enhance the

usefulness of the quarterly reports to

investors. For each of these four

sections, paragraphs (b)(1)(i) and (ii) of

the Rule require broker-dealers to give a

quantitative description of the aggregate

nature of their order flow. In this

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75427

63The term ‘‘venue’’ is intended to be interpreted

broadly to cover ‘‘market centers’’ within the

meaning of Rule 11Ac1–5(a)(14), as well as any

other person or entity to which a broker routes nondirected orders for execution. Consequently, the

term excludes an entity that is used merely as a

vehicle to route an order to a venue selected by the

broker-dealer. Interpretive issues may arise in

determining the applicability of the Rule when a

person or entity trades under the auspices of an

exchange. To assure meaningful disclosure of

significant execution venues, all orders routed to a

particular exchange for execution should be

aggregated when calculating a broker-dealer’s top

ten market centers and those with 5% of orders. If

a particular market maker or dealer at the exchange

receives orders pursuant to any arrangement that

gives it a preference to trade with the order as

principal, such arrangement must be specifically

included in the discussion of the relationship

between broker-dealer and venue that is required by

Rule 11Ac1–6(b)(1)(iii).

64Schwab Letter, note 21 above, at 5.

65 Interpretive issues could arise in the case of an

order that is routed to multiple venues by the

broker-dealer (if an execution venue alone makes

the decision to forward an order to a second venue,

the second venue generally would not be included

in a broker-dealer’s report). If an order is executed

after being routed by the broker-dealer to multiple

venues, the venue that executed the order should

be considered the venue to which the order was

routed for purposes of the Rule. If an order is not

executed after being routed to multiple venues (e.g.,

it was cancelled or expired), the first venue should

be considered the venue to which the order was

routed for purposes of the Rule. The Commission’s

staff will be available to provide further interpretive

guidance on compliance with the Rule.

respect, Rule 11Ac1–6 is unlike Rule

11Ac1–5, which requires market centers

to categorize their orders on a securityby-security basis. As noted above, the

quarterly reports on order routing are

intended to provide a general overview

of a broker-dealer’s practices that is

accessible and useful to individual

investors. Broker-dealers are free,

however, to disclose any additional

information concerning their order

routing practices that they believe will

be helpful to customers.

A broker-dealer’s quantitative

description of order routing must

include the percentage of total customer

orders for a particular section that were

non-directed orders, and the

percentages of total non-directed orders

for a section that were market orders,

limit orders, and other orders. This

general description of a broker-dealer’s

order flow should facilitate customer

understanding of its routing practices.

For example, a customer may use the

reports to evaluate whether the brokerdealer specializes in the type of orders

that the customer typically uses. The

quantitative description also will

include the identity of the ten venues to

which the largest number of nondirected orders for the section were

routed for execution, as well as any

venue to which five percent or more of

non-directed orders were routed.63 In

contrast, the proposed rule would have

required disclosure of all venues to

which non-directed orders were routed.

A commenter noted that large brokerdealers may route a relatively small

number of orders to many different

venues.64 Disclosure therefore has been

limited to the most significant venues.65

For each of the venues identified in

each section of the report, the brokerdealer must disclose the percentage of

total non-directed orders for the section

routed to the venue, and the percentages

of total non-directed market orders, nondirected limit orders, and non-directed

other orders for the section that were

routed to the venue. The percentages,

rather than numbers, of orders are used

to facilitate customer understanding of

the probability that particular types of

orders will be routed to different venues

without the need for calculations, as

well as to protect potentially sensitive

order flow information.

Under paragraph (b)(1)(iii), a brokerdealer also will be required to discuss

the material aspects of its relationship

with each venue identified in each

section of the report, including a

description of any payment for order

flow arrangement or profit-sharing

relationship as it relates to the type of

securities for that section. The term

‘‘payment for order flow’’ is defined

very broadly in Exchange Act Rule 10b–

10(d)(9) to include any payment or

benefit that results in compensation to

the broker-dealer for routing orders to a

particular venue. This definition

encompasses a wide range of practices

in addition to monetary payments, such

as ‘‘research, clearing, custody, products

or services,’’ ‘‘reciprocal agreements for

the provision of order flow,’’ and

‘‘discounts, rebates, or any other

reductions of or credits against any fee

to, or expense or other financial

obligation of, the broker or dealer

routing a customer order that exceeds

that fee, expense or financial

obligation.’’ The term ‘‘profit-sharing

relationship’’ is defined in paragraph

(a)(7) of Rule 11Ac1–5 to mean any

ownership or other type of affiliation

under which the broker-dealer, directly

or indirectly, shares in any profits that

may be derived from the execution of

non-directed orders. It therefore

specifically covers internalization of

customer orders by a broker-dealer that

executes customer orders as principal.

The purpose of requiring disclosure

concerning the relationships between a

broker-dealer and the venues to which

it routes orders is to alert customers to

potential conflicts of interest that may

influence the broker-dealer’s orderrouting practices. Currently, Rule 10b–

10(a)(2)(i)(C) requires a broker-dealer,

when acting as agent for the customer,

to disclose on the confirmation of a

transaction whether payment for order

flow was received and that the source

and nature of the compensation for the

transaction will be furnished on written

request. In addition, Exchange Act Rule

11Ac1–3(a) requires broker-dealers to

disclose in new and annual account

statements its policies on the receipt of

payment for order flow and its policies

for routing orders that are subject to

payment for order flow. The

Commission believes that disclosure of

potential conflicts of interest in

conjunction with a quantitative

description of where all non-directed

orders are routed may provide

customers with a clearer understanding

of a broker-dealer’s order routing

practices than is provided under current

rules. The Commission intends to

consider in the near future whether to

modify or rescind, as necessary, the

disclosure requirements currently in

effect concerning payment for order

flow, in light of the new quarterly

disclosure requirements.

Rule 11Ac1–6 does not require that

broker-dealers provide a quantitative

estimate of the aggregate dollar amount

of payment for order flow received

during a quarter from each order

execution venue. First, there are

potentially a multitude of varying

arrangements for payment for order

flow. Estimating the amounts produced

by such arrangements could be difficult,

subjective, and costly. Second, the

Commission is concerned that

disclosure of the aggregate dollar

amounts of payment for order flow,

without requiring comparable

disclosure of the dollar amount of

trading profits that redound to the

benefit of broker-dealers pursuant to

profit-sharing relationships, potentially

could paint an inaccurate picture of the

relative financial incentives generated

by the two types of relationships.

Although the Rule 11Ac1–6 does not

require an estimate of the aggregate

dollar amount of payment for order

flow, a broker’s description of a

payment for order flow arrangement

must include disclosure of the material

aspects of the arrangement. These

would include a description of the

terms of the arrangement, such as any

amounts per share or per order that the

broker receives. Similarly, in describing

a profit-sharing relationship, a broker

would be expected to disclose the extent

to which it could share in profits

derived from the execution of nondirected orders. An example would be

the extent of the ownership relation

75428 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

66Currently, Rule 10b–10(a)(1) requires a brokerdealer to include the time of transaction on the

confirmation of a transaction or a statement that the

time of transaction will be furnished on written

request. To assure consistency, paragraph (a)(9) of

Rule 11Ac1–6 adopts the definition of the term

‘‘time of the transaction’’ set forth in Rule 10b–

10(d)(3)—‘‘the time of execution, to the extent

feasible, of the customer’s order.’’ Broker-dealers

must maintain customer order information to

comply with Rule 10b–10 and other existing

regulatory requirements. The Commission therefore

disagrees with a commenter’s assertion that the ‘‘on

request’’ disclosures of Rule 11Ac1–6 would be

costly and redundant. Schwab Letter, note 21

above, at 6. Another commenter doubted, as a

matter of agency law, that ‘‘any firm would

presently fail to honor such a customer request.’’

Datek Letter, note 58 above, at 5.

67 44 U.S.C. 3501 et seq.

68 44 U.S.C. 3507.

between the broker and execution

venue.

Finally, as noted above, the Rule as

adopted does not include a requirement

that broker-dealers provide a narrative

discussion and analysis of their order

routing practices. Broker-dealers remain

free, of course, to communicate such

information concerning their order

routing practices that they believe

would be helpful to customers.

C. Customer Requests for Information

A broker-dealer’s quarterly reports

should provide a useful picture of its

order routing practices as a whole, but

will not inform individual customers

where their own orders were routed.

Currently, there is no market-wide

requirement that brokers disclose where

they route individual orders on behalf of

customers. Although NYSE Rule 409(f)

requires NYSE members, when

confirming transactions, to disclose ‘‘the

name of the securities market on which

the transaction was made,’’ transactions

executed at venues other than

exchanges typically are classified as

‘‘OTC.’’ Thus, the identity of the

particular OTC market maker or ATS

that executed an order is not required to

be disclosed. Moreover, the NYSE’s rule

does not cover non-members or

securities that are not listed on the

NYSE.

To assure that customers have ready

access to routing information

concerning their own orders, paragraph

(c) of Rule 11Ac1–6 requires brokerdealers, on request of a customer, to

disclose to the customer the identity of

the venue to which the customer’s

orders were routed for execution in the

six months prior to the request, whether

the orders were directed orders or nondirected orders, and the time of the

transactions, if any, that resulted from

such orders.66 To alert customers to the

availability of individual order routing

information, paragraph (c)(2) of the Rule

requires broker-dealers to notify their

customers at least annually of their

option to request such information.

With Rule 11Ac1–6, those customers

interested in monitoring the brokerdealer’s routing their orders will be

entitled to learn important information

about how their orders were handled.

When combined with information that

such customers may already maintain,

such as the time they submitted an

order to their broker-dealer, the

consolidated BBO at the time they

submitted the order, and the price at

which an order was executed, the

information to be provided on request

potentially could give customers a

considerable capacity to monitor and

evaluate their broker-dealer’s order

routing decisions and the quality of

executions obtained at different venues.

Broker-dealers would not, however, be

required to bear the expense of

providing individualized order routing

information to those who had not asked

to receive it.

V. Effective Dates and Phase-In of

Compliance Dates

Rule 11Ac1–5 is effective on January

30, 2001. The first phase-in of securities

subject to the Rule will begin on

Monday, April 2, 2001. As of this date,

the Rule will apply to the 1000 NYSE

securities, 1000 Nasdaq securities, and

200 Amex securities with the highest

average daily share volume for the

quarter ending December 31, 2000. On

this first phase-in date, market centers

must begin collecting the necessary data

to prepare their monthly reports. In

addition, they must make their first

report, for April 2001, available by the

end of May 2001. The second phase-in

date will be July 2, 2001. From this date

forward, the Rule will apply to the next

1000 NYSE securities, the next 1000

Nasdaq securities, and the next 200

Amex securities with the highest

average daily share volume for the

quarter ending March 31, 2001. The

third and final phase-in of Rule 11Ac1–

5 will begin on October 1, 2001. From

this date forward, the Rule will apply to

all national market system securities. As

discussed in section VI.B below, the

Commission believes that all market

centers currently collect the basic order

data that is necessary to generate the

Rule’s statistical measures. In addition,

many market centers already prepare, or

retain independent companies to

prepare, similar statistical reports for

private use. It is likely, therefore, that

market centers will be able to make

arrangements for production of reports

under Rule 11Ac1–5 in advance of the

compliance dates. If a market center

believes that it will be unable to meet

the compliance dates for good cause, it

may request a temporary exemption

from the Commission pursuant to

paragraph (c) of the Rule. Finally, the

Commission directs the national

securities exchanges and the national

securities association subject to Rule

11Ac1–5(b)(2) to comply with that

provision by submitting a national

market system plan to the Commission

by no later than February 15, 2001.

Rule 11Ac1–6 also is effective on

January 30, 2001. Broker-dealers must

comply with the Rule for all covered

securities on July 2, 2001. Accordingly,

a broker-dealer’s first report, for the

quarter beginning in July and ending in

September, must be made publicly

available by the end of October 2001. In

addition, broker-dealers would be

required to respond to customer

requests for information on orders that

were routed on July 2, 2001, and after.

VI. Paperwork Reduction Act

As explained in the Proposing

Release, certain provisions of Rule

11Ac1–5 and Rule 11Ac1–6 contain

‘‘collection of information’’

requirements within the meaning of the

Paperwork Reduction Act of 1995

(‘‘PRA’’).67 Accordingly, the

Commission submitted the collection of

information requirements contained in

the rules to the Office of Management

and Budget (‘‘OMB’’) for review. They

were approved by OMB, which assigned

the following control numbers: Rule

11Ac1–5, control number 3235–0542,

and Rule 11Ac1–6, control number

3235–0541, with an expiration date for

each of November 30, 2003. The

collections of information are in

accordance with section 3507 of the

PRA.68 With regard to Rule 11Ac1–5,

the Commission staff has adjusted its

PRA burden estimate in response to

comments to include the potential for

upfront preparations to comply with the

data collection requirements of the Rule.

With regard to Rule 11Ac1–6, the

Commission staff has adjusted its PRA

burden estimate to reflect a change from

the rule as proposed that reduces the

amount of information that brokerdealers will be required to disclose

concerning their order routing practices.

Accordingly, the Commission has

submitted PRA change worksheets to

OMB to reflect the adjusted estimates of

the burden of compliance.

The collections of information relate

to rules that will help further the

national market system objectives set

forth in Exchange Act section

11A(a)(1)(C). These objectives include

the economically efficient execution of

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75429

69 5 U.S.C. 552 et seq.

70 Knight Trading Letter, note 17 above, at 6, 9.

71 ICI Letter, note 15 above, at 5.

72TAG Letter, note 17 above, at 2.

73See, e.g., Charles Schwab Letter, note 21 above,

at 12; CHX Letter, note 25 above, at 6; Morgan

Stanley Letter, note 15 above, at 18; Letter from

Deborah A. Lamb, Chair, Advocacy Advisory

Committee, and Maria J.A. Clark, Associate,

Association for Investment Management and

Research, to Jonathan G. Katz, Secretary, SEC, dated

Sept. 22, 2000, at 3–4.

74Wilkie Farr & Gallagher Letter, note 29 above,

at 4.

75CHX Letter, note 25 above, at 6.

76Phlx Letter, note 25 above, at 3.

77 In its comment letter, BRUT ECN disputed the

Proposing Release’s estimate of six hours per month

to collect the data necessary to generate the

monthly reports. It stated that its compliance would

require ‘‘upwards of 100 hours initially to ensure

for the efficient generation of required data,

although said process would streamline future

compliance efforts.’’ Letter from William O’Brien,

Senior Vice President & General Counsel, The

BRUT ECN, L.L.C., to Jonathan G. Katz, Secretary,

SEC, dated Oct. 5, 2000, at 1 n. 3 (‘‘BRUT Letter’’).

To reflect the potential for upfront preparations to

comply with data collection requirements, the

estimated burden of compliance in section VI.B

below has been updated.

78For example, NASD rules require members

trading Nasdaq securities to submit electronic data

on individual order executions to the NASD

pursuant to its Order Audit Trail System (‘‘OATS’’)

requirements. NASD Rules 6950–6957. This data

includes the basic order information that would be

necessary to calculate the statistical measures of

execution quality required by Rule 11Ac1–5. One

commenter stated that it believed ‘‘the NASD’s

OATS project, which entailed the development of

data collection and warehousing on a similar scale,

is a useful comparison of the development costs’ of

Rule 11Ac1–5. Schwab Letter, note 21 above, at 12.

Market centers that already comply with the OATS

data requirements, however, will have the Nasdaq

order information necessary to comply with the

data collection requirements of Rule 11Ac1–5.

79The CHX stated that the Proposing Release’s

‘‘estimate of six hours per month for each market

center to generate the required reports seems to us

unrealistically low.’’ CHX Letter, note 25 above, at

6. The Proposing Release, however, separately

addressed the issues of (1) data collection and (2)

generation of the monthly reports from such data.

The estimate of six hours per month applied solely

to the burden of data collection. After the data is

collected by market centers, it can be transferred to

third party vendors with programs in place to

generate the necessary reports. The Proposing

Release estimated that vendors could provide this

service for approximately $2500 per month.

80See, e.g., Morgan Stanley Letter, note 15 above,

at 15; NASD Letter, note 49 above, at 4; CBOE

Letter, note 47 above, at 4–5.

orders, fair competition among brokerdealers and among markets, the

availability to broker-dealers and

investors of information with respect to

transactions in securities, and the

practicability of brokers executing

investors’ orders in the best market. The

collection of information obligations

imposed by Rule 11Ac1–5 and Rule

11Ac1–6 are mandatory. The monthly

order execution reports prepared and

disseminated in electronic form by

market centers pursuant to proposed

Rule 11Ac1–5 will be available to the

public and will not be kept confidential.

Likewise, the quarterly order routing

reports prepared and disseminated by

broker-dealers pursuant to Rule 11Ac1–

6 will be available to the public and will

not be kept confidential. The individual

responses by broker-dealers to customer

requests for order routing information

required by Rule 11Ac1–6 will be made

available the customer and not to the

general public. The Commission, SROs,

and other securities regulatory

authorities would gain possession of the

responses only upon request. Any

responses received by the Commission,

SROs, and other securities regulatory

authorities will be kept confidential to

the extent permitted by the Freedom of

Information Act.69 An agency may not

conduct or sponsor, and a person is not

required to comply with, a collection of

information unless it displays a

currently valid OMB control number.

A. Comments on Collection of

Information Requirements

The Commission requested public

comment on the collection of

information requirements contained in

the Proposing Release. Commenters that

addressed recordkeeping and reporting

burdens generally focused their

attention on the statistical disclosures

required by Rule 11Ac1–5. Knight

Trading Group, Inc. believed that Rule

11Ac1–5 would be ‘‘feasible and

implementable without undue burden

on market centers because they already

must produce much of the required

information’’ pursuant to existing

regulatory requirements. Knight also

noted that third party vendors could

generate the required reports for market

centers and that ‘‘such an approach

would offer an alternative for market

centers that do not wish to incur the

costs associated with developing and

administering any systems needed to

collect and disseminate the required

information.’’ 70 The Investment

Company Institute stated that ‘‘given

technological advances in the

dissemination of information and the

wide use of the Internet by retail

investors, we believe that the reports

can be made available to the public in

a reasonably efficient manner at a low

cost.’’ 71 In addition, the Transaction

Auditing Group, Inc., a third party

service provider for the analysis and

reporting of execution quality, noted

that ‘‘as long as dissemination is

permitted via the Internet, the

collection, analysis and publication of

large volumes of information would be

feasible.72

Several other commenters, in contrast,

suggested generally that complying with

the recordkeeping and reporting

requirements of Rule 11Ac1–5 would be

burdensome for many market centers.73

A comment letter submitted on behalf of

five broker-dealer firms, for example,

stated that, although the firms had ‘‘not

done a rigorous cost analysis with

respect to the proposals, the Firms

expect that the cost of compliance

would be considerable, in terms of

programming and monitoring tasks.’’ 74

The CHX stated that the ‘‘data capture,

preparation and reporting burden

involved in complying with proposed

Rule 11Ac1–5 would be significant,

even for the CHX, and, in all likelihood,

excessive for many other market

centers.’’ 75 The Phlx estimated that ‘‘the

cost of creating the reporting system, as

well as creating the interfaces with our

members to meet their requirements

under the Rule, would be at least

$500,000 and require between six

months and one year to fully

implement.’’ 76

The Commission does not agree with

these high estimates concerning the

recordkeeping and reporting burden of

Rule 11Ac1–5. As a basis for

compliance, market centers themselves

need maintain only the most basic order

information, such as the type and size

of order, the time of order receipt, the

time of order execution, and execution

price.77 The Commission believes that

all market centers retain this basic order

data.78 This data must then be compared

with a record of the consolidated quote

stream to generate the statistics required

by Rule 11Ac1–5. Although some

market centers may choose to program

their own systems to perform this task,

third party vendors already provide this

service for many market centers. Based

on Commission staff discussions with

industry sources, it appears that

individual market centers could obtain

this service for approximately $2500 per

month, and smaller market centers may

be able to obtain this same service at an

even lower cost. Accordingly, the

Commission believes that the total costs

to prepare the monthly order execution

reports do not appear to be large for any

market center.79

While the Commission received no

comments that specifically addressed

the PRA discussion of Rule 11Ac1–6, it

did receive several comments that

touched on PRA related issues. Most

commenters supported improved

disclosure of order routing practices by

broker-dealers. Some, however, were

concerned about the potentially long

length and limited usefulness of some of

the disclosure requirements included in

the rule as proposed.80 To maintain the

brevity and reduce the compliance

75430 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

81Schwab Letter, note 21 above, at 6. In addition,

another commenter believed that the proposed

retention period of six months was ‘‘onerous and

unnecessary’’ and that a 90-day time period would

be sufficient. Edward Jones Letter, note 15 above,

at 5. The Commission has retained the six-month

period to assure that individual customers, after

having an opportunity to review the quarterly

reports giving a general overview of their brokerdealers’ order routing practices, can obtain

information concerning their own orders for the full

period covered by the quarterly report.

82 Datek Letter, note 58 above, at 5. 83See BRUT Letter, note 77 above, at 1.

84These figures could vary substantially among

market centers. In addition, some SROs may

provide this data collection service for their

members because such centralized data collection

is more efficient than data collection by individual

members.

burdens of the quarterly reports, the

Commission has deleted several

provisions from the proposed rule that

would have required potentially long

and complex disclosures. In particular,

it has eliminated paragraph (b)(iv) of the

proposed rule, which would have

required a discussion of the significant

objectives that the broker or dealer

considered in determining where to

route non-directed orders, the extent to

which order executions achieved those

objectives, a comparison of the quality

of executions actually obtained with

those produced by other venues for

comparable orders during the relevant

time period, and whether the broker or

dealer has made or intends to make any

material change in its order routing

practices in the succeeding quarter. In

addition, paragraph (b)(ii) has been

altered so that a broker-dealer will not

be required to identify every venue to

which it routed any orders. Instead,

only the top ten venues and any others

that received 5% of more of the brokerdealer’s orders must be disclosed.

One commenter addressed the burden

of complying with paragraph (c) of Rule

11Ac1–6, which requires broker-dealers

to provide, upon customer request,

information regarding the customer’s

orders routed for execution in the six

months prior to the request. The

commenter asserted that ‘‘it is apparent

that this would be a time-consuming,

burdensome and expensive requirement

to fulfill.’’ 81 The Commission strongly

believes that those brokerage customers

who express an interest in obtaining

information about the routing of their

own orders should have ready access to

such information. Indeed, another

commenter doubted that, as a matter of

agency law, ‘‘any firm would presently

fail to honor such a customer

request.’’ 82 Particularly considering that

the level of disclosure contained in the

quarterly broker-dealer reports has been

reduced, a requirement that brokerdealers respond to customer requests for

order information will help assure that

customers can obtain the data they need

to evaluate the quality of their brokerdealer’s services. Broker-dealers must

retain customer order information to

comply with existing regulatory

requirements. The Commission does not

believe that responding to customer

requests for such information will

constitute an unduly burdensome

requirement for broker-dealers.

B. Total Annual Reporting and

Recordkeeping Burdens

The collection of information

obligations of Rule 11Ac1–5 will apply

to all market centers that receive

covered orders in national market

system securities. Market centers are

defined as exchange market makers,

OTC market makers, alternative trading

systems, national securities exchanges,

and national securities associations. The

Commission estimates that

approximately 140 exchange market

makers, 450 OTC market makers, 29

alternative trading systems, seven

national securities exchanges, and one

national securities association will be

subject to the collection of information

obligations of Rule 11Ac1–5. Each of

these respondents will be required to

respond to the collection of information

on a monthly basis.

Rule 11Ac1–5 will require market

centers to make available to the public

monthly order execution reports in

electronic form. To prepare the reports,

market centers first will need to collect

basic data on orders and executions

(e.g., type and size of order, time of

order receipt and execution). Second,

this data will need to be processed to

calculate the statistics required by the

Rule and present those statistics in an

electronic report.

The Commission believes that market

centers covered by the Rule retain all of

the underlying raw data necessary to

generate these reports in electronic

format. Consequently, it does not appear

that the Rule will require substantial

additional data collection burdens.

Commenters noted, however, that

market centers may incur startup costs

to prepare their systems to generate the

specific data required by the Rule.83 The

Commission staff estimates that, on

average, market centers could spend 90

hours to complete these preparations.

Assuming internal staff costs of $53 per

hour, the estimated 627 market centers

could expend a total of approximately

$3 million in startup costs, or a total of

approximately $600,000 per year

annualized over an expected useful life

of five years. In addition, the

Commission staff estimates that, on an

ongoing basis, the Rule will cause

respondents to spend an average of 6

hours per month in additional time to

collect the data necessary to generate

the reports, or 72 hours per year.84 With

an estimated 627 market centers subject

to the Rule, the total data collection

burden to comply with the monthly

reporting requirement is estimated to be

$600,000 per year for startup costs and

45,144 hours per year on an ongoing

basis.

Once the necessary data is collected,

market centers can either program their

systems to generate the statistics and

reports, or transfer the data to a service

provider (such as an independent

company in the business of preparing

such reports or an SRO) that will

generate the statistics and reports.

Although the largest market centers and

SROs may choose to generate the reports

themselves, the Commission anticipates

that the great majority of market centers

will rely on service providers to prepare

the reports for them. It is significantly

more efficient to consolidate the

processing and reporting function in a

limited number of entities than for each

market center to prepare its own reports.

Once an entity has incurred the upfront

costs of programming its systems to

process data and generate a report for a

single market center, there is very little

additional cost to performing the same

function for many additional market

centers. Based on discussions with

industry sources, the Commission staff

estimates that an individual market

center could retain a service provider to

prepare a monthly report for

approximately $2,500 per month. This

per-respondent estimate is based on the

rate that a market center could expect to

obtain if it negotiated on an individual

basis. Based on discussions with

industry sources, we believe it is likely

that a group of market centers,

particularly the smaller members of a

particular SRO, could obtain a much

lower per-respondent rate on a

collective basis. Thus, particularly for

the smaller members of an SRO, the

monthly cost to retain a service provider

could be substantially less than $2,500.

Based on the $2,500 estimate, however,

the monthly cost to the 627 market

centers to retain service providers to

prepare reports would be $1,567,500, or

an annual cost of approximately $18.8

million.

Rule 11Ac1–6 will require brokerdealers to prepare and disseminate

quarterly order routing reports. Much of

the information needed to generate

these reports already should be

collected by broker-dealers in

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75431

85This estimate is based on FYE 1999 FOCUS

Reports received by the Commission. While there

are currently approximately 7500 broker-dealers

registered with the Commission, only

approximately 3800 broker-dealers potentially route

non-directed orders in covered securities.

86Securities Exchange Act Release No. 40122

(June 30, 1998), 63 FR 35508, n. 65.

87This estimate is based on FYE 1999 FOCUS

Reports received by the Commission.

88As set out more specifically in section III.C

above, the required disclosures will reflect

statistical measures of such things as number of

orders, number of shares, number of cancelled

orders, size of spreads, frequency and size of price

improvement, frequency of executions at the quote,

frequency of executions outside the quote, and

speed of execution (both with and without price

improvement).

connection with their periodic

evaluations of their order routing

practices. To comply with the Rule,

however, broker-dealers will incur

additional burdens in preparing the

reports and disseminating them on a

free Internet web site (and responding to

requests for written copies of the

reports).

The collection of information

obligations of Rule 11Ac1–6 will apply

to all broker-dealers that route nondirected customer orders in covered

securities. The Commission estimates

that there are currently approximately

3800 broker-dealers that could be

subject to the collection of information

obligations of the Rule.85 Each of these

respondents (if engaged in the business

of routing non-directed orders on behalf

of customers) will be required to

respond to the collection of information

on a quarterly basis with respect to the

Rule’s reporting obligations, and on an

ongoing basis with respect to the Rule’s

requirement to respond to customer

requests for order routing information.

There are extreme differences in the

nature of the securities business

conducted by the approximately 3,800

broker-dealers that could be subject to

the Rule. They range from the very

largest firms with nationwide

operations, which are relatively few in

number, to thousands of much smaller

introducing firms. To handle their

customer accounts, these small firms

rely primarily on clearing brokers. There

currently are approximately 330

clearing brokers. The Commission

previously has noted that ‘‘from a

functional perspective, introducing and

clearing brokers act as a unit in

handling a customer’s account. In most

respects, introducing brokers are

dependent on clearing firms to clear and

to execute customer trades, to handle

customer funds and securities, and to

handle many back-office functions,

including issuing confirmations of

customer trades and customer account

statements.’’ 86 The Commission

anticipates that clearing brokers

primarily will bear the burden of

complying with the reporting and

recordkeeping requirements of the Rule

on behalf of many small introducing

firms. In addition, however, there are

approximately 610 introducing brokers

that receive funds or securities from

their customers.87 Because at least some

of these firms also may have greater

involvement in determining where

customer orders are routed for

execution, they have been included,

along with clearing brokers, in

estimating the total burden of the Rule.

As discussed above, the reporting

requirements of Rule 11Ac1–6 have

been cut back from the proposed rule.

The Commission staff estimates that

each firm significantly involved in order

routing practices will incur an average

burden of 20 hours to prepare and

disseminate a quarterly report required

by Rule 11Ac1–6, or a burden of 80

hours per year. With an estimated 940

broker-dealers significantly involved in

order routing practices, the total burden

per year to comply with the quarterly

reporting requirement in Rule 11Ac1–6

is estimated to be 75,200 hours.

Rule 11Ac1–6 also would require

broker-dealers to respond to individual

customer requests for information on

orders handled by the broker-dealer for

that customer. Clearing brokers

generally would bear the burden of

responding to these requests. The

Commission staff estimates that each

clearing broker will incur an average

burden of 0.2 hours to prepare, deliver,

and retain a response to a customer

required by Rule 11Ac1–6. The annual

burden could vary significantly among

clearing brokers based on the number of

customers and number of inquiries by

each customer. The Commission staff

estimates that an average clearing broker

will incur an annual burden of 400

hours (2,000 responses × 0.2 hours/

response) to prepare, disseminate and

retain responses to customers required

by the Rule. With an estimated 330

clearing brokers subject to the Rule, the

total burden per year to comply with the

customer response requirement in Rule

11Ac1–6 is estimated to be 132,000

hours.

VII. Cost-Benefit Analysis

The Commission is adopting two

rules to improve public disclosure of

broker-dealer and market center

practices in the routing and execution of

customer orders. The rules are intended

to increase access to information about

how investors’ securities transactions

are executed, thereby enhancing an

investor’s ability to make choices on the

basis of execution criteria important to

the particular investor. The required

disclosures also should aid brokerdealers in satisfying their duty of best

execution. The disclosures and

enhanced investor knowledge should

promote vigorous and beneficial

competition among broker-dealers to

seek out, and among market centers to

provide, superior execution of customer

orders.

A. Costs and Benefits of Rule 11Ac1–5

Under Rule 11Ac1–5, each market

center (defined as any national

securities exchange, national securities

association, exchange market maker,

OTC market maker, or alternative

trading system) will be required to make

monthly disclosure of certain statistical

measures of execution quality on a

security-by-security basis.88 The

Commission anticipates that the Rule

will generate the benefits and costs

described below.

1. Benefits

There currently is little or no publicly

available information that would allow

investors and broker-dealers to compare

and evaluate execution quality among

different market centers. Some market

centers make order execution

information privately available to

independent companies, which then

prepare reports on execution quality

that are sold to broker-dealers. Other

market centers provide reports on

execution quality directly to brokerdealers or to their members. The

information in these reports generally

has not been publicly disseminated.

Moreover, some broker-dealers have

reported difficulty in obtaining useful

information on execution quality from

market centers. For example,

participants in a Commission

roundtable on the on-line brokerage

industry indicated that not all market

centers were willing to make order

execution information available and,

even when such information was made

available, not all of it was useful or in

a form that allowed for cross-market

comparisons.

By improving public disclosure of

execution quality, the Commission

anticipates that the Rule will help

broker-dealers fulfill their duty of best

execution. That duty requires a brokerdealer to seek the most favorable terms

reasonably available under the

circumstances for a customer’s order.

Routing orders to a market center that

merely guarantees an execution at the

best published quote does not

necessarily satisfy that duty; best

75432 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

89These savings are based on a sample of market

orders for 10 high-volume Nasdaq securities from

June 2000, and represent the projected benefits

summed over all Nasdaq stocks for one year. The

annual savings exclude changes in effective spread

for marketable limit orders and for any trade greater

than 4999 shares.

90Under this assumption, annual savings to

Nasdaq investors would be approximately $175

million. These savings are calculated in the manner

described in the preceding note.

91Mercatus Center Letter, note 29 above, at 16.

92The Mercatus Center’s comment letter

addresses the potential benefits associated with

more frequent rebalancing, but ignores the potential

changes in securities that investors choose.

93 Yakov Amihud & Haim Mendelson, Asset

Pricing and the Bid-Ask Spread, 17 J. Financial

Economics 223 (1986).

execution is a facts and circumstances

determination. A broker-dealer must

consider several factors affecting the

quality of execution, including, for

example, the opportunity for price

improvement, the likelihood of

execution (which is particularly

important for customer limit orders), the

speed of execution, and the trading

characteristics of the security, together

with other non-price factors such as

reliability and service. While brokerdealers currently may be able to obtain

order execution information from some

market centers, that information may be

of limited use and may not allow

broker-dealers to compare execution

quality among the different market

centers. Although these statistics are by

no means determinative of best

execution, the Commission expects that

the monthly reporting of the uniform

statistical measures required by the Rule

will provide broker-dealers with a

clearer sense of execution quality among

market centers, and will be helpful to

broker-dealers in seeking to fulfill their

duty of best execution.

The Commission also believes that the

reporting required by Rule 11Ac1–5 will

facilitate investors’ ability to evaluate

the quality of order executions provided

by different market centers and to have

meaningful input into how their brokerdealer executes their orders. Differences

in execution quality across market

centers can be very important to

investors. For example, a difference in

execution price of 1⁄16 for a 1000 share

order can equal a savings of $62.50 for

an investor. Currently, investors possess

few tools to compare order executions

on different markets, and they typically

leave routing decisions to their brokerdealer. Different investors, however,

may have different concerns and

priorities related to execution of their

orders, such as an opportunity for price

improvement and the speed of

execution. The Rule will require

disclosure of information that will

enhance investors’ evaluation of these

matters.

The Commission believes that Rule

11Ac1–5 will have the additional

benefit of stimulating competition

between market centers to improve the

quality of their executions. Market

centers compete to attract order flow.

An important way in which market

centers seek to attract order flow is by

providing—and developing a reputation

for providing—superior executions. The

Rule will give broker-dealers and

investors meaningful information,

which they have not previously had,

bearing on execution quality. Access to

that information will allow brokerdealers and investors to direct orders to

market centers on the basis of their

order execution performance. Improved

disclosure should result in some

increase in the number of shares

executed with price improvement and a

reduction in the number of shares

executed with price ‘‘disimprovement.’’

Price disimprovement can occur, for

example, because of quote exhaustion—

the cumulative volume of orders is

greater than quoted size and the market

center does not provide liquidity

enhancement. The Commission

anticipates that public disclosure will

benefit investors by putting competitive

pressure on market centers to reduce

inefficiencies, to increase opportunities

for price improvement, to decrease

instances of price disimprovement, and

to improve the quality of execution in

all other respects. Market centers that

are able to provide better service should

be rewarded with more order flow.

Ultimately, the Commission anticipates

that these improvements in execution

also will benefit investors by leading to

reduced trading costs, increased trading

quality, and possibly increased trading

volume.

For example, if investors that now pay

more than the median effective spread

were able to obtain executions at the

median effective spread, the required

disclosures could save investors in

Nasdaq stocks $110 million in annual

trading costs.89 Moreover, the savings to

investors would be even greater if

effective spreads improved to the level

of the 25th percentile of Nasdaq market

centers.90 There also could be a similar

type of benefit for investors in the listed

markets, although possibly to a lesser

extent given the smaller number of

market centers. Finally, over time the

disclosures rules may provide the

impetus for new market structures that

provide further reductions in trading

costs.

In commenting on the costs and

benefits of Rule 11Ac1–5, the Mercatus

Center asserted that the potential

savings in transaction costs for investors

must also be counted as a cost to market

intermediaries, noting that ‘‘this sum is

simply a transfer of wealth from brokers

and market centers to investors’’ and

that ‘‘when calculating the net benefits

or costs of a rule, such wealth transfers

cancel each other out.’’ 91 In contrast, we

believe that the savings to investors

described above may be associated with

an additional net benefit that would be

realized at the market centers. The

ultimate result depends on what causes

the differences in execution quality that

we currently observe across market

centers. If these differences are all due

to differences in efficiency, then the

potential savings to investors discussed

above would necessarily be the result of

transfers of order flow to the more

efficient market centers. This

consolidation would likely result in

further efficiencies due to economies of

scale.

On the other hand, the differences in

transaction costs across market centers

may reflect differing abilities by market

centers to thwart competitive pressures

and earn quasi-monopoly rents in the

absence of adequate disclosure. If this

were the case, then any investor savings

might simply be the result of squeezing

out some of these excess profits, with no

attendant change in order routing

practices. As the Mercatus Center points

out, under this scenario the savings to

investors represent a wealth transfer

from the owners of the market centers.

Of course, there are several other

benefits to investors, discussed below,

that flow from reduced transactions

costs, even if one assumes that there are

no net efficiency improvements

available.

The savings calculation presented

above implicitly assumes no change in

the amount or type of transactions made

by investors. Apart from direct savings

to investors, a reduction in transaction

costs will allow investors to manage

their portfolios to better match their

needs and desires, through a

combination of rebalancing more

frequently and incorporating a different

mix of securities.92 For example, some

investors currently may avoid holding

certain less-liquid securities because of

transaction costs. After the Rule is

implemented, they may want to include

these securities in their portfolio if the

Rule leads to a significant reduction in

transaction costs.

Another potential benefit of reduced

transactions costs is a reduction in the

cost of capital applied to new

investments. Amihud and Mendelson

(1986) 93 provide both theoretical and

empirical evidence that lower relative

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75433

94Michael J. Brennan & Avanidhar

Subrahmanyam, Market Microstructure and Asset

Pricing: On the Compensation for Illiquidity in

Stock Returns, 41 J. Financial Economics 441

(1996).

95Both studies examine cross-sectional

differences in required returns associated with

cross-sectional differences in transaction costs so

their empirical estimates may not be indicative of

the size of the reduction in market-wide required

returns that would accompany a market-wide

reduction in transaction costs.

96Mercatus Center Letter, note 29 above, at 18;

Phlx Letter, note 25 above, at 3; Morgan Stanley

Letter, note 15 above, at 18; Wilkie Farr & Gallagher

Letter, note 29 above, at 4.

97For example, NASD rules require members

trading Nasdaq securities to submit electronic data

on individual order executions to the NASD

pursuant to its Order Audit Trail System

requirements. NASD Rules 6950–6957. This data

includes the basic order information that would be

necessary to calculate the statistical measures of

execution quality required by Rule 11Ac1–5.

spreads are associated with lower

required returns. Further, their

empirical conclusions are supported by

Brennan and Subrahmanyam (1996).94

The intuition behind these studies is

simple: in considering how much they

are willing to pay for securities up front,

investors consider how much of the

future value will be lost to transaction

costs.95

2. Costs

For purposes of the Paperwork

Reduction Act, the Commission staff has

estimated that compliance with Rule

11Ac1–5 by the estimated 627 market

centers could require 56, 430 hours for

initial preparations and, on an ongoing

basis, impose 45,144 in burden hours

for data collection and $18.8 million in

other costs ($2,500 per month for

preparation of reports by service

vendors). The staff estimates that 100%

of the burden hours could be expended

by market centers’ internal staff.

Assuming internal staff costs of $53 per

hour, the estimated 627 market centers

could expend a total of approximately

$600,000 per year in startup costs (a

total of $3 million annualized over an

expected useful life of five years) and a

total of approximately $2.4 million per

year in ongoing data collection costs.

The estimated aggregate annual cost for

compliance with the Rule could be

approximately $21.8 million ($18.8

million+$2.4 million+$0.6 million).

Several commenters asserted that the

costs of disclosing the execution quality

information required by Rule 11Ac1–5

would be substantial. Many of these

same commenters asserted that the

benefits of the rules would be minimal

and that the costs associated with the

rules would outweigh the benefits.96

As discussed above in connection

with the PRA, the Commission disagrees

with these commenters’ estimates

regarding the direct costs of compliance

with Rule 11Ac1–5. As a basis for

compliance, market centers themselves

need maintain only the most basic order

information, such as the type and size

of order, the time of order receipt, the

time of order execution, and execution

price. The Commission believes that all

market centers retain this basic order

data.97 Such data then must be

compared with a record of the

consolidated quote stream to generate

the statistics required by the Rule.

Although some market centers may

choose to program their own systems to

perform this task, independent

companies already provide this service

for many market centers. These

independent companies have expended

the up-front costs of automating the

processes and maintaining a record of

the consolidated quote stream. Market

centers need only transmit their basic

order information to the service

provider, which then is able to generate

the necessary reports from the

information. Based on discussions with

industry sources, it appears that

individual market centers could obtain

this service for approximately $2,500

per month, and it is possible that

smaller market centers could obtain this

same service at an even lower cost.

Accordingly, the total costs to prepare

the monthly order execution reports do

not appear to be large for any market

center. The Commission believes the

significant potential benefits from

disclosure justify these costs.

B. Costs and Benefits of Rule 11Ac1–6

Under Rule 11Ac1–6, broker-dealers

that route orders in equity and options

securities on behalf of customers will be

required to prepare quarterly reports

that give an overview of their order

routing practices. The Rule also will

require broker-dealers to disclose to

customers, on request, where that

customer’s individual orders were

routed for execution.

1. Benefits

The Commission anticipates that

improved disclosure of order routing

practices will result in better-informed

investors, will provide broker-dealers

with more incentives to obtain superior

executions for their customer orders,

and will thereby increase competition

between market centers to provide

superior executions. Currently, the

decision about where to route a

customer order is frequently made by

the broker-dealer, and broker-dealers

may make that decision, at least in part,

on the basis of factors that are unknown

to their customers. The Rule’s

disclosure requirements will provide

investors with a clearer picture of the

overall routing practices of different

broker-dealers. The Commission

contemplates that this will lead to

greater investor involvement in order

routing decisions and, ultimately, will

result in improved execution practices.

Because of the disclosure requirements,

broker-dealers may be more inclined (or

investors may direct their brokerdealers) to route orders to market

centers providing superior executions.

Broker-dealers who fail to do so may

lose customers to other broker-dealers

who will do so. In addition, the

improved visibility could shift order

flow to those market centers that

consistently generate the best prices for

investors. This increased investor

knowledge and involvement could

ultimately have the effect of increasing

competition between market centers to

provide superior execution.

The order routing disclosures of Rule

11Ac1–6, when combined with the

execution quality disclosure made by

market centers, will allow investors to

monitor the extent to which, in

choosing execution venues, there are, in

fact, systematic trade-offs that must be

made between price and other factors,

and the amount of those trade-offs. For

example, if the best prices are

consistently produced by one of the

leading market centers with cuttingedge, highly-reliable trading systems,

there would be little, if any, trade-off

between price and systems reliability.

Similarly, the rules will help customers

weigh the trade-off between a market

center that provided immediate

executions at the quote, and a market

center that executed orders on average

in under 30 seconds, but that

consistently generated prices resulting

in average effective spreads that were a

significant amount per share better than

those paid by investors at other market

centers. Currently, however, investors

have little or no information that would

allow them to evaluate how their

broker-dealer has responded to such

trade-offs. Rule 11Ac1–6, along with

Rule 11Ac1–5, is intended to remedy

this glaring absence of public

information. After the rules become

effective, competitive forces can be

brought to bear on broker-dealers both

with respect to the explicit trading costs

associated with brokerage commissions

and the implicit trading costs associated

with execution quality. The

Commission believes that investors

ultimately will be the beneficiaries of

this expanded competition.

75434 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

98A higher average rate of internal staff costs is

used for the preparation of quarterly reports based

on the assumption that they would be prepared, at

least in part, by higher level staff than that involved

with responding to customer requests.

99 15 U.S.C. 78w(a).

100 15 U.S.C. 78c(f). 101 5 U.S.C. 601 et seq.

2. Costs

For purposes of the Paperwork

Reduction Act, the Commission staff has

estimated that the Rule 11Ac1–6 could,

on an annual basis, impose 75,200

burden hours on broker-dealers to

comply with the quarterly reporting

requirement of the Rule. The staff

estimates that 100% of those burden

hours will be expended by brokerdealers’ internal staff. Assuming

internal staff costs that average $85 per

hour,98 the aggregate annual cost of

compliance with the quarterly reporting

requirement could be approximately

$6.4 million. In addition, compliance

with the Rule will require staff time to

respond to requests by customers for

disclosure of the market centers to

which their orders have been routed.

For purposes of the Paperwork

Reduction Act, the Commission staff has

estimated that compliance with such

requests could, on an annual basis,

impose 132,000 burden hours.

Assuming average internal staff costs of

$53 per hour, the annual cost of

compliance with the customer response

requirement could be approximately $7

million.

As noted in section III.A.3 above,

several commenters have raised

concerns over the potential risk of

meritless class-action suits faced by

brokers as a result of increased

disclosure. From society’s perspective,

the time and effort spent both asserting

and defending any meritless action is a

net cost. The Commission believes,

however, that the potential for meritless

litigation has been minimized by its

inclusion of a Preliminary Note to Rule

11Ac1–5. The Note, with the attendant

discussion in this release, states, among

other things, that the statistical

disclosures do not encompass all of the

factors that may be important to

investors in evaluating the order routing

services of a broker-dealer and that the

disclosures alone do not create a reliable

basis to address whether any particular

broker-dealer failed to meet its legal

duty of best execution. This clear

statement should substantially address

the risk that the required disclosures

will be misinterpreted and misused in

private litigation. In light of the addition

of the Preliminary Note and the best

execution considerations addressed

above, the Commission believes that the

benefits of better visibility of execution

quality justify any residual risk of

meritless litigation arising after the

additional information is publicly

available.

VIII. Consideration of Burden on

Competition and Promotion of

Efficiency, Competition, and Capital

Formation

Section 23(a)(2) of the Exchange Act

requires the Commission, when making

rules under the Exchange Act, to

consider the impact of such rules on

competition.99 In addition, section 3(f)

of the Exchange Act requires the

Commission, when engaging in

rulemaking that requires it to consider

or determine whether an action is

necessary or appropriate in the public

interest, to consider whether the action

will promote efficiency, competition,

and capital formation.100

The Commission has considered Rule

11Ac1–5 and Rule 11Ac1–6 in light of

these standards and believes that the

rules will not impose a burden on

competition not necessary or

appropriate in furtherance of the

purposes of the Exchange Act. To the

contrary, by enhancing the disclosure of

order execution and order routing

practices, the Rules should promote fair

and vigorous competition. Investors

currently have little information to

evaluate the order routing practices of

their broker-dealers. As a result, there

currently may be limited opportunities

for fair competition among brokerdealers based on the quality of their

order routing services. By requiring

broker-dealers to disclose information

on their order routing practices, the

Rules may stimulate competition among

broker-dealers based on the quality of

their order routing services. Similarly,

by requiring market centers to disclose

order execution information in a

manner that permits comparative

analysis, the rules may stimulate

competition among market centers

based on the quality of their order

execution services. In addition, because

the rules would apply equally to market

centers, with respect to order execution

disclosure, and broker-dealers, with

respect to order routing disclosure, the

rules would not result in disparate

treatment of these entities that could

hinder competition.

The Commission also believes that the

rules will allow investors and brokerdealers to make better-informed choices

in finding the best market for orders to

be executed. Accordingly, the rules may

promote market efficiency. In addition,

the availability of information on order

execution and order routing quality may

bolster investor confidence, thereby

promoting capital formation.

IX. Final Regulatory Flexibility

Analysis

This Final Regulatory Flexibility

Analysis (‘‘FRFA’’) has been prepared in

accordance with the Regulatory

Flexibility Act.101 It relates to Rule

11Ac1–5 and Rule 11Ac1–6 under the

Exchange Act. The rules will require

market centers to make disclosures of

order execution information and brokerdealers to make disclosures of order

routing information.

A. Need for the Rules

The Commission believes that there is

a need for improved disclosure of order

execution information by market

centers. Investors today can obtain

consolidated quote information that

represents the best bid and offer from

among different market centers. This

information, however, may not

accurately reflect the quality of order

executions that may be obtained from

the different market centers. Many

market centers offer significant

opportunities for execution of orders at

prices better that the consolidated

quote. Conversely, some market centers

execute orders at prices less favorable

than the consolidated quote at the time

of order receipt. The amount of price

improvement or disimprovement may

result in significant savings or costs to

investors. Although some market

centers make order execution

information available to private

companies or to their members, this

information generally has not been

publicly disseminated. Moreover, the

lack of uniformity in the way this

information is prepared has made it

difficult for users of the information to

compare execution quality across

market centers.

The Commission also believes that

there is a corresponding need for

disclosure of order routing information

by broker-dealers. If investors do not

know where their broker-dealers route

orders for execution, the order

execution information provided by

market centers will be of little benefit to

investors. The lack of availability of

order routing information also may

make it difficult for investors to monitor

their broker-dealer’s order-routing

decisions.

Rule 11Ac1–5 is designed to address

the need for improved disclosure of

order execution information by market

centers. In particular, the Rule is

intended to provide investors and

broker-dealers with uniform information

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75435

102Morgan Stanley Letter, note 15 above, at 18;

Wilkie Farr & Gallagher Letter, note 29 above, at 4.

103Exchange Act Rule 0–10(b), 17 CFR 240.0–

10(c).

104These estimates are based on the FYE 1999

FOCUS Reports received by the Commission from

exchange market makers, OTC market makers, and

ATSs that would be subject to Rule 11Ac1–5.

105 17 CFR 240.0–10(e).

106This estimate is based on the FYE 1999

FOCUS Reports received by the Commission from

broker-dealers subject to Rule 11Ac1–6.

107These estimates are smaller than those used

generally to estimate the burden costs for purposes

of the Paperwork Reduction Act. Assuming any of

Continued

on execution quality that can be used to

compare execution quality across

market centers. This information should

assist investors and broker-dealers in

finding the best market for orders to be

executed, thereby promoting

competition among market centers and

broker-dealers on the basis execution

quality and leading to more efficient

transactions in securities.

Rule 11Ac1–6 is designed to address

the complementary need for brokerdealers to disclose to customers where

their orders are routed for execution.

The primary objective of the rule is to

afford customers a greater opportunity

to monitor their broker-dealer’s order

routing practices. Supplied with

information on where their orders are

routed, as well as information about the

quality of execution from the market

centers to which their orders are routed,

investors will be able to make better

informed decisions with respect to their

orders. The information also may assist

investors in selecting a broker-dealer.

B. Significant Issues Raised By Public

Comment

No commenter specifically addressed

the Initial Regulatory Flexibility

Analysis that was included in the

Proposing Release. Some commenters

stated, however, that they believed

compliance with the proposed rules,

particularly Rule 11Ac1–5, could be

significantly more burdensome for

smaller firms than for large ones.102 As

discussed below, the Commission does

not agree that compliance with the rules

will be unduly burdensome for those

entities that are considered small

entities for purposes of the Regulatory

Flexibility Act.

C. Small Entities Subject To the Rules

Both Rule 11Ac1–5 and Rule 11Ac1–

6 will affect entities that are considered

small entities for purposes of the

Regulatory Flexibility Act.

1. Small Entities Affected By Rule

11Ac1–5

Rule 11Ac1–5 will impose disclosure

requirements on every market center

that receives covered orders in national

market system securities. Market centers

are defined as exchange market makers,

OTC market makers, alternative trading

systems, national securities exchanges,

and national securities associations.

Exchange market makers, OTC market

makers, and alternative trading systems

that are not registered as exchanges are

required to register as broker-dealers.

Accordingly, these entities would be

considered small entities if they fall

within the standard for small entities

that applies to broker-dealers. Under

Exchange Act Rule 0–10(b), a brokerdealer is considered a small entity for

purposes of Regulatory Flexibility Act if

(1) it had total capital of less than

$500,000 on the date in the prior fiscal

year as of which its audited financial

statements were prepared, of, if not

required to prepare such statements, it

had total capital of less than $500,000

on the last business day of the preceding

fiscal year, and (2) it is not affiliated

with any person (other than a natural

person) that is not a small entity.103

Based on this standard, the Commission

estimates that two exchange market

makers, one OTC market maker, and no

alternative trading systems that will be

subject to Rule 11Ac1–5 are small

entities.104

None of the national securities

exchanges or the national securities

association subject to the Rule is a small

entity. Paragraph (e) of the Exchange

Act Rule 0–10 105 provides that the term

‘‘small business,’’ when referring to an

exchange, means any exchange that has

been exempted from the reporting

requirements of 17 CFR 240.11Aa3–1.

Under this standard, none of the

national securities exchanges affected

by the Rule is a small entity. Similarly,

the national securities association

subject to the Rule is not a small entity

as defined by 13 CFR 121.201.

2. Small Entities Affected By Rule

11Ac1–6

Rule 11Ac1–6 will impose disclosure

requirements on every broker-dealer

that routes non-directed customer

orders in covered securities. Under the

standard for determining whether a

broker-dealer is a small entity in

Exchange Act Rule 0–10(b), the

Commission estimates that

approximately 41 broker-dealers subject

to Rule 11Ac1–6 are small entities.106

D. Projected Reporting, Recordkeeping

and Other Compliance Requirements

1. Reporting Requirements Under Rule

11Ac1–5

Rule 11Ac1–5 will impose new

reporting requirements on market

centers, including those considered

small entities. Under the Rule, market

centers will be required to prepare and

make available to the public monthly

reports that categorize and summarize

their order executions. For purposes of

the Paperwork Reduction Act, the

Commission staff estimates that

individual market centers will spend 90

hours in initial preparations and, on an

annual basis, spend 72 burden hours

and incur $30,000 ($2,500 per month) in

monetary costs to comply with the

monthly reporting requirement.

Assuming internal compliance staff

costs of $53 per hour, the total cost per

small entity for burden hours will be

$4,770 for initial preparations and

$3,816 on an annual basis. The

Commission estimates the total cost, on

an ongoing basis, required to prepare

and disseminate the monthly reports by

the estimated three small entities

subject to the Rule will be $108,360 per

year (3 × ($30,000 + $3,816)). As

discussed further above, small entities

likely could obtain a much reduced rate

through the auspices of an SRO or other

organization.

2. Reporting Requirements Under Rule

11Ac1–6

Rule 11Ac1–6 will impose new

reporting requirements on brokerdealers, including those considered

small entities. Under the Rule, brokerdealers will be required to prepare and

make available to the public quarterly

reports that give an overview of their

routing of non-directed orders in

covered securities. In addition, brokerdealers, on request of a customer, will

be required to disclose the identity of

the venues to which the customer’s

orders were routed in the six months

prior to the request, whether the orders

were directed or non-directed orders,

and the time of the transactions

resulting from such orders.

As discussed in section VI.B above, it

is unlikely that many small entities will

have significant involvement in order

routing practices, primarily because

they are affiliated with a clearing broker.

With respect to the 41 small entities that

are subject to the Rule and are not

affiliated with a clearing broker, the

Commission does not anticipate that

they engage in significant order routing

on behalf of customers. If any of the 41

small entities were required to comply

with the Rule, the Commission staff

estimates that they would expend, on

average, 32 hours to prepare quarterly

reports and 2 hours to respond to eight

customer requests.107 Assuming internal

75436 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

the 41 small entities actually route non-directed

orders on behalf of customers, it is likely that the

number of orders would be very small. The burden

of preparing quarterly reports and responding to

customer requests would therefore be substantially

less than the overall industry average.

compliance costs that average $85 per

hour, the aggregate cost for each small

entity to comply with the Rule is

estimated to be $2890.

E. Agency Action To Minimize Effect on

Small Entities

The Regulatory Flexibility Act directs

the Commission to consider significant

alternatives that would accomplish the

stated objectives, while minimizing any

significant adverse impact on small

entities. In connection with Rule

11Ac1–5 and Rule 11Ac1–6, the

Commission considered the following

alternatives: (1) The establishment of

differing compliance or reporting

requirements or timetables that take into

account the resources available to small

entities; (2) the clarification,

consolidation, or simplification of

compliance and reporting requirements

under the rules for small entities; (3) the

use of performance rather than design

standards; and (4) an exemption from

coverage of the rules, or any part

thereof, for small entities.

1. Rule 11Ac1–5

Rule 11Ac1–5 is designed to provide

uniform order execution information

from the different market centers to

allow investors and broker-dealers to

compare execution quality across

markets. Accordingly, the Commission

believes that establishing differing

reporting requirements for small entities

would be inconsistent with the

objectives of the Rule. Similarly, the

Commission believes that the

clarification, consolidation, or

simplification of reporting requirements

for small entities would be inconsistent

with the objective of providing uniform

order execution information from the

different market centers.

Regarding the use of performance

standards rather than design standards,

Rule 11Ac1–5 specifies the statistical

measures that must appear in the

monthly order execution reports. The

Commission considered whether the

Rule should require market centers only

to make available electronic files with

raw data on an order-by-order basis.

Under this alternative, market centers

would provide the necessary fields of

information, and analysts could

calculate the statistical measures of

execution quality that they consider

appropriate. The Commission has not

adopted this alternative because it

would be inconsistent with the objective

of assuring a uniform basis for

comparing execution quality across

market centers. The Rule does not

establish a particular technology for

disseminating the required reports to

the public, other than requiring that

market centers make their data available

for downloading from a free website in

a consistent, usable, and machinereadable electronic format.

As to whether Rule 11Ac1–5 should

exempt small entities from its coverage,

the Commission considered several

alternatives that could minimize the

impact of the Rule on small entities.

Specifically, the Commission

considered an exemption for market

centers that execute relatively few

orders in total. Also, the Commission

considered an exemption to eliminate

the disclosure requirement for

individual securities in which a market

center executes relatively few orders.

Finally, as discussed above, the

Commission considered whether it

would be feasible to allow small market

centers to provide raw data rather than

the statistical measures required by the

proposed rule. No commenters

expressed support for these types of

exemptions or exceptions for small

entities. Given the need for a uniform

basis to compare execution quality

across market centers, the Commission

has determined not to adopt exemptions

or exclusions specifically for small

entities.

2. Rule 11Ac1–6

Rule 11Ac1–6 is designed to provide

investors with information on the order

routing practices of their broker-dealers.

The Rule requires broker-dealers to

prepare quarterly order routing reports

and respond to requests from individual

investors for information on how their

orders were routed. As to the

establishment of different reporting

requirements or timetables and the

clarification, consolidation, or

simplification of reporting requirements

for small entities, the Commission does

not believe that the proposal could be

formulated differently for small entities

and still achieve its stated objectives.

The Commission requested comment

on whether to exclude from the Rule

broker-dealers that route a relatively

small number of customer orders. No

commenter expressed support for such

an exclusion. Moreover, an exemption

from the Rule for small entities would

be inconsistent with the objectives of

the Rule. Its primary objective is to

afford customers a greater opportunity

to monitor their broker-dealer’s order

routing practices. All broker-dealers

currently have an obligation to

periodically review their order routing

practices to meet their duty of best

execution to their customers. The

Commission does not believe that the

disclosures required by Rule 11Ac1–6

will be unduly burdensome for small

entities, particularly now that the

requirement of a narrative discussion

and analysis of order routing objectives

and results has been eliminated from

the rule as it was proposed.

X. Statutory Authority

Pursuant to the Exchange Act and

particularly Sections 3(b), 5, 6, 11A, 15,

17, 19, 23(a), and 36 thereof, 15 U.S.C.

78c, 78e, 78f, 78k–1, 78o, 78q, 78s,

78w(a), and 78mm, the Commission

proposes to adopt Sections 240.11Ac1–

5 and 240.11Ac1–6 of Chapter II of Title

17 of the Code of Federal Regulations in

the manner set forth below.

List of Subjects in 17 CFR Part 240

Broker-dealers, Reporting and

recordkeeping requirements, Securities.

Text of Rules

For the reasons set forth in the

preamble, the Commission is amending

Chapter II of Title 17 of the Code of

Federal Regulations as follows:

PART 240—GENERAL RULES AND

REGULATIONS, SECURITIES

EXCHANGE ACT OF 1934

1. The authority citation for Part 240

continues to read in part as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j,

77s, 77z–2, 77eee, 77ggg, 77nnn, 77sss, 77ttt,

78c, 78d, 78f, 78i, 78j, 78j–1, 78k, 78k–1, 78l,

78m, 78n, 78o, 78p, 78q, 78s, 78u–5, 78w,

78x, 78ll(d), 78mm, 79q, 79t, 80a–20, 80a–23,

80a–29, 80a–37, 80b–3, 80b–4 and 80b–11,

unless otherwise noted.

* * * * *

2. Sections 240.11Ac1–5 and

240.11Ac1–6 are added before the

undesignated center heading ‘‘Securities

Exempted from Registration’’ to read as

follows:

§ 240.11Ac1–5 Disclosure of order

execution information.

Preliminary Note: Section 240.11Ac1–

5 requires market centers to make

available standardized, monthly reports

of statistical information concerning

their order executions. This information

is presented in accordance with uniform

standards that are based on broad

assumptions about order execution and

routing practices. The information will

provide a starting point to promote

visibility and competition on the part of

market centers and broker-dealers,

particularly on the factors of execution

price and speed. The disclosures

required by this section do not

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75437

encompass all of the factors that may be

important to investors in evaluating the

order routing services of a broker-dealer.

In addition, any particular market

center’s statistics will encompass

varying types of orders routed by

different broker-dealers on behalf of

customers with a wide range of

objectives. Accordingly, the statistical

information required by this Section

alone does not create a reliable basis to

address whether any particular brokerdealer failed to obtain the most

favorable terms reasonably available

under the circumstances for customer

orders.

(a) Definitions. For the purposes of

this section:

(1) The term alternative trading

system shall have the meaning provided

in § 242.300(c) of this chapter.

(2) The term average effective spread

shall mean 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

consolidated best bid and offer at the

time of order receipt and, for sell orders,

as double the amount of difference

between the midpoint of the

consolidated best bid and offer at the

time of order receipt and the execution

price.

(3) The term average realized spread

shall mean 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

consolidated best bid and offer five

minutes after the time of order

execution and, for sell orders, as double

the amount of difference between the

midpoint of the consolidated best bid

and offer five minutes after the time of

order execution and the execution price;

provided, however, that the midpoint of

the final consolidated best bid and offer

disseminated for regular trading hours

shall be used to calculate a realized

spread if it is disseminated less than

five minutes after the time of order

execution.

(4) The term categorized by order size

shall mean dividing orders into separate

categories for sizes from 100 to 499

shares, from 500 to 1999 shares, from

2000 to 4999 shares, and 5000 or greater

shares.

(5) The term categorized by order type

shall mean dividing orders into separate

categories for market orders, marketable

limit orders, inside-the-quote limit

orders, at-the-quote limit orders, and

near-the-quote limit orders.

(6) The term categorized by security

shall mean dividing orders into separate

categories for each national market

system security that is included in a

report.

(7) The term consolidated best bid

and offer shall mean the highest firm

bid and the lowest firm offer for a

security that is calculated and

disseminated on a current and

continuous basis pursuant to an

effective national market system plan.

(8) The term covered order shall mean

any market order or any limit order

(including immediate-or-cancel orders)

received by a market center during

regular trading hours at a time when a

consolidated best bid and offer is being

disseminated, and, if executed, is

executed during regular trading hours,

but shall exclude any order for which

the customer requests special handling

for execution, including, but not limited

to, orders to be executed at a market

opening price or a market closing price,

orders submitted with stop prices,

orders to be executed only at their full

size, orders to be executed on a

particular type of tick or bid, orders

submitted on a ‘‘not held’’ basis, orders

for other than regular settlement, and

orders to be executed at prices unrelated

to the market price of the security at the

time of execution.

(9) The term exchange market maker

shall mean any member of a national

securities exchange that is registered as

a specialist or market maker pursuant to

the rules of such exchange.

(10) The term executed at the quote

shall mean, for buy orders, execution at

a price equal to the consolidated best

offer at the time of order receipt and, for

sell orders, execution at a price equal to

the consolidated best bid at the time of

order receipt.

(11) The term executed outside the

quote shall mean, for buy orders,

execution at a price higher than the

consolidated best offer at the time of

order receipt and, for sell orders,

execution at a price lower than the

consolidated best bid at the time of

order receipt.

(12) The term executed with price

improvement shall mean, for buy orders,

execution at a price lower than the

consolidated best offer at the time of

order receipt and, for sell orders,

execution at a price higher than the

consolidated best bid at the time of

order receipt.

(13) The terms inside-the-quote limit

order, at-the-quote limit order, and

near-the-quote limit order shall mean

non-marketable buy orders with limit

prices that are, respectively, higher

than, equal to, and lower by $0.10 or

less than the consolidated best bid at the

time of order receipt, and nonmarketable sell orders with limit prices

that are, respectively, lower than, equal

to, and higher by $0.10 or less than the

consolidated best offer at the time of

order receipt.

(14) The term market center shall

mean any exchange market maker, OTC

market maker, alternative trading

system, national securities exchange, or

national securities association.

(15) The term marketable limit order

shall mean any buy order with a limit

price equal to or greater than the

consolidated best offer at the time of

order receipt, and any sell order with a

limit price equal to or less than the

consolidated best bid at the time of

order receipt.

(16) The term effective national

market system plan shall have the

meaning provided in § 240.11Aa3–

2(a)(2).

(17) The term national market system

security shall have the meaning

provided in § 240.11Aa2–1.

(18) The term OTC market maker

shall mean any dealer that holds itself

out as being willing to buy from and sell

to its customers, or others, in the United

States, a national market system security

for its own account on a regular or

continuous basis otherwise than on a

national securities exchange in amounts

of less than block size.

(19) The term regular trading hours

shall mean the time between 9:30 a.m.

and 4:00 p.m. Eastern Time, or such

other time as is set forth in the

procedures established pursuant to

paragraph (c)(2) of this section.

(20) The term time of order execution

shall mean the time (to the second) that

an order was executed at any venue.

(21) The term time of order receipt

shall mean the time (to the second) that

an order was received by a market

center for execution.

(b) Monthly electronic reports by

market centers. (1) Every market center

shall make available for each calendar

month, in accordance with the

procedures established pursuant to

paragraph (b)(2) of this section, a report

on the covered orders in national market

system securities that it received for

execution from any person. Such report

shall be in electronic form; shall be

categorized by security, order type, and

order size; and shall include the

following columns of information:

(i) For market orders, marketable limit

orders, inside-the-quote limit orders, atthe-quote limit orders, and near-thequote limit orders:

(A) The number of covered orders;

(B) The cumulative number of shares

of covered orders;

(C) The cumulative number of shares

of covered orders cancelled prior to

execution;

75438 Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations

(D) The cumulative number of shares

of covered orders executed at the

receiving market center;

(E) The cumulative number of shares

of covered orders executed at any other

venue;

(F) The cumulative number of shares

of covered orders executed from 0 to 9

seconds after the time of order receipt;

(G) The cumulative number of shares

of covered orders executed from 10 to

29 seconds after the time of order

receipt;

(H) The cumulative number of shares

of covered orders executed from 30

seconds to 59 seconds after the time of

order receipt;

(I) The cumulative number of shares

of covered orders executed from 60

seconds to 299 seconds after the time of

order receipt;

(J) The cumulative number of shares

of covered orders executed from 5

minutes to 30 minutes after the time of

order receipt; and

(K) The average realized spread for

executions of covered orders; and

(ii) For market orders and marketable

limit orders:

(A) The average effective spread for

executions of covered orders;

(B) The cumulative number of shares

of covered orders executed with price

improvement;

(C) For shares executed with price

improvement, the share-weighted

average amount per share that prices

were improved;

(D) For shares executed with price

improvement, the share-weighted

average period from the time of order

receipt to the time of order execution;

(E) The cumulative number of shares

of covered orders executed at the quote;

(F) For shares executed at the quote,

the share-weighted average period from

the time of order receipt to the time of

order execution;

(G) The cumulative number of shares

of covered orders executed outside the

quote;

(H) For shares executed outside the

quote, the share-weighted average

amount per share that prices were

outside the quote; and

(I) For shares executed outside the

quote, the share-weighted average

period from the time of order receipt to

the time of order execution.

(2) Every national securities exchange

on which national market system

securities are traded and national

securities association shall act jointly in

establishing procedures for market

centers to follow in making available to

the public the reports required by

paragraph (b)(1) of this section in a

uniform, readily accessible, and usable

electronic form. In the event there is no

effective national market system plan

establishing such procedures, market

centers shall prepare their reports in a

consistent, usable, and machinereadable electronic format, and make

such reports available for downloading

from an Internet web site that is free and

readily accessible to the public.

(3) A market center shall make

available the report required by

paragraph (b)(1) of this section within

one month after the end of the month

addressed in the report.

(c) Exemptions. The Commission

may, by order upon application,

conditionally or unconditionally

exempt any person, security, or

transaction, or any class or classes of

persons, securities, or transactions, from

any provision or provisions of this

section, if the Commission determines

that such exemption is necessary or

appropriate in the public interest, and is

consistent with the protection of

investors.

§ 240.11Ac1–6 Disclosure of order routing

information.

(a) Definitions. For the purposes of

this section:

(1) The term covered security shall

mean:

(i) Any national market system

security and any other security for

which a transaction report, last sale data

or quotation information is

disseminated through an automated

quotation system as defined in Section

3(a)(51)(A)(ii) of the Act (15 U.S.C.

78c(a)(51)(A)(ii)); and

(ii) Any option contract traded on a

national securities exchange for which

last sale reports and quotation

information are made available pursuant

to an effective national market system

plan.

(2) The term customer order shall

mean an order to buy or sell a covered

security that is not for the account of a

broker or dealer, but shall not include

any order for a quantity of a security

having a market value of at least $50,000

for a covered security that is an option

contract and a market value of at least

$200,000 for any other covered security.

(3) The term directed order shall

mean a customer order that the

customer specifically instructed the

broker or dealer to route to a particular

venue for execution.

(4) The term make publicly available

shall mean posting on an Internet web

site that is free and readily accessible to

the public, furnishing a written copy to

customers on request without charge,

and notifying customers at least

annually in writing that a written copy

will be furnished on request.

(5) The term non-directed order shall

mean any customer order other than a

directed order.

(6) The term effective national market

system plan shall have the meaning

provided in § 240.11Aa3–2(a)(2).

(7) The term national market system

security shall have the meaning

provided in § 240.11Aa2–1.

(8) The term payment for order flow

shall have the meaning provided in

§ 240.10b–10(d)(9).

(9) The term profit-sharing

relationship shall mean any ownership

or other type of affiliation under which

the broker or dealer, directly or

indirectly, may share in any profits that

may be derived from the execution of

non-directed orders.

(10) The term time of the transaction

shall have the meaning provided in

§ 240.10b–10(d)(3).

(b) Quarterly report on order routing.

(1) Every broker or dealer shall make

publicly available for each calendar

quarter a report on its routing of nondirected orders in covered securities

during that quarter. For covered

securities other than option contracts,

such report shall be divided into three

separate sections for securities that are

listed on the New York Stock Exchange,

Inc., securities that are qualified for

inclusion in the Nasdaq Stock Market,

Inc., and securities that are listed on the

American Stock Exchange LLC or any

other national securities exchange. Such

report also shall include a separate

section for covered securities that are

option contracts. Each of the four

sections in a report shall include the

following information:

(i) The percentage of total customer

orders for the section that were nondirected orders, and the percentages of

total non-directed orders for the section

that were market orders, limit orders,

and other orders;

(ii) The identity of the ten venues to

which the largest number of total nondirected orders for the section were

routed for execution and of any venue

to which five percent or more of nondirected orders were routed for

execution, the percentage of total nondirected orders for the section routed to

the venue, and the percentages of total

non-directed market orders, total nondirected limit orders, and total nondirected other orders for the section that

were routed to the venue; and

(iii) A discussion of the material

aspects of the broker’s or dealer’s

relationship with each venue identified

pursuant to paragraph (b)(1)(ii) of this

section, including a description of any

arrangement for payment for order flow

and any profit-sharing relationship.

Federal Register / Vol. 65, No. 232 / Friday, December 1, 2000 / Rules and Regulations 75439

1For example, in August 1999, only 32% of

equity options classes were traded on more than

one exchange. By the end of September 2000, the

number of equity options classes that were

multiply-traded had risen to 45%. In addition,

aggregate options volume traded only on a single

exchange fell from 61% to 15% over this same

period.

2 In accepting orders and routing them to an

exchange for execution, brokers act as agents for

their customers and owe them a duty of best

execution. A broker’s duty of best execution is

derived from common law agency principles and

fiduciary obligations. It is incorporated both in selfregulatory organizations’ rules and in the antifraud

provisions of the federal securities laws through

judicial and Commission decisions. This duty

requires a broker to seek the most favorable terms

reasonably available under the circumstances for a

customer’s transaction. As a result, brokers must

periodically assess the quality of competing

markets. See Securities Exchange Act Release No.

37619A (September 6, 1996), 61 FR 48290

(September 12, 1996).

(2) A broker or dealer shall make the

report required by paragraph (b)(1) of

this section publicly available within

one month after the end of the quarter

addressed in the report.

(c) Customer requests for information

on order routing. (1) Every broker or

dealer shall, on request of a customer,

disclose to its customer the identity of

the venue to which the customer’s

orders were routed for execution in the

six months prior to the request, whether

the orders were directed orders or nondirected orders, and the time of the

transactions, if any, that resulted from

such orders.

(2) A broker or dealer shall notify

customers in writing at least annually of

the availability on request of the

information specified in paragraph (c)(1)

of this section.

(d) Exemptions. The Commission

may, by order upon application,

conditionally or unconditionally

exempt any person, security, or

transaction, or any class or classes of

persons, securities, or transactions, from

any provision or provisions of this

section, if the Commission determines

that such exemption is necessary or

appropriate in the public interest, and is

consistent with the protection of

investors.

Dated: November 17, 2000.

By the Commission.

Jonathan G. Katz,

Secretary.

[FR Doc. 00–30131 Filed 11–30–00; 8:45 am]

BILLING CODE 8010–01–P

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 240

[Release No. 34–43591; File No. S7–17–00]

RIN 3235–AH96

Firm Quote and Trade-Through

Disclosure Rules for Options

AGENCY: Securities and Exchange

Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange

Commission (‘‘SEC’’ or ‘‘Commission’’)

is adopting an amendment to Rule

11Ac1–1 under the Securities Exchange

Act of 1934 (‘‘Exchange Act’’) to require

options exchanges and options market

makers to publish firm quotes. The

Commission also is adopting new Rule

11Ac1–7 under the Exchange Act to

require a broker-dealer to disclose to its

customer when its customer’s order for

listed options is executed at a price

inferior to a better published quote and

what that better quote was, unless the

transaction was effected on a market

that is a participant in an intermarket

options linkage plan approved by the

Commission. These rules will facilitate

the ability of market participants to

obtain the best price for customer

orders.

EFFECTIVE DATE: February 1, 2001.

FOR FURTHER INFORMATION CONTACT:

Deborah Flynn, Senior Special Counsel,

at (202) 942–0075, Kelly Riley, Special

Counsel, at (202) 942–0752, John

Roeser, Attorney, at (202) 942–0762,

Terri Evans, Special Counsel, at (202)

942–4162, and Heather Traeger,

Attorney, at (202) 942–0763, Division of

Market Regulation, Securities and

Exchange Commission, 450 Fifth Street,

NW., Washington, DC 20549–1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Executive Summary

II. Background

A. Prior Attempts to Limit Intermarket

Trade-Throughs

B. Application of the Quote Rule in the

Options Market

III. Description of Proposed Rulemaking

A. Proposed Trade-Through Disclosure

Rule

B. Proposed Amendments to the Quote

Rule

IV. Discussion

A. Trade-Through Disclosure Rule

1. Minimum Requirements for Linkage

Plans

2. Mandatory Participation in a Linkage

Plan

3. Exception from Disclosure Requirement

for Block Trades

4. Definition of Trade-Through

a. OPRA Delays

b. Systems Malfunctions

c. Relief from Firm Quote Obligation

d. Thirty-Second Delay

e. Trades Not Excluded from the Definition

of Trade-Through

5. Compliance Date

B. Amendments to the Quote Rule

1. Collecting and Making Available

Quotation Sizes

2. Firm Quote Sizes for Customer and

Broker-Dealer Orders

3. Minimum Quote Size

4. Automatic Execution Systems

5. Exception During Trading Rotations

6. Thirty-Second Response

7. One-Percent Exception

8. Amendments to Defined Terms

9. Compliance Date

V. Paperwork Reduction Act

A. Use and Disclosure of the Information

Collected

B. Trade-Through Disclosure Rule

1. Capital Costs

2. Burden Hours

C. Amendments to the Quote Rule

1. Capital Costs

2. Burden Hours

VI. Costs and Benefits of Final Rules

A. Costs and Benefits of the Trade-Through

Disclosure Rule

1. Comments

2. Benefits

3. Costs

B. Costs and Benefits of Amendments to

the Quote Rule

1. Comments

2. Benefits

1. Costs

C. Conclusion

VII. Effects on Competition, Efficiency, and

Capital Formation

VIII. Final Regulatory Flexibility Analysis

A. Need for, and Objectives of, the Rules

B. Significant Issues Raised by Public

Comment

C. Small Entities Subject to the Rules

D. Projected Reporting, Recordkeeping, and

Other Compliance Requirements

E. Agency Action to Minimize Effect on

Small Entities

IX. Statutory Authority

I. Executive Summary

Recent increases in the multiple

listing of options classes previously

listed on a single exchange have

intensified the competition among the

option exchanges and heightened the

need to further integrate the options

markets into the national market system.

The marked increase in multiple trading

is indicative of the dynamic

environment in which the options

markets currently operate.1 While the

growth in multiple trading has

increased the competition between

markets, it also has dramatically altered

the environment in which options

market participants conduct their

trading. In particular, multiple trading

raises new best execution challenges for

brokers.2 When an option is listed on

only one exchange, brokers do not have

to decide where to route an order, and

consequently, satisfying their best

execution obligations is simpler than

when they must consider the relative

merits of routing an order to two or

more market centers. With as many as

five options exchanges currently trading