[Federal Register Volume 65, Number 232 (Friday, December 1, 2000)]
[Rules and Regulations]
[Pages 75414-75439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30131]



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Part IV





Securities and Exchange Commission





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17 CFR Part 240



Disclosure of Order Execution and Routing Practice; and



Firm Quote and Trade-Through Disclosure Rules for Options; Final Rules

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

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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.

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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 phase-in 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 
Sec. 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 
broker-dealer for execution.
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    \1\ The 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 broker-dealers 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.
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    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,

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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 broker-dealer 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\
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    \2\ Source: 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.
    \3\ Source: NYSE. In addition, the American Stock Exchange LLC 
(``Amex'') accounted for 69.9% of share volume in Amex equities 
during September 2000. Source: Amex.
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    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 off-board 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\
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    \4\ Securities 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.
    \5\ These dealer practices are discussed in section IV.A.2 of 
the Fragmentation Release.
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    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 broker-dealers 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\
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    \6\ Securities Exchange Act Release No. 43084 (July 28, 2000), 
65 FR 48406.
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    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

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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.
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    \7\ Section 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.
    \8\ An 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).
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    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 year-long 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 
broker-dealers. 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\
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    \9\ See 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 broker-dealer'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.
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    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\
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    \10\ This estimate is described in the cost-benefit discussion 
in section VII.A.1 below.
    \11\ The 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.
    \12\ The 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.
    \13\ Commenters 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 non-marketable 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.
    \14\ Preferencing 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.
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    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

[[Page 75417]]

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.
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    \15\ See, 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'').
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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\
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    \16\ The 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.
    \17\ See, 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'').
    \18\ Letter 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'').
    \19\ Letter from Meng-yuan Wang, Executive Director of EMM, UBS 
Warburg, to Jonathan G. Katz, Secretary, SEC, dated Sept. 25, 2000, 
at 1.
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    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\

[[Page 75418]]

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\
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    \20\ CSE 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 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.
    \21\ Letter 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'').
---------------------------------------------------------------------------

    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 over-emphasize 
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.
---------------------------------------------------------------------------

    \22\ See, 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'').
---------------------------------------------------------------------------

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 over-emphasize 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.
---------------------------------------------------------------------------

    \23\ See, 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'').
---------------------------------------------------------------------------

    For example, the Commission previously has stated that a broker-
dealer 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.
---------------------------------------------------------------------------

    \24\ See, e.g., Securities Exchange Act Release No. 37619A 
(Sept. 6, 1996), 61 FR 48290 (``Order Handling Rules Release''), at 
section III.C.2.
---------------------------------------------------------------------------

    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 cutting-edge, 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

[[Page 75419]]

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\
---------------------------------------------------------------------------

    \25\ See, 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'').
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \26\ For 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
    \28\ A 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.
---------------------------------------------------------------------------

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

[[Page 75420]]

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 broker-dealer'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.
---------------------------------------------------------------------------

    \29\ SIA 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 
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.
---------------------------------------------------------------------------

    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 
broker-dealer'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 broker-dealers 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\
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    \30\ For 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.
    \31\ Exchange 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).
    \32\ Exchange Act Section 11A(a)(1)(C)(iv).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \33\ Similarly, 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).
    \34\ See id. at section III.C.2.
---------------------------------------------------------------------------

    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

[[Page 75421]]

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\
---------------------------------------------------------------------------

    \35\ A 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.
    \36\ When 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.
    \38\ The Commission's staff will be available to provide 
interpretive guidance to market centers on how orders should be 
reported under the Rule.
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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\
---------------------------------------------------------------------------

    \39\ See Division of Market Regulation, SEC, Report on 
Electronic Communications Networks and After-Hours 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).
    \40\ The 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.
    \41\ The full title of the Nasdaq Plan is ``Joint Self-
Regulatory 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.''
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \42\ One 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.
---------------------------------------------------------------------------

    Two types of orders warrant further discussion. The first type--
immediate-or-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. 
Immediate-or-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

[[Page 75422]]

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, ``mid-point pricing,'' 
pursuant to which both buy and sell orders are executed at the midpoint 
of the opening quoted bid and offer.\43\
---------------------------------------------------------------------------

    \43\ The 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.
---------------------------------------------------------------------------

    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 
broker-dealer'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 exchange-listed 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.
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    \44\ Rule 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.
    \45\ See NASD Economic Research Dept., 
http://www.marketdata.nasdaq.com (visited June 27, 2000).
---------------------------------------------------------------------------

    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 
security-by-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.
---------------------------------------------------------------------------

    \46\ Interactive Brokers Letter, Note 17 above, at 4.
    \47\ Letter from Thomas A. Bond, Chicago Board Options Exchange, 
to Jonathan G. Katz, Secretary, SEC, dated Oct. 9, 2000 at 3 (``CBOE 
Letter'').

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[[Page 75423]]

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.
---------------------------------------------------------------------------

    \48\ Phlx Letter, note 25 above, at 4; CSE Letter, note 13 
above, at 6-7; Schwab Letter, note 21 above, at 10-11.
---------------------------------------------------------------------------

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.
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    \49\ A 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.
---------------------------------------------------------------------------

    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 non-manipulatory 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.
---------------------------------------------------------------------------

    \50\ Interactive Brokers Letter, note 17 above, at 3-4.
---------------------------------------------------------------------------

    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 non-marketable 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 at-the-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.
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    \51\ The 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.
---------------------------------------------------------------------------

    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

[[Page 75424]]

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.
---------------------------------------------------------------------------

    \52\ The 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 
five-minute time period in the Rule as adopted.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \53\ See, 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.
---------------------------------------------------------------------------

    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 non-marketable 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\
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    \54\ For 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).
---------------------------------------------------------------------------

    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

[[Page 75425]]

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 non-marketable 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.
---------------------------------------------------------------------------

    \55\ See, e.g., TAG Letter, note 17 above, at 5; Edward Jones 
Letter, note 15 above, at 3.
    \56\ See, e.g., NASD Letter, note 49 above, at 5; Schwab Letter, 
note 21 above, at 9-10.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \57\ Section 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.
---------------------------------------------------------------------------

    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

[[Page 75426]]

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.
---------------------------------------------------------------------------

    \58\ See, 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.
    \59\ NASD Letter, note 49 above, at 4; CHX Letter, note 25 
above, at 11; Edward Jones Letter, note 15 above, at 4.
    \60\ Morgan Stanley Letter, note 15 above, at 15; Schwab Letter, 
note 21 above, at 3-4; Wilkie Farr & Gallagher Letter, note 29 
above, at 3.
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    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, 
broker-dealers 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 broker-dealer'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\
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    \61\ To 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.
---------------------------------------------------------------------------

    Finally, Rule 11Ac1-6 applies to all types of orders (e.g., pre-
opening orders and short sale orders), but broker-dealers must give an 
overview of their routing practices only for ``non-directed orders.'' 
Paragraph (a)(5) defines a non-directed 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-of-quarter 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

[[Page 75427]]

respect, Rule 11Ac1-6 is unlike Rule 11Ac1-5, which requires market 
centers to categorize their orders on a security-by-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 broker-dealer 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 non-
directed 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 broker-dealers may route a relatively small 
number of orders to many different venues.\64\ Disclosure therefore has 
been limited to the most significant venues.\65\
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    \63\ The 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 non-
directed 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).
    \64\ Schwab 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.
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    For each of the venues identified in each section of the report, 
the broker-dealer 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, non-directed 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 broker-dealer 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 order-routing 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 non-directed orders. An example would be the extent of the 
ownership relation

[[Page 75428]]

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 
broker-dealers, 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 non-directed 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.
---------------------------------------------------------------------------

    \66\ Currently, Rule 10b-10(a)(1) requires a broker-dealer 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.
---------------------------------------------------------------------------

    With Rule 11Ac1-6, those customers interested in monitoring the 
broker-dealer'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 broker-dealers 
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.
---------------------------------------------------------------------------

    \67\ 44 U.S.C. 3501 et seq.
    \68\ 44 U.S.C. 3507.
---------------------------------------------------------------------------

    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

[[Page 75429]]

orders, fair competition among broker-dealers 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.
---------------------------------------------------------------------------

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

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\
---------------------------------------------------------------------------

    \70\ Knight Trading Letter, note 17 above, at 6, 9.
    \71\ ICI Letter, note 15 above, at 5.
    \72\ TAG Letter, note 17 above, at 2.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \73\ See, 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.
    \74\ Wilkie Farr & Gallagher Letter, note 29 above, at 4.
    \75\ CHX Letter, note 25 above, at 6.
    \76\ Phlx Letter, note 25 above, at 3.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
    \78\ For 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.
    \79\ The 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.
---------------------------------------------------------------------------

    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

[[Page 75430]]

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 broker-dealer's orders must be disclosed.
---------------------------------------------------------------------------

    \80\ See, 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.
---------------------------------------------------------------------------

    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 broker-dealers respond to 
customer requests for order information will help assure that customers 
can obtain the data they need to evaluate the quality of their broker-
dealer'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.
---------------------------------------------------------------------------

    \81\ Schwab 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 broker-dealers' 
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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \83\ See BRUT Letter, note 77 above, at 1.
    \84\ These 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.
---------------------------------------------------------------------------

    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 broker-dealers 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

[[Page 75431]]

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 non-directed 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.
---------------------------------------------------------------------------

    \85\ This 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \86\ Securities Exchange Act Release No. 40122 (June 30, 1998), 
63 FR 35508, n. 65.
    \87\ This estimate is based on FYE 1999 FOCUS Reports received 
by the Commission.
---------------------------------------------------------------------------

    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  x  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 broker-dealers 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.
---------------------------------------------------------------------------

    \88\ As 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).
---------------------------------------------------------------------------

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 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.
    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 broker-dealer 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

[[Page 75432]]

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 broker-dealers 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 broker-dealer 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 broker-dealer. 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 broker-dealers 
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.
---------------------------------------------------------------------------

    \89\ These 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.
    \90\ Under this assumption, annual savings to Nasdaq investors 
would be approximately $175 million. These savings are calculated in 
the manner described in the preceding note.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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

    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.
---------------------------------------------------------------------------

    \92\ The Mercatus Center's comment letter addresses the 
potential benefits associated with more frequent rebalancing, but 
ignores the potential changes in securities that investors choose.
---------------------------------------------------------------------------

    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

[[Page 75433]]

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\
---------------------------------------------------------------------------

    \93\ Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-
Ask Spread, 17 J. Financial Economics 223 (1986).
    \94\ Michael J. Brennan & Avanidhar Subrahmanyam, Market 
Microstructure and Asset Pricing: On the Compensation for 
Illiquidity in Stock Returns, 41 J. Financial Economics 441 (1996).
    \95\ Both 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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \96\ Mercatus 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \97\ For 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.
---------------------------------------------------------------------------

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 broker-dealers) 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 cutting-edge, 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.

[[Page 75434]]

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 broker-dealers' 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.
---------------------------------------------------------------------------

    \98\ A 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \99\ 15 U.S.C. 78w(a).
    \100\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    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 broker-dealers 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 broker-dealers 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 broker-dealers to make disclosures of order 
routing information.
---------------------------------------------------------------------------

    \101\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------

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

[[Page 75435]]

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 
broker-dealers 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.
---------------------------------------------------------------------------

    \102\ Morgan Stanley Letter, note 15 above, at 18; Wilkie Farr & 
Gallagher Letter, note 29 above, at 4.
---------------------------------------------------------------------------

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 broker-
dealer 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\
---------------------------------------------------------------------------

    \103\ Exchange Act Rule 0-10(b), 17 CFR 240.0-10(c).
    \104\ These 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \105\ 17 CFR 240.0-10(e).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \106\ This estimate is based on the FYE 1999 FOCUS Reports 
received by the Commission from broker-dealers subject to Rule 
11Ac1-6.
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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  x  
($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 broker-
dealers, including those considered small entities. Under the Rule, 
broker-dealers 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, broker-dealers, 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

[[Page 75436]]

compliance costs that average $85 per hour, the aggregate cost for each 
small entity to comply with the Rule is estimated to be $2890.
---------------------------------------------------------------------------

    \107\ These estimates are smaller than those used generally to 
estimate the burden costs for purposes of the Paperwork Reduction 
Act. Assuming any of 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.
---------------------------------------------------------------------------

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 machine-readable 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:


Sec. 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

[[Page 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 broker-dealer 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 Sec. 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 non-marketable 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 Sec. 240.11Aa3-2(a)(2).
    (17) The term national market system security shall have the 
meaning provided in Sec. 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, at-the-quote limit orders, and near-the-quote 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;

[[Page 75438]]

    (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 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.
    (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.


Sec. 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 Sec. 240.11Aa3-2(a)(2).
    (7) The term national market system security shall have the meaning 
provided in Sec. 240.11Aa2-1.
    (8) The term payment for order flow shall have the meaning provided 
in Sec. 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 Sec. 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 non-directed 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 non-directed 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 non-directed orders for the section were routed for execution and 
of any venue to which five percent or more of non-directed orders were 
routed for execution, the percentage of total non-directed orders for 
the section routed to the venue, and the percentages of total non-
directed market orders, total non-directed limit orders, and total non-
directed 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.

[[Page 75439]]

    (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 non-directed 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