[Federal Register Volume 66, Number 89 (Tuesday, May 8, 2001)]
[Notices]
[Pages 23291-23308]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-11472]


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SECURITIES AND EXCHANGE COMMISSION

(Release No. 34-44233; File No. SR-PCX-00-25)


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
3 to Proposed Rule Change by the Pacific Exchange, Inc. Relating to the 
Archipelago Exchange

April 30, 2001.
    Pursuant to Section 19(b)(1) under the Securities Exchange Act of 
1934 (``Exchange Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is 
hereby given that on April 19, 2001, the Pacific Exchange, Inc. 
(``PCX'' or ``Exchange''), through its subsidiary PCX Equities, Inc. 
(``PCXE'' or ``Corporation''), filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') Amendment No. 3 to the proposed 
rule change as described in Items I, II and III below, which Items have 
been prepared by the PCXE. On December 15, 2000, the proposed rule 
change and Amendment No. 1 was published for comment in the

[[Page 23292]]

Federal Register.\3\ On February 27, 2001, the PCXE filed Amendment No. 
2 to the proposal.\4\ The Commission is publishing this notice to 
solicit comments on Amendment No. 3 to the proposed rule change from 
interested persons. The Commission is also publishing the PCX's 
Supplemental Response to Comment Letters as Appendix A, B, and C.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 43608 (Nov. 21, 
2000), 65 FR 78822 (Dec. 15, 2000) (``Arca Proposing Release'').
    \4\ See letter from Cherie Macauley, Wilmer, Cutler & Pickering, 
Counsel for the Exchange to John Polise, Senior Special Counsel, 
Division of Market Regulation, Commission, dated February 26, 2001 
(``Amendment No. 2''). The Commission does not believe that notice 
of Amendment No. 2 is necessary. Amendment No. 2 is similar to 
Amendment No. 3, but there are some substantive differences in 
Amendment No. 3 that supersede Amendment No. 2. Amendment No. 2 is 
publicly available in the Commission's Public Reference Room and the 
PCX's principal place of business.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The PCX, through its wholly owned subsidiary PCXE, is proposing to 
create a new electronic trading facility of the PCXE, called the 
Archipelago Exchange (``ArcaEx'' or ``Arca''). The proposed changes to 
the proposed rules, as published in the Arca Proposing Release, are 
below.
    Additions are in italics; Deletions are in [brackets].

Rules of PCX Equities, Inc.

* * * * *

Rule 1

Definitions

    Rule 1.1--No change.
    (a)-(p)--No change.

Imbalance

    (q) For the purposes of the Opening Auction, [and] the Market Order 
Auction and the Trading Halt Auction, as the case may be, the term 
``Imbalance'' shall mean the number of buy or sell shares [orders] that 
can not be matched with other shares [orders] at the Indicative Match 
Price at any given time.

Indicative Match Price

    (r) For the purposes of the Opening Auction, [or] the Market Order 
Auction and the Trading Halt Auction, as the case may be, the term 
``Indicative Match Price'' shall mean for each security (1) the price 
at which the maximum volume of shares [orders] are executable; or (2) 
if there are two or more prices at which the maximum volume of shares 
[orders] are executable, the price that is closest to the closing price 
of the previous trading day's normal market hours, as determined by the 
Consolidated Tape.
    (s)-(w)--No change.

NASD

    (x) The term ``NASD'' shall mean the National Association of 
Securities Dealers, Inc.

Nasdaq

    (y) The term ``Nasdaq'' shall mean The Nasdaq Stock Market, Inc.

Nasdaq Market Maker

    (z) The term ``Nasdaq Market Maker'' shall mean (1) a Nasdaq market 
maker as defined in NASD Rule 4200(a)(22), as amended from time to 
time, or (2) an electronic communications network (``ECN'').

Nasdaq/NM Security

    (aa) The term ``Nasdaq/NM Security'' shall mean any security (i) 
designated as a national market system security pursuant to the NASD's 
``National Market System Securities Designation Plan with respect to 
Nasdaq Securities,'' filed with and approved by the Commission pursuant 
to SEC Rule 11Aa2-1 under the Exchange Act and (ii) that is either 
listed on the Corporation pursuant to Rule 5 or as to which unlisted 
trading privileges have been granted pursuant to Section 12(f) of the 
Exchange Act.

Nasdaq System

    (bb) The term ``Nasdaq System'' shall mean the system operated by 
Nasdaq.

Nasdaq System BBO

    (cc) The term ``Nasdaq System BBO'' shall mean the best bid or 
offer that is disseminated pursuant to SEC Rule 11Ac1-1 among the 
Nasdaq System participants in those issues that are traded on the 
Nasdaq System.
    (dd)-(gg) [(x)-(aa)]--No change.

OTC/UTP Participant

    (hh) The term ``OTC/UTP Participant'' shall mean any registered 
national securities exchange or national securities association that is 
a signatory to the OTC/UTP Plan.

OTC/UTP Plan

    (ii) The term ``OTC/UTP Plan'' shall mean the Nasdaq National 
Market/Unlisted Trading System/ Unlisted Trading Privileges Plan, as 
from time to time amended according to its provisions.

OTC/UTP Primary Market

    (jj) The term ``OTC/UTP Primary Market'' for a Nasdaq/NM Security 
means Nasdaq; provided, however, that if for any 12-month period the 
number of reported transactions and the reported share volume in a 
Nasdaq/NM Security in any other OTC/UTP Participant's market exceeds 
50% of the aggregate reported transactions and reported share volume of 
all OTC/UTP Participants in such security, then that OTC/UTP 
Participant's market shall be the OTC/UTP Primary Market.

OTC/UTP Regulatory Halt

    (kk) The term ``OTC/UTP Regulatory Halt'' means a trade suspension 
or halt called by the OTC/UTP Primary Market for the purpose of 
dissemination of material news.
    (ll)-(uu) [(bb)-(kk)]--No change.

Sponsorship Provisions

    (vv) [(ll)] The term ``Sponsorship Provisions'' shall mean the 
provisions set [sent] forth in Rule 7.29(b)(2). For a Sponsored 
Participant to obtain authorized access to the Archipelago Exchange, 
the Sponsored Participant and its Sponsoring ETP Holder must enter into 
an agreement which incorporates the Sponsorship Provisions.
    (ww)-(aaa) [(mm)-(qq)]--No change.
* * * * *

Rule 2

Equity Trading Permits

    Rules 2.1-2.4--No change.

[Publication of Approved ETP Applications]

    Rule 2.5. Reserved. [With respect to each ETP that is issued, the 
Corporation shall promptly distribute a notice thereof to all ETP 
Holders by publishing the name of each new ETP Holder in the 
Corporation's Weekly Bulletin.]
    Rules 2.6-2.100--No change.
* * * * *

Rule 7

Equities Trading

    Rules 7.1-7.5--No change.

Trading Differentials

    Rule 7.6(a)--No change.
    Commentary:
    .01-.04--No change.
    .05 The minimum price variation (``MPV'') for equity securities 
traded on the Archipelago Exchange shall be [1/64 of $1.00 for those 
securities that are quoted in fractions and] $0.01 [for those equity 
securities that are quoted in decimals]; provided, however, at all 
times the MPV shall be consistent with the Decimalization 
Implementation Plan.
    .06 The minimum price improvement increment (``MPII'') on the 
Archipelago

[[Page 23293]]

Exchange shall be equal to $0.01 or 10% of the NBBO spread, whichever 
is more.
    (b)--No change.
    Rules 7.7 -7.17--No change.

Trading in Nasdaq/NM Securities

    Rule 7.18[. Reserved.] (a) Access.
    (1) The Corporation shall permit each Nasdaq Market Maker, acting 
in its capacity as a market maker, telephone access, or such other 
access as may be established between the Corporation and the Nasdaq 
System (collectively, ``approved access''), to the Corporation for each 
Nasdaq/NM Security in which such market maker is registered as a market 
maker. Such approved access shall include appropriate procedures to 
assure the timely response to communications received through telephone 
or other approved access.
    (2) Nasdaq Market Makers may use such approved access to transmit 
orders for execution on the Corporation. Market Makers, via the 
facilities of the Corporation, may send orders via approved access to 
any Nasdaq Market Maker in each Nasdaq/NM security in which it displays 
quotations.
    (3) Any order received via approved access from a Nasdaq Market 
Maker shall be effected in accordance with the Rules of the Corporation 
applicable to transactions on the Archipelago Exchange.
    (4) No Market Maker shall permit the imposition of any access or 
execution fee, or any other fee or charge, with respect to transactions 
in Nasdaq/NM Securities effected with Nasdaq Market Makers that are 
communicated to the Corporation through telephone access.
    (b) Display. The Corporation will display on the Archipelago 
Exchange, at a minimum, the Nasdaq System BBO.
    (c) OTC/UTP Regulatory Halts. Whenever, in the exercise of its 
regulatory function, the OTC/UTP Primary Market for a Nasdaq/NM 
Security determines that an OTC/UTP Regulatory Halt is appropriate, the 
Corporation shall halt or suspend trading in that security until the 
notification by the OTC/UTP Primary Market that the halt or suspension 
is no longer in effect. The Corporation will assume that adequate 
publication or dissemination has occurred upon the expiration of one 
hour after initial publication in a national news dissemination service 
of the information that gave rise to an OTC/UTP Regulatory Halt and 
may, at its discretion, re-open trading at that time, notwithstanding 
notification from the OTC/UTP Primary Market that the halt or 
suspension is no longer in effect.
    (d) Applicability. The following Rules of the Corporation will not 
be applicable to transactions on the Corporation in Nasdaq/NM 
Securities: Rules 7.16, 7.55-7.57.
    Rules 7.19-7.22--No change.

Obligations of Market Makers

    Rule 7.23(a). General. ETP Holders who are registered as Market 
Makers in one or more securities traded on the Corporation must engage 
in a course of dealings for their own account to assist in the 
maintenance, insofar as reasonably practicable, of fair and orderly 
markets on the Corporation in accordance with this Rule. The 
responsibilities and duties of a Market Maker specifically include, but 
are not limited to, the following:
    (1)-(5)--No change.
    (6) [Enter and maintain a] Maintain one Cleanup Order in each 
security in which the Market Maker is registered as such for each 
Market Order Auction.
    (b)-(d)--No change.
    Rules 7.24-7.30--No change.

Orders and Modifiers

    Rule 7.31.
    (a)-(e)--No change.
    (f) Tracking Order.
    (1)-(6)--No change.
    (7) The Corporation shall suspend the Tracking Order Process for a 
security when a locked or crossed market exists in that security. The 
Tracking Order Process for that security shall resume when the locked 
or crossed market in that security no longer exists.
    (8)[(7)]--No change.
    (g)-(h)--No change.
    (i) Directed Order.
    (1) Any market or limit order to buy or sell which has been 
directed to a particular Market Maker by the User.
    (2) The Corporation shall suspend the Directed Order Process for a 
security when a locked or crossed market exists in that security. The 
Directed Order Process for that security shall resume when the locked 
or crossed market in that security no longer exists.
    (j)-(r)--No change.
    (s) Cross Order. A two-sided order with instructions to match the 
identified buy-side with the identified sell-side at a specified price 
(the ``cross price''). For the purposes of this Rule 7.31(s), an order 
of block size shall have the same meaning as set forth in Rule 7.57. A 
Cross Order will be executed as follows; provided, however, no Cross 
Orders shall be matched at the cross price without interacting with any 
orders in the Arca Book unless the cross price improves the BBO by the 
MPII:
    (1)--No change.
    (2) If the cross price is outside the NBBO,
    (A) and the cross price is between the BBO,
    (i) first, the portion of the Cross Order that may be executed in 
another market shall be routed away for execution [pursuant to Section 
5 of Rule 7]; and
    (ii) then, the remainder of the Cross Order shall be matched at the 
cross price without interacting with any orders in the Arca Book.
    (B) and the cross price is at the BBO,
    (i) first, the portion of the Cross Order that may be executed in 
another market shall be routed away for execution [pursuant to Section 
5 of Rule 7];
    (ii)-(iii)--No change.
    (C) and the cross price is outside the BBO,
    (i) and the NBBO is better than the BBO,
    (1) first, the portion of the Cross Order that may be executed in 
another market shall be routed away for execution [pursuant to Section 
5 of Rule 7];
    (2)-(3)--No change.
    (ii) and the NBBO equals the BBO,
    (1)--No change.
    (2) then, the portion of the Cross Order that may be executed in 
another market shall be routed away for execution [pursuant to Section 
5 of Rule 7];
    (3)--No change.
    (t) Auction-Only Limit Order. A limit order that is to be executed 
only during the Market Order Auction or the Trading Halt Auction, as 
the case may be.
    (u) Cleanup Order.
    (1)(A) [Only Market Makers may submit] Cleanup Orders may be 
submitted on behalf of Market Makers only [to the Archipelago 
Exchange]. Cleanup Orders may not be submitted on behalf of any Users 
other than Market Makers.
    (B) Archipelago Exchange, on behalf of each Market Maker, will 
submit each Cleanup Order.
    (C) Only one Cleanup Order per security may be submitted on behalf 
of each Market Maker.
    (2) Cleanup Orders must be submitted [to the Archipelago Exchange] 
before 6:15 am (Pacific Time) and remain in effect until the conclusion 
of the Market Order Auction.
    (3)-(5)--No change.
    (6) Cleanup Orders will only be executed if:
    (A) There is an Imbalance [of Market Orders] at the conclusion of 
the Market Order Auction, as provided in Rule 7.35; and
    (B) The Imbalance is less than or equal to the aggregate size of 
all Cleanup Orders in the relevant security.
    (7)-(8)--No change.
    (v)-(w)--No change.
    (x) Primary Only Order (PO Order). For exchange-listed securities 
only, a

[[Page 23294]]

market order that is to be routed as a market-on-open order to the 
primary market for participation in the primary market opening or re-
opening process.
    (1) A PO Order entered for participation in the primary market 
opening must be entered before 6:28 am (Pacific Time) and it will not 
be included in the Market Order Auction.
    (2) A PO Order entered for participation in the primary market re-
opening after a trading halt must be entered after trading was halted 
on the Corporation and before the Re-Opening Time. The PO Order will 
not be included in the Trading Halt Auction.
    Rules 7.32-7.33--No change.

Trading Sessions

    Rule 7.34(a)--No change.
    (b) Market Maker Obligations.
    (1) [During the Core Trading Session,] Market Makers will be 
obligated to enter Q Orders in securities in which they are registered 
in accordance with Rule 7.23, beginning at the start of the Core 
Trading Session or at such earlier time during the Opening Session as 
determined from time to time by the Corporation, and continuing until 
the end of the Core Trading Session. [by the time Core Trading Hours 
begin. During the Opening Session and the Late Trading Session,] Market 
Makers are not obligated to enter Q Orders in securities in which they 
are registered at any times other than those established pursuant to 
the previous sentence.
    (2) Market Makers [are required to enter at least] must maintain 
one Cleanup Order for all securities in which they are registered for 
each Market Order Auction.
    (c)--No change.
    (d) Orders Permitted in Each Session.
    (1) During the Opening Session:
    (A) Orders eligible for the Display Order Process [(other than Q 
Orders)] and for the Working Order Process that have been designated as 
available for the Opening Session are eligible for entry into and 
execution on the Archipelago Exchange.
    (B)-(F)--No change.
    (G) Notwithstanding that the Market Order Auction occurs during the 
Opening Session, as set forth in Rule 7.34(a)(1), the following orders 
not designated for the Opening Session shall participate in the Market 
Order Auction:
    (i) Market orders designated for the Core Trading Session and 
entered prior to the conclusion of the Market Order Auction; and
    (ii) Limited Price Orders designated for the Core Trading Session 
and entered prior to 6:28 am (Pacific Time).
    (2)-(3)--No change.
    (e)-(f)--No change.

Opening Session Auctions

    Rule 7.35. (a) Order Entry and Cancellation Before Opening Auction
    (1)--No change.
    (2) Only Limited Priced Orders designated for the Opening Session 
will be eligible for the Opening Auction. Market orders entered before 
the Opening Auction or during the Opening Session will participate in 
the Market Order Auction. Limited Price Orders designated for the Core 
Trading Session and not designated for the Opening Session will become 
eligible for execution at the commencement of the Market Order Auction 
pursuant to Rule 7.35(c) [7.37 at the commencement of the Core Trading 
Session].
    (3)-(4)--No change.
    (b)--No change.
    (c) Market Order Auction.
    (1)--No change.
    (2) Reduction of Imbalances
    (A) Any Imbalance in the Market Order Auction may be reduced by new 
orders, entered on the side of the market opposite the Imbalance, 
pursuant to the following priority:
    (i) Market orders;
    (ii) Limited Price Orders eligible for the Opening Session;
    (iii) Limited Price Orders designated for the Core Trading Session 
and entered before 6:28 am (Pacific Time);
    (iv) Auction-Only Limit Orders; and
    (v) Cleanup Orders.
    (B) Between 6:28 am (Pacific Time) and the conclusion of the Market 
Order Auction, Limited Price Orders eligible for the Opening Session or 
the Core Trading Session may be cancelled, but Limited Price Orders not 
eligible for the Opening Session, market orders, Auction-Only Limit 
Orders and Cleanup Orders may not be cancelled.
    (C)--No change.
    (3) Determination of Market Order Auction Price
    (A) If there is no Imbalance, orders will be executed in the Market 
Order Auction at the Indicative Match Price as of 6:30 am (Pacific 
Time).
    (B) If an Imbalance exists, or if an equilibrium exists between buy 
market orders and sell market orders, as many buy market orders and 
sell market orders as possible shall be matched, on a time priority 
basis, once an NBBO is available,
    (i) at the midpoint of the NBBO at 6:30 am (Pacific Time), in the 
case of exchange-listed securities for which the Corporation is not the 
primary market; or
    (ii) at the midpoint of the NBBO at 6:30 am (Pacific Time), in the 
case of Nasdaq-listed securities, provided that the NBBO is not 
crossed; or
    (iii) at the midpoint of the first uncrossed NBBO after 6:30 am 
(Pacific Time), in the case of Nasdaq securities in which the NBBO is 
crossed but one side of the BBO is not crossed by the NBBO; or
    (iv) at the midpoint of the first uncrossed NBBO after 6:30 a.m. 
(Pacific Time), in the case of Nasdaq securities in which the NBBO is 
crossed and where both sides of the BBO are crossed by the NBBO; or
    ([i]v) at the bid (offer) of the BBO that was crossed prior to 6:30 
am (Pacific Time), in the case of Nasdaq securities in which the BBO is 
crossed by a market participant; or
    (vi) at the Indicative Match Price as of 6:30 am (Pacific Time) in 
the case of those issues for which the Corporation is the primary 
market. If equilibrium exists between buy and sell market orders, the 
match price shall be at the last Corporation sale price in the security 
regardless of the trading session[,provided, that,]; however, if the 
last Corporation sale price is lower than [inferior to] the BBO, the 
match price shall be the displayed bid in the security, or if the last 
Corporation sale price is higher than the BBO, the match price will be 
the displayed offer in the security [Corporation bid (offer)].
    Such executions shall be designated with a modifier to identify 
them as Market Order Auction trades. The market orders that are 
eligible for, but not executed in the Market Order Auction, shall 
become eligible for execution in the Core Trading Session immediately 
upon conclusion of the Market Order Auction.
    (d) [Reserved.] Re-Opening After Trading Halts. To re-open trading 
in a security following a trading halt in that security, the 
Archipelago Exchange shall conduct a Trading Halt Auction, as described 
below:
    (1) Re-Opening Time. After trading in a security has been halted, 
the Corporation shall disseminate the estimated time at which trading 
in that security will re-open (the ``Re-Opening Time'').
    (2) Publication of Indicative Match Price and Imbalances
    (A) Immediately after trading is halted in a security, and various 
times thereafter as determined from time to time by the Corporation, 
the Indicative Match Price of the Trading Halt Auction and the volume 
available to trade at such price, shall be published via electronic 
means as determined from time to time by the Corporation. If such a 
price does not exist (i.e., there is an Imbalance of market orders), 
the Archipelago Exchange shall indicate via

[[Page 23295]]

electronic means that an Indicative Match Price does not exist.
    (B) Immediately after trading is halted in a security, and various 
times thereafter as determined from time to time by the Corporation, 
the market order Imbalance associated with the Trading Halt Auction, if 
any, shall be published via electronic means as determined from time to 
time by the Corporation.
    (C) If the difference between the Indicative Match Price and the 
last price prior to the trading halt, as determined by the Consolidated 
Tape, is equal to or greater than a pre-determined amount, as 
determined from time to time by the Corporation, the Archipelago 
Exchange will assign a ``SIG'' designator to such Indicative Match 
Price and publish such designator via electronic means as determined 
from time to time by the Corporation.
    (3) Reduction of Imbalances
    (A) Any Imbalance in the Trading Halt Auction may be reduced by new 
orders, entered on the side of the market opposite the Imbalance, 
pursuant to the following priority:
    (i) Market orders;
    (ii) Limited Price Orders; and
    (iii) Auction-Only Limit Orders.
    (B) Primary Only Orders may be submitted to the Archipelago 
Exchange during a trading halt. Cleanup Orders are not eligible for 
execution in the Trading Halt Auction.
    (C) The Corporation, if it deems such action necessary, will 
disseminate the time, prior to the time that orders are matched 
pursuant to the Trading Halt Auction, at which orders may no longer be 
cancelled.
    (D) Interaction with ITS
    (i) If a pre-opening indication is required pursuant to the ITS 
Plan, the Corporation will disseminate three minutes prior to the Re-
Opening Time the applicable price range, consisting of the Indicative 
Match Price as one end of the price range and the Indicative Match 
Price plus an amount determined by the Corporation for the higher end 
of the price range.
    (ii) The Archipelago Exchange will treat any responses to a pre-
opening indication as an Auction-Only Limit Order.
    (E) Other market centers may use private communication connections 
to enter Auction-Only Limit Orders for a Trading Halt Auction.
    (4) Determination of Trading Halt Auction Price
    (A) For exchange-listed stocks:
    (i) If there is no Imbalance and no other market center has re-
opened trading in the security, orders will be executed in the Trading 
Halt Auction at the Indicative Match Price as of the Re-Opening Time.
    (ii) If an Imbalance exists, or if an equilibrium exists between 
buy market orders and sell market order, or if another market center 
has re-opened trading in the security, as many buy market orders and 
sell market orders as possible shall be matched, on a time priority 
basis, at the midpoint of the first uncrossed, unlocked NBBO, once an 
NBBO is available.
    (B) For Nasdaq stocks:
    (i) If there is no Imbalance, orders will be executed in the 
Trading Halt Auction at the Indicative Match Price as of the Re-Opening 
Time.
    (ii) If an Imbalance exists, or if an equilibrium exists between 
buy market orders and sell market orders, as many buy market orders and 
sell market orders as possible shall be matched, on a time priority 
basis, once an NBBO is available,
    (a) at the midpoint of the NBBO at the Re-Opening Time, provided 
that the NBBO is not crossed; or
    (b) at the midpoint of the first uncrossed NBBO after the Re-
Opening Time, in the case in which the NBBO is crossed, but one side of 
the BBO is not crossed by the NBBO; or
    (c) at the midpoint of the first uncrossed NBBO after the Re-
Opening Time, in the case in which the NBBO is crossed and where both 
sides of the BBO are crossed by the NBBO; or
    (d) at the bid (offer) of the BBO that was crossed prior to the Re-
Opening Time, in the case in which the BBO is crossed by a market 
participant; or
    (C) For those issues for which the Corporation is the primary 
market: Orders will be executed at the Indicative Match Price at the 
Re-Opening Time. If equilibrium exists between buy and sell market 
orders, the match price shall be at the last Corporation sale price in 
the security regardless of the trading session; however, if the last 
Corporation sale price is lower than the BBO, the match price shall be 
the displayed bid in the security, or if the last Corporation sale 
price is higher than the BBO, the match price will be the displayed 
offer in the security.
    (5) If any orders are not executed in their entirety during the 
Trading Halt Auction, then such orders shall be executed in accordance 
with Rule 7.37 after the completion of the Trading Halt Auction.
    (6) After the completion of the Trading Halt Auction, the 
Archipelago Exchange will re-open for trading the previously halted 
security in accordance with Rule 7.
    (e)--No change.
    (f) Whenever in the judgment of the Corporation the interests of a 
fair and orderly market so require, the Corporation may adjust the 
timing of the auctions set forth in this Rule.

Order Ranking and Display

    Rule 7.36. The Archipelago Exchange shall display to Users and 
other market participants all non-marketable limit orders in the 
Display Order Process. The Archipelago Exchange will also disseminate 
current consolidated quotations/last sale information, and such other 
market information as may be made available from time to time pursuant 
to agreement between the Corporation and other market centers.
    (a) Ranking. Orders of Users shall be ranked and maintained in the 
Display Order Process and/or Working Order Process of the Arca Book 
according to price-time priority, such that within each price level, 
all orders shall be organized by the time of entry in the following 
manner.
    (1) Display Order Process. Within the Display Order Process:
    (A)--No change.
    (B) The displayed portion of Reserve Orders (not the reserve size) 
shall be ranked at the specified limit price and the time of order 
entry. If the displayed portion of the Reserve Order is decremented 
such that 99 shares or fewer are displayed [in its entirety], the 
displayed portion of the Reserve Order shall be refreshed for
    (i) the displayed amount; or
    (ii) the entire reserve amount, if the remaining reserve amount is 
smaller than the displayed amount,
    from the reserve portion and shall be submitted and ranked at the 
specified limit price and the new time that the displayed portion of 
the order was refreshed.
    (C)--No change.
    (2)--No change.
    (b)-(c)--No change.

Order Execution

    Rule 7.37. Subject to the restrictions on short sales under Rule 
10a-1 under the Exchange Act, like-priced orders, bids and offers shall 
be matched for execution by following Steps 1 through 5 in this Rule; 
provided, however, for an execution to occur in any Order Process, the 
price must be equal to or better than the NBBO, unless the Archipelago 
Exchange has routed orders to all away markets at the NBBO.
    (a)-No change.
    (b) If an incoming marketable order has not been executed in its 
entirety pursuant to paragraph (a) of this Rule, any remaining part of 
the order shall be routed to the Display Order Process.

[[Page 23296]]

    (1) Step 2: Display Order Process.
    (A) An incoming marketable order shall first attempt to be matched 
for execution against orders in the Display Order Process at the 
display price of the resident order for the total amount of stock 
available at that price or for the size of the incoming order, 
whichever is smaller. For the purposes of this subsection, the size of 
an incoming Reserve Order includes the displayed and reserve size and 
the size of the portion of the Reserve Order resident in the Display 
Order Process is equal to its displayed size. If the incoming 
marketable order has not been executed in its entirety, the remaining 
part of the order shall be routed to the Working Order Process.
    (B)--No change.
    (2) Step 3: Working Order Process.
    (A)-(B)--No change.
    (C) If any change in the NBBO or other available away trading 
interest would cause a potential match between the away order and an 
order in the Working Order Process, a commitment to trade shall be sent 
to that market center or market participant pursuant to Step 5 below 
after having proceeded through Step 4.
    (c)--No change.
    (d) Step 5: Routing Away.
    (1)--No change.
    (2) If an order has not been executed in its entirety pursuant to 
paragraphs (a) through (c) of this Rule and it has not been designated 
as a Fill-or-Return, Fill-or-Return Plus Order or PNP Order, the order 
shall be routed for execution as follows:
    (A)(i) The order shall be routed, either in its entirety or as 
component orders, to another market center or market participant as a 
limit order priced at the quote published by the market center or 
market participant.
    (ii) Based upon a User's instruction, a marketable reserve order 
may be routed (1) serially as component orders, such that each 
component corresponds to the displayed size, or (2) only once in its 
entirety, including both the displayed and reserve portions.
    (B)-(E)--No change.
    (e)--No change.
    Rules 7.38-7.42--No change.

Use of Directed Order Process

    Rule 7.43[.Reserved.] It shall be considered conduct inconsistent 
with just and equitable principles of trade for a User to use the 
Directed Order Process for the purpose of bypassing otherwise 
applicable fees.
    Rules 7.44-7.64--No change.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the PCXE included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discusses any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The PCXE has prepared summaries, set forth in sections 
A, B and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    As discussed in detail in the Arca Proposing Release, the PCX 
proposes to establish rules for Arca, a new exchange facility, as that 
term is defined in Section 3(a) of the Exchange Act.\5\ Arca, which is 
operated by Archipelago Exchange, L.L.C., is an electronic securities 
communications and trading facility intended for the use of ETP Holders 
and their customers. Arca would provide automatic order execution 
capabilities in the equity securities listed or traded on the PCXE. 
Arca would operate in place of PCXE's traditional floor trading 
facilities. In addition to certain minor changes, like renumbering 
rules,\6\ the PCXE proposes the following substantive changes to the 
proposed rule changes set forth in the Arca Proposing Release.\7\
---------------------------------------------------------------------------

    \5\ 15 U.S.C. 78c(a).
    \6\ In addition to the proposed rule changes, the PCX proposes 
several corrections to the text of the Arca Proposing Release:
    (1) Section 2(c)(iv) (Order Execution), footnote 82--Footnote 82 
should read `` `Marketable' means, for a Limited Price Order, the 
price crosses or matches the NBBO on the other side of the market. 
Market orders are always considered marketable.'' See Arca Proposing 
Release at 78827.
    (2) Section 2(c)(vii) (Opening Session Auctions)--In the second 
paragraph under ``Opening Auctions,'' the references to ``the last 
.T sale'' should be replaced with the phrase ``the prior day's 
closing price.'' See Arca Proposing Release at 78832.
    (3) Section 2(c)(vii) (Opening Session Auctions)--Example 3 of 
the Market Order Auction should be deleted. See Arca Proposing 
Release at 78833.
    \7\ See Arca Proposing Release, note 3, supra.
---------------------------------------------------------------------------

a. Implementation of OTC/UTP Plan
    To implement the OTC/UTP Plan, the PCX proposes the addition of 
Proposed Rule 7.18--``Trading in Nasdaq/NM Securities''--as well as a 
number of new definitions in Proposed Rule 1. These rule revisions are 
described below.
i. Definitions
    The PCX introduces the following new terms in Proposed Rule 1:
    (1) Proposed Rule 1.1(x)--PCXE has inserted as Proposed Rule 1.1(x) 
the following definition of the term ``NASD'' shall mean ``the National 
Association of Securities Dealers, Inc.''
    (2) Proposed Rule 1.1(y)--PCXE has added the definition of the term 
``Nasdaq'' as Proposed Rule 1.1(y). ``Nasdaq'' means ``The Nasdaq Stock 
Market, Inc.''
    (3) Proposed Rule 1.1(z)--PCXE has added the definition of the term 
``Nasdaq Market Maker'' as Proposed Rule 1.1(z). A ``Nasdaq Market 
Maker'' shall mean (1) a Nasdaq market maker as defined in NASD Rule 
4200(a)(22), as amended from time to time, or (2) an electronic 
communications network (``ECN'').
    (4) Proposed Rule 1.1(aa)--PCXE has added as Proposed Rule 1.1(aa) 
the definition of the term ``Nasdaq/NM Security,'' which means ``any 
security (i) designated as a national market system security pursuant 
to the NASD's `National Market System Securities Designation Plan with 
respect to Nasdaq Securities,' filed with and approved by the 
Commission pursuant to SEC Rule 11Aa2-1 under the Exchange Act and (ii) 
that is either listed on the Corporation pursuant to Rule 5 or as to 
which unlisted trading privileges have been granted pursuant to Section 
12(f) of the Exchange Act.''
    (5) Proposed Rule 1.1(bb)--PCXE has inserted the definition of the 
term ``Nasdaq System'' as Proposed Rule 1.1(bb). ``Nasdaq System'' 
means ``the system operated by Nasdaq.''
    (6) Proposed Rule 1.1(cc)--PCXE has added the definition of the 
term ``Nasdaq System BBO'' as Proposed Rule 1.1(cc). ``Nasdaq System 
BBO'' means ``the best bid or offer that is disseminated pursuant to 
SEC Rule 11Ac1-1 among the Nasdaq System participants in those issues 
that are traded on the Nasdaq System.''
    (7) Proposed Rule 1.1(hh)--PCXE has added the definition of the 
term ``OTC/UTP Participant'' as Rule 1.1(hh). ``OTC/UTP Participant'' 
is defined as ``any registered national securities exchange or national 
securities association that is a signatory to the OTC/UTP Plan.''
    (8) Proposed Rule 1.1(ii)--PCXE has inserted the definition of the 
term ``OTC/UTP Plan as Proposed Rule 1.1(ii). ``OTC/UTP Plan'' shall 
mean ``the Nasdaq National Market/Unlisted Trading System/Unlisted 
Trading Privileges Plan, as from time to time amended according to its 
provisions.''

[[Page 23297]]

    (9) Proposed Rule 1.1(jj)--PCXE has inserted the definition of the 
term ``OTC/UTP Primary Market'' as Proposed Rule 1.1(jj). ``OTC/UTP 
Primary Market'' for a Nasdaq/NM Security ``means Nasdaq; provided, 
however, that if for any 12-month period the number of reported 
transactions and the reported share volume in a Nasdaq/NM Security in 
any other OTC/UTP Participant's market exceeds 50% of the aggregate 
reported transactions and reported share volume of all OTC/UTP 
Participants in such security, then that OTC/UTP Participant's market 
shall be the OTC/UTP Primary Market.''
    (10) Proposed Rule 1.1(kk)--PCXE has inserted the definition of 
``OTC/UTP Regulatory Halt'' as Proposed Rule 1.1(kk). An ``OTC/UTP 
Regulatory Halt'' is ``a trade suspension or halt called by the OTC/UTP 
Primary Market for the purpose of dissemination of material news.''
ii. Trading in Nasdaq/NM Securities
    To implement the OTC/UTP Plan for the PCXE, PCXE has added Proposed 
Rule 7.18, ``Trading in Nasdaq/NM Securities,'' which is described in 
more detail below.
    Paragraph (a) of Proposed Rule 7.18 describes access for trading 
Nasdaq/NM Securities. Paragraph (a)(1) reads: ``The Corporation shall 
permit each Nasdaq Market Maker, acting in its capacity as a market 
maker, telephone access, or such other access as may be established 
between the Corporation and the Nasdaq System (collectively, ``approved 
access''), to the Corporation for each Nasdaq/NM Security in which such 
market maker is registered as a market maker. Such approved access 
shall include appropriate procedures to assure the timely response to 
communications received through telephone or other approved access.'' 
Paragraph (a)(2) states that ``Nasdaq Market Makers may use such 
approved access to transmit orders for execution on the Corporation. 
Market Makers, via the facilities of the Corporation, may send orders 
via approved access to any Nasdaq Market Maker in each Nasdaq/NM 
security in which it displays quotations.'' Paragraph (a)(3) provides 
that ``[a]ny order received via approved access from a Nasdaq Market 
Maker shall be effected in accordance with the Rules of the Corporation 
applicable to transactions on the Archipelago Exchange.'' Paragraph 
(a)(4) reads: ``No Market Maker shall permit the imposition of any 
access or execution fee, or any other fee or charge, with respect to 
transactions in Nasdaq/NM Securities effected with Nasdaq Market Makers 
that are communicated to the Corporation through telephone access.''
    Paragraph (b) of Proposed Rule 7.18 states that ``[t]he Corporation 
will display on the Archipelago Exchange, at a minimum, the Nasdaq 
System BBO.''
    Paragraph (c), which describes OTC/UTP Regulatory Halts states: 
``Whenever, in the exercise of its regulatory function, the OTC/UTP 
Primary Market for a Nasdaq/NM Security determines that an OTC/UTP 
Regulatory Halt is appropriate, the Corporation shall halt or suspend 
trading in that security until the notification by the OTC/UTP Primary 
Market that the halt or suspension is no longer in effect. The 
Corporation will assume that adequate publication or dissemination has 
occurred upon the expiration of one hour after initial publication in a 
national news dissemination service of the information that gave rise 
to an OTC/UTP Regulatory Halt and may, at its discretion, re-open 
trading at that time, notwithstanding notification from the OTC/UTP 
Primary Market that the halt or suspension is no longer in effect.''
    Finally, paragraph (d) states that ``[t]he following Rules of the 
Corporation will not be applicable to transactions on the Corporation 
in Nasdaq/NM Securities: Rules 7.16, 7.55-7.57.''
b. Re-Opening After Trading Halts
    The PCX has introduced a procedure, called the Trading Halt 
Auction, for re-opening a security after a trading halt. The Trading 
Halt Auction is described in detail in Proposed Rule 7.35(d). Moreover, 
the definitions of certain auction-related terms have been revised to 
reflect this new procedure.
i. Definitions
    The following definitions have been revised to accommodate the 
Trading Halt Auction:
    (1) Proposed Rules 1.1(q) and (r)--The definitions of ``Imbalance'' 
and ``Indicative Match Price'' have been revised to indicate that these 
terms are applicable to the Trading Halt Auction as well as the Opening 
and Market Order Auctions.
    (2) Proposed Rule 7.31(t)--The definition of an Auction-Only Limit 
Order has been revised to state that it is a limit order that is to be 
executed during the Trading Halt Auction or the Market Order Auction.
    (3) Proposed Rule 7.31(x)--The definition of a Primary Only Order 
(``PO Order'') has been revised to clarify that a User may submit a PO 
Order for participation in the primary market re-opening process as 
well as the primary market opening process. Proposed Rule 7.31(x)(2) 
states that ``[a] PO Order entered for participation in the primary 
market re-opening after a trading halt must be entered after trading 
was halted on the Corporation and before the Re-Opening Time. The PO 
Order will not be included in the Trading Halt Auction.''
ii. Trading Halt Auction
    Subject to certain minor variations, the Trading Halt Auction, as 
described in Proposed Rule 7.35, operates in much the same fashion as 
the Market Order Auction. Specifically, to re-open trading in a 
security following a trading halt in that security, Arca will conduct a 
Trading Halt Auction, as described below.
    After trading in a security has been halted, the PCXE will 
disseminate the estimated time at which trading in that security will 
re-open. This estimated time will be designated the ``Re-Opening 
Time.'' Similarly, immediately after trading is halted in a security, 
and various times thereafter as determined from time to time by the 
PCXE, the Indicative Match Price of the Trading Halt Auction and the 
volume available to trade at such price, shall be published via 
electronic means as determined from time to time by the PCXE. If such a 
price does not exist (i.e., there is an Imbalance of market orders), 
Arca shall indicate via electronic means that an Indicative Match Price 
does not exist. In addition, immediately after trading is halted in a 
security, and various times thereafter as determined from time to time 
by the PCXE, the market order Imbalance associated with the Trading 
Halt Auction, if any, will be published via electronic means as 
determined from time to time by the PCXE. If the difference between the 
Indicative Match Price and the last price prior to the trading halt, as 
determined by the Consolidated Tape, is equal to or greater than a pre-
determined amount, as determined from time to time by the PCXE, Arca 
will assign a ``SIG'' designator to such Indicative Match Price and 
publish such designator via electronic means as determined from time to 
time by the PCXE.
    Any Imbalance in the Trading Halt Auction may be reduced by new 
orders entered on the side of the market opposite the Imbalance, 
pursuant to the following priority: (1) market orders; (2) Limited 
Price Orders; and (3) Auction-Only Limit Orders. Cleanup Orders are not 
eligible for execution in the Trading Halt Auction. Primary Only Orders 
may be submitted to Arca during a trading halt for execution in the 
primary market. The PCXE, if it deems such

[[Page 23298]]

action necessary, will disseminate the time, prior to the time that 
orders are matched pursuant to the Trading Halt Auction, at which 
orders may no longer be cancelled.
    During the Trading Halt Auction, Arca will interact with ITS as 
follows: If a pre-opening indication is required pursuant to the ITS 
Plan, the PCXE will disseminate three minutes prior to the Re-Opening 
Time the applicable price range, consisting of the Indicative Match 
Price as one end of the price range and the Indicative Match Price plus 
an amount determined by the PCXE for the higher end of the price range. 
Arca will treat any responses to a pre-opening indication as an 
Auction-Only Limit Order. In addition to ITS, other market centers may 
use private communication connections to enter Auction-Only Limit 
Orders for a Trading Halt Auction.
    Arca will determine the price of the Trading Halt Auction as 
follows: For exchange-listed stocks, if there is no Imbalance and no 
other market center has re-opened trading in the security, orders will 
be executed in the Trading Halt Auction at the Indicative Match Price 
as of the Re-Opening Time. However, if an Imbalance exists, or if an 
equilibrium exists between buy market orders and sell market order, or 
if another market center has re-opened trading in the security, as many 
buy market orders and sell market orders as possible shall be matched, 
on a time priority basis, at the midpoint of the first uncrossed, 
unlocked NBBO, once an NBBO is available.
    For Nasdaq stocks, if there is no Imbalance, orders will be 
executed in the Trading Halt Auction at the Indicative Match Price as 
of the Re-Opening Time. However, if an Imbalance exists, or if an 
equilibrium exists between buy market orders and sell market orders, as 
many buy market orders and sell market orders as possible shall be 
matched, on a time priority basis, once an NBBO is available: (1) at 
the midpoint of the NBBO at the Re-Opening Time, provided that the NBBO 
is not crossed; (2) at the midpoint of the first uncrossed NBBO after 
the Re-Opening Time, in the case in which the NBBO is crossed, but one 
side of the BBO is not crossed by the NBBO; (3) at the midpoint of the 
first uncrossed NBBO after the Re-Opening Time, in the case in which 
the NBBO is crossed and where both sides of the BBO are crossed by the 
NBBO; or (4) at the bid (offer) of the BBO that was crossed prior to 
the Re-Opening Time, in the case in which the BBO is crossed by a 
market participant.
    For those issues for which the Corporation is the primary market, 
orders will be executed at the Indicative Match Price at the Re-Opening 
Time. If equilibrium exists between buy and sell market orders, the 
match price shall be at the last Corporation sale price in the security 
regardless of the trading session. However, if the last Corporation 
sale price is lower than the BBO, the match price shall be the 
displayed bid in the security, or if the last Corporation sale price is 
higher than the BBO, the match price will be the displayed offer in the 
security.
    Finally, if any orders are not executed in their entirety during 
the Trading Halt Auction, then such orders shall be executed in 
accordance with Rule 7.37 after the completion of the Trading Halt 
Auction. In addition, after the completion of the Trading Halt Auction, 
Arca will re-open for trading the previously halted security in 
accordance with Rule 7.
c. Miscellaneous
    In addition to rule revisions related to trading in Nasdaq 
securities and the Trading Halt Auctions, the PCX proposes the 
following miscellaneous changes:
i. Rule 1--Definitions
    (1) Proposed Rules 1.1(q) and (r)--PCXE has changed the term 
``orders'' to ``shares'' in the definitions of ``Imbalance'' and 
``Indicative Match Price.''
ii. Rule 2--Equity Trading Permits
    (1) Proposed Rule 2.5--PCXE has deleted Rule 2.5, ``Publication of 
Approved ETP Applications.''
iii. Rule 7--Equities Trading
    (1) Proposed Rule 7.6(a), Comm. 05--In Commentary .05 of Proposed 
Rule 7.6(a), PCXE has deleted the reference to a minimum price 
variation (``MPV'') of 1/64th of $1.00 for those securities quoted in 
fractions, thereby limiting the MPV for equity securities traded on 
Arca to $0.01.
    (2) Proposed Rule 7.6(a), Comm. 06--PCXE has revised Commentary .06 
to Proposed Rule 7.6(a). To clarify the applicable spread, PCXE has 
inserted ``NBBO'' into the statement that the ``minimum price 
improvement increment (``MPII'') on the Archipelago Exchange shall be 
equal to $0.01 or 10% of the NBBO spread, whichever is more.''
    (3) Proposed Rules 7.23(a)(6), 7.31(u)(1)-(2) and 7.34(b)(2)--These 
proposed rules have been revised to clarify that (1) each Market Maker 
must maintain only one Cleanup Order and (2) Arca will submit each 
Cleanup Order on behalf of each Market Maker.
    (4) Proposed Rules 7.31(f)(7) and 7.31(i)(2)--Pursuant to these two 
proposed rules, the Corporation shall suspend the Directed and Tracking 
Order Processes for a security when a locked or crossed market exists 
in that security. The Directed and Tracking Order Processes for that 
security will resume when the locked or crossed market in that security 
no longer exists.
    (5) Proposed Rule 7.31(s)--PCXE has deleted the references to 
``Section 5 of Rule 7'' from the definition of a Cross Order.
    (6) Proposed Rule 7.31(u)(6)(A)--PCXE has deleted the phrase ``of 
Market Orders'' from paragraph (u)(6)(A) of the definition of a Cleanup 
Order.
    (7) Proposed Rule 7.34(b)(1)--Proposed Rule 7.34(b)(1) has been 
revised to clarify that Market Makers are obligated to enter Q Orders 
in securities in which they are registered beginning at the start of 
the Core Trading Session or at such earlier time during the Opening 
Session as determined from time to time by the PCXE, and continuing 
until the end of the Core Trading Session. Market Makers are not 
obligated to enter Q Orders at any other times that the PCXE is open 
for business.
    (8) Proposed Rules 7.34(d)(1)(G), 7.35(a)(2) and 
7.35(c)(2)(A)(iii)--These proposed rules have been revised to clarify 
that, although the Market Order Auction occurs during the Opening 
Session, the following orders, which have not been designated for the 
Opening Session will participate in the Market Order Auction: (1) 
Market orders designated for the Core Trading Session and entered prior 
to the conclusion of the Market Order Auction and (2) Limited Price 
Orders designated for the Core Trading Session and entered prior to 
6:28 am (Pacific Time).
    (9) Proposed Rule 7.35(c)(2)(B)--PCXE has added ``Limited Price 
Orders not eligible for the Opening Session'' to the list of order 
types that may not be cancelled between 6:28 am (Pacific Time) and the 
conclusion of the Market Order Auction.
    (10) Proposed Rule 7.35(c)(3)(B)--This section has been modified to 
indicate that, if the Market Order Auction price is based upon the NBBO 
under Proposed Rule 7.35(c), then the price will not be determined 
until an NBBO is available.
    (11) Proposed Rule 7.35(c)(3)(B)(iii)--This subparagraph has been 
revised to state ``at the midpoint of the first uncrossed NBBO after 
6:30 am (Pacific Time), in the case of Nasdaq securities in which the 
NBBO is crossed but one side of the BBO is not crossed by the NBBO.''

[[Page 23299]]

    (12) Proposed Rule 7.35(c)(3)(B)(iv)--Another pricing scenario has 
been added to the Market Order Auction. In this scenario, if an 
Imbalance exists, or if an equilibrium exists between buy market orders 
and sell market orders, as many buy market orders and sell market 
orders as possible shall be matched, on a time priority basis, once an 
NBBO is available, ``at the midpoint of the first uncrossed NBBO after 
6:30 a.m. (Pacific Time), in the case of Nasdaq securities in which the 
NBBO is crossed and where both sides of the BBO are crossed by the 
NBBO.''
    (13) Proposed Rule 7.35(c)(3)(B)(vi)--PCXE has clarified the 
wording of Proposed Rule 7.35(c)(3)(B)(vi) to state the following: 
``[I]f equilibrium exists between buy and sell market orders, the match 
price shall be at the last Corporation sale price in the security 
regardless of the trading session; however, if the last Corporation 
sale price is lower than the BBO, the match price shall be the 
displayed bid in the security, or if the last Corporation sale price is 
higher than the BBO, the match price will be the displayed offer in the 
security.''
    (14) Proposed Rule 7.35(f)--PCXE has added paragraph (f) to 
Proposed Rule 7.35, which reads ``[w]henever in the judgment of the 
Corporation the interests of a fair and orderly market so require, the 
Corporation may adjust the timing of the auctions set forth in this 
Rule.''
    (15) Proposed Rule 7.36(a)(1)(B)--PCXE has revised this paragraph 
to read: ``The displayed portion of Reserve Orders (not the reserve 
size) shall be ranked at the specified limit price and the time of 
order entry. If the displayed portion of the Reserve Order is 
decremented such that 99 shares or fewer are displayed, the displayed 
portion of the Reserve Order shall be refreshed for (1) the displayed 
amount; or (2) the entire reserve amount, if the remaining reserve 
amount is smaller than the displayed amount, from the reserve portion 
and shall be submitted and ranked at the specified limit price and the 
new time that the displayed portion of the order was refreshed.''
    (16) Proposed Rule 7.37(b)(2)(C)--PCXE has added the phrase ``after 
having proceeded through Step 4'' to the end of Proposed Rule 
7.37(b)(2)(C).
    (17) Proposed Rule 7.37(d)(2)(A)(ii)--In this Proposed Rule, PCXE 
has clarified that a marketable reserve order may be routed either (1) 
serially as component orders, such that each component corresponds to 
the displayed size or (2) only once in its entirety, including both the 
displayed and reserve portions.
    (18) Proposed Rule 7.43--PCXE has added Proposed Rule 7.43, ``Use 
of the Directed Order Process.'' Proposed Rule 7.43 states that ``[i]t 
shall be considered conduct inconsistent with just and equitable 
principles of trade for a User to use the Directed Order Process for 
the purpose of bypassing otherwise applicable fees.''
2. Statutory Basis
    The Exchange believes the proposed rule change is consistent with 
Section 6(b) of the Act,\8\ in general, and furthers the objectives of 
Section 6(b)(5),\9\ in particular, in that it is designed to promote 
just and equitable principles of trade, to foster cooperation and 
coordination with persons engaged in facilitating transactions in 
securities, and to remove impediments and perfect the mechanisms of a 
free and open market and to protect investors and the public interest.
---------------------------------------------------------------------------

    \8\ 15 U.S.C. 78f(b).
    \9\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is not necessary or appropriate 
in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received from Members, Participants, or Others

    Written comments on the proposed rule change were neither solicited 
nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will--
    (A) by order approve such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 3, including whether Amendment No. 3 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of 
the submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the PCX. All 
submissions should refer to Amendment No. 3 of File No. SR-PCX-00-25 
and should be submitted by May 29, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\10\
---------------------------------------------------------------------------

    \10\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret McFarland,
Deputy Secretary.

Appendix A

April 19, 2001.

VIA MESSENGER

John Polise, Division of Market Regulation, Securities and Exchange 
Commission, Mail Stop 1001, 450 Fifth Street, N.W., Washington, DC 
20549.

    Re: Archipelago Exchange: Supplemental Response to Comment 
Letters SR-PCX-00-25, Amendment No. 3
    Dear Mr. Polise: On behalf of the Pacific Exchange, Inc., via 
its wholly owned subsidiary PCX Equities, Inc., (collectively, 
``PCX''), we appreciate the opportunity to respond to the comment 
letters submitted to the Securities and Exchange Commission (``SEC'' 
or ``Commission'') regarding the Archipelago Exchange (``ArcaEx'') 
rule filing.\11\
---------------------------------------------------------------------------

    \11\ See Arca Proposing Release, note 3, supra.
---------------------------------------------------------------------------

    To date, nine commenters have submitted ten comment letters 
concerning ArcaEx.\12\

[[Page 23300]]

Five commenters fully supported the proposal.\13\ Of these five 
favorable letters, three represented PCX members. For example, the 
Los Angeles and San Francisco Specialists Associations stated that 
they ``strongly support the PCX's proposal and urge the [Commission] 
to approve this proposal as soon as possible.'' \14\ Similarly, D.A. 
Davidson wrote that it ``applauds the effort to create a New 
Marketplace which will level the playing field for all 
participants.'' \15\ In addition to member support, the ArcaEx 
proposal was received favorably by two established electronic 
marketplaces--the Cincinnati Stock Exchange (``CSE'') and the 
Arizona Stock Exchange (``AZX''). The CSE ``believes that the PCX 
proposal is an innovative approach that seeks to challenge the 
floor-based exchange models for the benefit of public investors.'' 
\16\ The AZX urged the Commission ``to expedite the PCX proposed 
rule change'' because it believes that it will help to resolve 
pressing market structure issues.\17\
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    \12\ Letter from Michael T. Dorsey, Senior Vice President, 
General Counsel and Secretary, Knight Trading Group, Inc., to 
Jonathan G. Katz, Secretary, SEC, dated Feb. 9, 2001 (``Knight 
Letter''); Letter from Steve Wunsch, President, Arizona Stock 
Exchange (``AZX''), to Jonathan G. Katz, Secretary, SEC, dated Feb. 
1, 2001 (``AZX Letter''); Letter from Robert R. Glauber, Chief 
Executive Officer and President, NASD Regulation, Inc. (``NASDR''), 
to Jonathan G. Katz, Secretary, SEC, dated Jan. 26, 2001 (``NASDR 
Letter''); Letter from Richard G. Ketchum, President, Nasdaq, to 
Jonathan G. Katz, Secretary, SEC, dated Jan. 22, 2001 (``Nasdaq II 
Letter''); Letter from Jeffrey T. Brown, Cincinnati Stock Exchange 
(``CSE''), to Jonathan G. Katz, Secretary, SEC, dated Jan. 8, 2000 
(``CSE Letter''); Letter from David Hultman, D.A. Davidson & Co., to 
Jonathan G. Katz, Secretary, SEC, dated Jan. 5, 2000 (``D.A. 
Davidson Letter''); Letter from Los Angeles Specialists Association 
(``LASA''), to Jonathan G. Katz, Secretary, SEC, dated Jan. 4, 2000 
(``LASA Letter''); Letter from San Francisco Specialists Association 
(``SFSA''), to Jonathan G. Katz, Secretary, SEC, dated Jan. 3, 2000 
(``SFSA Letter''); Letter from John F. Malitzis, Associate General 
Counsel, Nasdaq, to Jonathan G. Katz, Secretary, SEC, dated Dec. 28, 
2000 (``Nasdaq I Letter''); and Letter from Lanny A. Schwartz, 
Executive Vice President and General Counsel, Philadelphia Stock 
Exchange (``Phlx''), to Jonathan G. Katz, Secretary, SEC, dated Dec. 
21, 2000 (``Phlx Letter'').
    \13\ See AZX Letter; CSE Letter; D.A. Davidson Letter; SFSA 
Letter; and LASA Letter.
    \14\ SFSA Letter at 1 and LASA Letter at 1.
    \15\ 15 D.A. Davidson Letter at 1.
    \16\ CSE Letter at 1.
    \17\ AZX Letter at 1.
---------------------------------------------------------------------------

    In contrast, three commenters, including two traditional 
markets--Nasdaq and the Philadelphia Stock Exchange (``Phlx'')--and 
a wholesale market maker, Knight Trading Group, Inc. (``Knight'') 
opposed the ArcaEx rule change.\18\ In addition, NASD Regulation, 
Inc., (``NASDR'') submitted a comment letter, but did not express a 
view in favor of or in opposition to the filing.\19\ In this letter, 
the PCX addresses the various concerns expressed by the commenters, 
particularly Nasdaq, Phlx and Knight, about the ArcaEx proposal. As 
discussed in detail below, the PCX does not believe any of the 
concerns raised in the comment letters should serve as an impediment 
to approval of the rule filing.
---------------------------------------------------------------------------

    \18\ See Knight Letter; Nasdaq II Letter; Phlx Letter; and 
Nasdaq I Letter.
    \19\ See NASDR Letter.
---------------------------------------------------------------------------

I. ArcaEx is Properly Regulated as a Facility of an Exchange

    The PCX believes that, contrary to Nasdaq's assertions,\20\ 
ArcaEx is properly regulated as a facility of an exchange and not as 
an exchange itself. Section 3(a)(2) of the Securities Exchange Act 
of 1934 (``Exchange Act'') provides that:
the term ``facility'' when used with respect to an exchange includes 
its premises, tangible or intangible property whether on the 
premises or not, any right to the use of such premises or property 
or any service thereof for the purpose of effecting or reporting a 
transaction on an exchange (including, among other things, any 
system of communication to or from the exchange, by ticket or 
otherwise maintained by or with the consent of the exchange), and 
any right of the exchange to the use of any property or service.
---------------------------------------------------------------------------

    \20\ Nasdaq II Letter at 1-3.
---------------------------------------------------------------------------

    ArcaEx will use PCX equipment and personnel \21\ and involve the 
participation of PCX market makers. Furthermore, executions 
performed on ArcaEx will be regulated and reported as PCX trades. In 
addition, by supplying an electronic trading system for the use of 
the PCX members and their customers, ArcaEx will provide a ``service 
* * * for the purpose of effecting * * * a transaction on an 
exchange,'' thus providing the PCX the ``right of the exchange to 
the use of * * * [such] service.'' Because effecting and reporting 
ArcaEx matches involves the PCX's premises, property and services, 
ArcaEx will meet the definition of a ``facility'' of an exchange as 
defined in Section 3(a)(2) of the Exchange Act.
---------------------------------------------------------------------------

    \21\ As the Commission noted previously in other contexts, the 
PCX's use of Archipelago Exchange, L.L.C., personnel and equipment 
does not alter the determination that ArcaEx should be regulated as 
a facility. See Securities Exchange Act Release No. 41210 (Mar. 24, 
1999), 64 FR 15857 (Apr. 1, 1999) (approval order of Phlx's VWAP 
Trading System) (``VWAP Release'') (``The Commission notes that the 
Exchange's use of [Universal Trading Technologies Corporation's] 
personnel and equipment in operating the [VWAP] System does not 
alter the Commission's determination that the System is properly 
regulated as a facility of the Exchange.'').
---------------------------------------------------------------------------

    Regulating ArcaEx as a ``facility'' of the PCX is consistent 
with the approach the Commission has followed in other cases similar 
to the PCX and ArcaEx situation. For example, the Commission 
approved the PCX's proposal to establish an exchange facility called 
the PCX Application of the OptiMark System, which was a trading 
system owned and operated by an entity other than an exchange.\22\ 
Likewise, the Phlx, itself, has contracted with third parties to 
establish the VWAP Trading System as a facility of the Phlx.\23\ In 
neither of these circumstances did the Commission require the 
entities which contracted with the exchanges to create a facility to 
register as national securities exchanges themselves.
---------------------------------------------------------------------------

    \22\ See Securities Exchange Act Release No. 39086 (Sept. 17, 
1997), 62 FR 50036 (Sept. 24, 1997) (``PCX OptiMark Release''). See 
also Securities Exchange Act Release No. 41967 (Sept. 30, 1999), 64 
FR 54704 (Oct. 7, 1999) (approval order for Nasdaq Application of 
OptiMark System) (``Nasdaq OptiMark Release''); Securities Exchange 
Act Release No. 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 1999) 
(approval order for Chicago Match System) (``Chicago Match 
Release'').
    \23\ 23 VWAP Release.
---------------------------------------------------------------------------

    Because ArcaEx is a facility of the PCX, a rule filing 
conforming to the requirements of Section 19 of the Exchange Act and 
Rule 19b-4 thereunder is the appropriate regulatory format for 
soliciting comments and seeking Commission approval of the 
arrangement.\24\ Despite Nasdaq's statements to the contrary,\25\ 
there is no need to file a Form 1 for ArcaEx because the PCX is 
already registered as a national securities exchange. Again, the use 
of a Rule 19b-4 filing for the creation of a new exchange facility 
follows the procedure used, and accepted by the Commission, with 
regard to other exchange facilities.\26\ Correspondingly, PCX, as 
the registered national securities exchange for the facility, will 
amend its Form 1 to the extent revision is required by Rule 6a-2 
under the Exchange Act for the creation of the ArcaEx facility.\27\
---------------------------------------------------------------------------

    \24\ Similarly, pursuant to the requirements of Section 19 of 
the Exchange Act, the PCX intends to set forth in a separate rule 
filing the fees that will be charged for the use of ArcaEx services. 
See Knight Letter at 2-3.
    \25\ Nasdaq II Letter at 1-3.
    \26\ See, e.g., PCX OptiMark Release and VWAP Release. See also 
Nasdaq OptiMark Release and Chicago Match Release.
    \27\ Knight's argument that PCX's reliance on unlisted trading 
privileges is in some way inappropriate is incorrect. Knight Letter 
at 4. Under the Exchange Act, the PCX, as a registered national 
securities exchange, may trade securities listed on the PCX and/or 
securities admitted to unlisted trading privileges. See generally 
Section 12 of the Exchange Act.
---------------------------------------------------------------------------

II. The Relationship Between PCX and the ArcaEx Facility Satisfies the 
Regulatory Requirements of the Exchange Act

    The PCX believes that ArcaEx, as a facility of the PCX, is 
designed to operate in a manner that is consistent with the 
regulatory purposes of the Exchange Act. Nasdaq's concerns about 
ArcaEx's compliance with the securities laws as well as the SEC's 
ability to oversee the ArcaEx facility are unfounded.\28\ The 
relationship between PCX and the ArcaEx facility--in both a rules-
related context and a contractual context--ensures ArcaEx's 
compliance with the securities laws.
---------------------------------------------------------------------------

    \28\ Nasdaq II Letter at 3-6.
---------------------------------------------------------------------------

    First and foremost, the PCX will be fully responsible for all 
activity that takes place through ArcaEx, including its regulation 
and oversight, because ArcaEx is a part of the exchange.\29\ The PCX 
will comply with its obligations under the Exchange Act with regard 
to ArcaEx, just as it does with its current trading facilities.\30\
---------------------------------------------------------------------------

    \29\ In response to Nasdaq's conflict of interest concerns 
regarding ArcaEx (see Nasdaq II Letter at 5), we note that the PCX 
will rely solely on its own regulatory staff to perform any 
regulatory functions concerning ArcaEx. In that vein, no employees 
of Archipelago Exchange, L.L.C., or Archipelago Holdings, L.L.C., 
nor any dual employees of PCX and the ArcaEx companies will be 
involved in regulatory oversight. Furthermore, all PCX regulatory 
staff must act in accordance with strict standards of 
confidentiality with regard to ArcaEx, just as they must in all 
their oversight dealings.
    \30\ See Section 6(b)(1) of the Exchange Act (the PCX will 
``comply * * * with the provisions of this title, the rules and 
regulations thereunder, and the rules of the exchange'').
---------------------------------------------------------------------------

    Second, ArcaEx, as a party that has agreed to operate a facility 
of a self-regulatory organization, is required to cooperate with the 
PCX in meeting its regulatory responsibilities and to submit to 
Commission oversight and examination. Such cooperation and oversight 
will be assured through the application of proposed PCXE Rule 14.3 
of the PCX Plan of Delegation.\31\ Proposed PCXE

[[Page 23301]]

Rule 14.3(a), which applies to Archipelago Exchange, L.L.C., 
(``Archipelago Exchange''), the operator and owner of the ArcaEx 
trading system, states:
---------------------------------------------------------------------------

    \31\ Proposed PCXE Rule 14.3 is based on the NASD's Plan of 
Allocation and Delegation of Functions by NASD to Subsidiaries.
---------------------------------------------------------------------------

    The books, records, premises, officers, directors, agents and 
employees of Archipelago Exchange, L.L.C., shall be deemed to be the 
books, records, premises, officers, directors, agents and employees 
of PCX and PCX Equities for purposes of and subject to oversight 
pursuant to the Securities Exchange Act. The books and records of 
Archipelago Exchange, L.L.C., shall be subject at all times to 
inspection and copying by the PCX, PCX Equities and the SEC.
    By legally equating the premises, personnel and records of 
Archipelago Exchange with those of the PCX, both the PCX and the SEC 
have jurisdiction over Archipelago Exchange's premises, personnel 
and records to the same extent that the PCX and the SEC have 
jurisdiction over the PCX's premises, personnel and records.
    In addition, proposed PCXE Rule 14.3(b) further enhances the SEC 
and PCX's ability to oversee all relevant aspects of the ArcaEx 
facility. Under this rule, the SEC and the PCX are granted access, 
not only to the operator of ArcaEx, but also to the parent company 
of the operator, Archipelago Holdings, L.L.C. (``Holdings''). 
Specifically, proposed PCXE Rule 14.3(b) states that ``[a]ll 
officers and directors of Archipelago Holdings, L.L.C., shall be 
deemed to be officers and directors of PCX and PCX Equities for 
purposes of and subject to oversight pursuant to the Securities 
Exchange Act.''
    Finally, the SEC and PCX's access to and oversight of ArcaEx's 
operating company and its parent is further solidified in the 
private contracts related to ArcaEx. Each of the clauses in Rule 
14.3 is included in the agreements between PCX and Archipelago 
Exchange and Holdings. Therefore, Archipelago Exchange and Holdings 
have a private contractual obligation as well as a regulatory 
obligation to abide by Rule 14.3.
    The relationship between the PCX and ArcaEx is structured in the 
same fashion as other facility arrangements between an exchange and 
third parties.\32\ Such facility arrangements have proven effective 
in the past and there is no reason to believe that the oversight 
quality will be hampered in any way in the present case.
---------------------------------------------------------------------------

    \32\ See, e.g., PCX OptiMark Release.
---------------------------------------------------------------------------

III. PCX Will Conduct All Necessary Surveillance of ArcaEx

    As part of its obligations under the Exchange Act and pursuant 
to its own rules,\33\ the PCX will conduct all necessary 
surveillance of the operation of and trading through ArcaEx, 
including a full audit trail capability. In doing so, ArcaEx, like 
all facilities of an exchange, will be subject to full oversight of 
the SEC. Pursuant to this oversight, the SEC will ensure that the 
PCX's surveillance program is adequate based on all relevant 
circumstances. Nevertheless, such an evaluation of a surveillance 
program is not accomplished via the public comment process of a Rule 
19b-4 filing. Notwithstanding this fact, PCX emphasizes that it has, 
not only the technological capability to establish and maintain an 
audit trail, but also the staff expertise and capital resources to 
satisfactorily oversee a new electronic market trading an increased 
number of securities. Therefore, the commenters' expressed fears 
that PCX is unprepared to regulate ArcaEx are unfounded.\34\
---------------------------------------------------------------------------

    \33\ See, e.g., Section 6(b)(5) of the Exchange Act (the 
exchange must have rules designed to prevent, among other things, 
``fraudulent and manipulative acts and practices [and] to promote 
just and equitable principles of trade'').
    \34\ Knight Letter at 4 and Nasdaq II Letter at 7-9. See also 
NASDR Letter.
---------------------------------------------------------------------------

    PCX, as a well-established exchange, has the requisite staff 
experience to support and to supplement the technological 
surveillance necessary for the all-electronic ArcaEx. Throughout its 
long trading history, PCX has succeeded in attracting qualified 
management and regulatory staff, who have repeatedly demonstrated 
their familiarity with the federal securities laws and the self-
regulatory role of a registered exchange. Furthermore, the PCX 
personnel have had the opportunity to hone their regulatory skills 
in both floor and electronic trading environments, like the PCX 
Application of OptiMark, making them particularly well-suited to the 
task at hand.
    Furthermore, consistent with the requirements of the Exchange 
Act, PCX will demonstrate to the SEC, as necessary, that it has 
adequate financial resources to fund a surveillance program for a 
fully electronic trading facility. Finally, PCX intends to implement 
a state-of-the-art electronic system for producing detailed audit 
trails of all orders submitted to ArcaEx. In accordance with its 
regulatory responsibilities, PCX will demonstrate to the Commission 
that the technology of the system will be more than adequate for the 
surveillance of, and trading on, ArcaEx.\35\
---------------------------------------------------------------------------

    \35\ In addition, PCX will cooperate with the Commission's 
Automation Review Policy with regard to ArcaEx. See Securities 
Exchange Act Release No. 27445, 54 FR 48703 (Nov. 24, 1989) (``ARP I 
Release'') and Securities Exchange Act Release No. 29185, 56 FR 
22490 (May 15, 1991) (``ARP II Release''). Specifically, in 
accordance with the details of ARP I and ARP II, PCX will ensure 
that ArcaEx has ``the capacity to accommodate current and reasonably 
anticipated future trading volume levels adequately and to respond 
to localized emergency conditions.'' ARP I Release at 48705-06.
---------------------------------------------------------------------------

IV. The Exchange Act Does Not Require a Market Maker in Every Security

    Contrary to Nasdaq's assertion that a failure to require a 
market maker in every security is a ``clear statutory deficiency,'' 
\36\ the Exchange Act neither explicitly nor implicitly makes such a 
demand on an exchange.\37\ First, no specific provision of the 
Exchange Act, including Sections 6 or 11A, or any rules and 
regulations promulgated thereunder, compel an exchange to employ 
market makers as a source of liquidity.
---------------------------------------------------------------------------

    \36\ Nasdaq II Letter at 10.
    \37\ Similarly, we note that, in the ArcaEx Proposing Release, 
the Commission requested comment on the minimum price improvement 
provided by ArcaEx in cross and directed orders. ArcaEx Proposing 
Release at 78836-37. We believe that the proposed crossing and 
directed order procedures were well designed in that they provide 
the customer with the best displayed quote within ArcaEx plus a 
minimum increment. We believe this is consistent with the Exchange 
Act and encourage the Commission to approve the proposal.
---------------------------------------------------------------------------

    Second, current established trading practices also support the 
notion that a market maker need not be registered in every security 
traded on an exchange. The Commission permits exchanges to trade 
securities via cabinet trading programs.\38\ With cabinet trading, 
buy and sell limit orders are booked for execution on the exchange 
and executed outside the regular specialist or market maker system. 
ArcaEx should not be held to a different standard than that applied 
to traditional exchanges.
---------------------------------------------------------------------------

    \38\ For example, PCXE Rule 7.20 states that
    [t]he Corporation may designate to be traded in the CABINET 
System those securities which in the judgment of the Corporation do 
not trade with sufficient frequency to warrant their retention in 
the specialist system * * *. Bids and offers in securities dealt in 
by use of cabinets shall be written on floor tickets which shall be 
filed in the cabinets in the following sequence: 1. According to 
price, and 2. According to the time received at the CABINET. Orders, 
including all bids and offers, in such securities shall be filled in 
the sequence indicated above.
    PCX Rule 7.20. For other examples of cabinet trading rules, see, 
e.g., CHX Art. XX, Rule 11 and CSE Rule 11.7.
---------------------------------------------------------------------------

    Third, no market maker requirement can be implied from the basic 
definition of what constitutes an exchange. Nasdaq claims that 
because ``provid[ing] a ready source of liquidity'' is ``the most 
fundamental requirement of a securities exchange,'' every exchange 
must require a market maker or specialist to be assigned to each 
security listed on that market.\39\ The Commission, however, 
specifically has rejected this argument in its discussion of the 
basic characteristics of an ``exchange'' in the ATS Release.\40\
---------------------------------------------------------------------------

    \39\ Nasdaq II Letter at 10.
    \40\ See generally Securities Exchange Act Release No. 40760 
(Dec. 8, 1998), 63 FR 70844 (Dec. 22, 1998) (``ATS Release''). In 
redefining the term ``exchange'' in the ATS Release, the Commission 
concluded that the fundamental characteristics of an exchange are: 
(1) bringing together the orders for securities of multiple buyers 
and sellers; and (2) using established, non-discretionary methods 
(whether by providing a trading facility or by setting rules) under 
which such orders interact with each other, and the buyers and 
sellers entering such orders agree to the terms of a trade. See Rule 
3b-16 under the Exchange Act. Indeed, despite critical comments by 
several commenters, the Commission rejected the ``liquidity'' 
standard Nasdaq now seeks to resurrect.
---------------------------------------------------------------------------

    Nasdaq's argument is merely a reiteration of the now-discarded 
definition of an ``exchange'' promulgated in the Delta Release.\41\ 
In 1990, the Commission interpreted the statutory definition of an 
exchange narrowly to include only those organizations that were 
``designed * * * to centralize trading and provide buy and sell 
quotations on a regular and continuous basis so that purchasers and 
sellers have a reasonable expectation that they can regularly 
execute their orders at those price

[[Page 23302]]

quotations.''\42\ In 1998, in light of the rapid technological 
changes taking place in the securities industry, the Commission 
rescinded the Delta definition and expressly rejected liquidity 
provided by markets makers as a defining characteristic of a 
securities exchange. In reaching this conclusion, the Commission 
explained that ``while the Delta interpretation was appropriate at 
the time, its emphasis on the `expectation' of regular execution of 
orders at quoted prices no longer reflects today's markets where 
alternative trading systems compete directly with registered 
exchanges and Nasdaq.''\43\ The Commission further clarified that:
---------------------------------------------------------------------------

    \41\ Securities Exchange Act Release No. 27611 (Jan. 12, 1990), 
55 FR 1980, 1900 (Jan. 19, 1990) (``Delta Release''). See also Board 
of Trade of the City of Chicago v. SEC, 923 F.2d 1270 (7th Cir. 
1991).
    \42\ Delta Release at 1900.
    \43\ ATS Release at 70899.
---------------------------------------------------------------------------

    More fundamentally, although traditional exchanges still provide 
liquidity through two-sided quotations and, hence, raise an 
expectation of execution at the quoted price, this is no longer the 
essential characteristic of a securities market where stock and 
other securities exchange hands. Today's technology enables market 
participants and investors to tap simultaneous and multiple sources 
of liquidity from remote locations. Market makers and specialists 
may be important liquidity providers on a particular exchange, but 
liquidity now comes from many sources.\44\
---------------------------------------------------------------------------

    \44\ ATS Release at 70899 (emphasis added).
---------------------------------------------------------------------------

    Furthermore, when the Commission broadened the definition of an 
exchange to include a greater variety of business models, it did so 
with the intent of ``encouraging innovative new markets''\45\ and 
fostering the development of new technology-driven trading designs. 
ArcaEx is such an ``innovative'' market and, therefore, there is no 
basis for commanding ArcaEx to alter its computer-based architecture 
to require market makers in every security.
---------------------------------------------------------------------------

    \45\ ATS Release at 70845.
---------------------------------------------------------------------------

V. The Alternative Order Routing Methods of ArcaEx Expand Investor 
Choice in a Manner Consistent with the Exchange Act

    Nasdaq and Knight questioned the status and function of the 
Archipelago electronic communications network \46\ (``ECN'') after 
the creation of ArcaEx.\47\ The broker-dealer commonly referred to 
as the Archipelago ECN will continue to exist as a registered 
broker-dealer renamed WAVE. The functions and activities of WAVE, 
however, will differ from the current activities of the Archipelago 
ECN. In particular, WAVE will perform three primary functions, 
including acting as (1) for a limited period of time, a residual 
ECN, (2) an introducing broker and (3) a routing broker. In order to 
perform these limited functions, WAVE will exist as an entity 
separate and distinct from ArcaEx. In addition, NASDR, rather than 
PCX, will be the Designated Examining Authority (``DEA'') for WAVE, 
just as it has been for the Archipelago ECN. We discuss the proposed 
business and regulation of WAVE in more detail below.
---------------------------------------------------------------------------

    \46\ See, e.g., Letter from Robert L. D. Colby, Division of 
Market Regulation, SEC, to Gerald Putnam, Archipelago, L.L.C., dated 
Jan. 12, 2001.
    \47\ Knight Letter at 5, n. 13, and Nasdaq II Letter at 9.
---------------------------------------------------------------------------

A. WAVE Will Perform Three Primary Functions

1. WAVE Will Continue to Perform as an ECN for a Limited Period of Time

    First, as a temporary matter, WAVE will continue to act as an 
ECN, to the extent necessary, for a limited period of time. 
Specifically, PCX and Archipelago have agreed that all securities 
eligible to be traded on ArcaEx (i.e., listed securities or 
securities with unlisted trading privileges (``UTP'')) will be 
traded only on ArcaEx; they will not be traded on PCX and the ECN. 
Therefore, no security will be traded concurrently on both ArcaEx 
and the ECN. As of this date, however, the plan for trading over-
the-counter (``OTC'') pursuant to UTP (the so-called ``OTC/UTP 
Plan'') only permits PCX, as an exchange participating in the Plan, 
to trade 1000 of the Nasdaq/NM securities.\48\ Until the OTC/UTP 
Plan has been expanded to incorporate all Nasdaq securities,\49\ 
WAVE will continue to act as an ECN for those securities excluded 
from the Plan. Once the OTC/UTP Plan has been expanded--which is 
expected to occur later this year--the remaining Nasdaq securities 
will be transferred for trading from the Archipelago ECN to ArcaEx 
pursuant to a roll-out plan. The ECN will cease to operate as such 
once all the Nasdaq securities have been transferred to ArcaEx.
---------------------------------------------------------------------------

    \48\ See, e.g., Securities Exchange Act Release No. 43545 (Nov. 
9, 2000), 65 FR 69581 (Nov. 17, 2000).
    \49\ Id. (the PCX request to expand the number of eligible 
Nasdaq/NM securities).
---------------------------------------------------------------------------

2. WAVE Will Act as an Introducing Broker

    Second, WAVE plans to register as an ETP Holder and act as an 
introducing broker for institutions or other entities who are not 
ETP Holders themselves. WAVE's position as the routing broker will 
not bestow any special status on WAVE in its capacity as an ETP 
Holder. WAVE, acting as an ETP Holder, and its customers will have 
the exact same access to ArcaEx as any other ETP Holder and its 
customers. In this regard, PCX and Archipelago will establish 
appropriate information barriers to address any concerns regarding 
WAVE's status relative to other ETP Holders.

3. WAVE Will Supply ArcaEx With a Routing Service

    Finally, the ongoing WAVE function most relevant for ArcaEx is a 
routing service. WAVE will route orders, as necessary, from ArcaEx 
to other market centers.\50\ Given various technical issues 
associated with market center-to-market center routing within the 
strictures of today's intermarket structure, PCX and Archipelago 
have opted to employ the services of a routing broker, rather than 
rely on routing orders to other markets directly from PCX itself.
---------------------------------------------------------------------------

    \50\ See, e.g., Proposed PCXE Rules 1.1(gg), 7.32 and 7.37(d).
---------------------------------------------------------------------------

    Despite the decision to employ WAVE in this intermarket 
capacity, no User is required to utilize the WAVE routing services. 
Furthermore, those Users who opt out of the WAVE routing services 
are not precluded from entering any order types, except a very 
limited subset of orders that specifically incorporates a WAVE 
routing requirement within the definition of the order. This limited 
subset includes Primary Only Orders as well as NOW Orders, if 
routing of the NOW Order is required.\51\ The only trading condition 
for those Users who do not use the WAVE routing services is that 
each order, if it has not been fully executed after it has 
progressed through each step of the ArcaEx trading algorithm,\52\ 
must be returned to the User or the User's designated agent prior to 
reaching the routing step of the algorithm.\53\ After the order is 
returned to the User, the User may then route the order to another 
market center as the User sees fit. In other words, the trading 
mechanism is the same for orders that do not rely on WAVE and orders 
that do rely on WAVE, except orders that do not rely on WAVE, of 
course, must, by definition, be routed outside of ArcaEx through 
another mechanism. The specifics of the routing function and its 
impact on ArcaEx Users are discussed in more detail below.
---------------------------------------------------------------------------

    \51\ See Proposed PCXE Rule 7.31(x).
    \52\ See generally Proposed PCXE Rule 7.37.
    \53\ See Proposed PCXE Rule 7.37(d) (describing ``Routing 
Away,'' Step 5 of the trading algorithm, after the Directed Order, 
Display Order, Working Order and Tracking Order Processes).
---------------------------------------------------------------------------

i. ArcaEx Provides Its Users With a Choice as to How Their Orders Will 
Be Routed to Away Markets

    ArcaEx has been designed to provide its Users with a choice as 
to how they wish to route orders to away markets. In this regard, 
Nasdaq and Knight misinterpret the various options available to 
Users in ArcaEx's routing structure.\54\ These two commenters 
correctly identify one ArcaEx routing option: a User may choose to 
utilize the routing services provided by WAVE, the broker-dealer 
affiliate of Archipelago Exchange, L.L.C. To do so, the User must 
enter into a routing agreement with WAVE under which WAVE ``agrees 
to act as agent for routing orders of the ETP Holder \55\ and the 
ETP Holder's Sponsored Participants \56\ entered into the 
Archipelago Exchange to other market centers or broker-dealers for 
execution, whenever such routing is required.''\57\
---------------------------------------------------------------------------

    \54\ Knight Letter at 4-5 and Nasdaq II Letter at 6-7.
    \55\ An ``ETP'' is an Equity Trading Permit issued by the PCXE 
for effecting approved securities transactions on the PCXE's Trading 
Facilities. Proposed PCXE Rule 1.1(m). An ``ETP Holder'' is ``a sole 
proprietorship, partnership, corporation, limited liability company 
or other organization in good standing that has been issued an ETP. 
An ETP Holder must be a registered broker or dealer pursuant to 
Section 15 of the Exchange Act.'' See Proposed PCXE Rule 1.1(n).
    \56\ A ``Sponsored Participant'' means ``a person which has 
entered into a sponsorship arrangement with a Sponsoring ETP Holder 
pursuant to [Proposed PCXE] Rule 7.29.'' Proposed PCXE Rule 1.1(jj).
    \57\ Proposed PCXE Rule 1.1(gg).
---------------------------------------------------------------------------

    Nasdaq and Knight, however, fail to recognize that a User is not 
required to use WAVE's routing services. Instead of signing a 
routing agreement with WAVE, a User may bypass WAVE entirely and opt 
to rely on its

[[Page 23303]]

own routing abilities or those of another broker-dealer by utilizing 
the Fill-or-Return, Fill-or-Return Plus or Post No Preference 
(``PNP'') order types \58\ supplied by ArcaEx.\59\ A Fill-or-Return 
order is ``[a]n order to buy or sell that is to be executed in whole 
or in part on the Corporation, and the portion not so executed is to 
be cancelled, without routing the order to another market center.'' 
\60\ A Fill-or-Return order, therefore, allows the order originator 
to re-route the order to another market in a manner of its own 
choosing, once it is informed that the order has not been executed 
in its entirety on the ArcaEx. This alternative allows the User to 
implement its own customized means for accomplishing the order 
routing.
---------------------------------------------------------------------------

    \58\ For a definition of the Fill-or-Return, Fill-or-Return Plus 
or PNP order types, see, respectively, Proposed PCXE Rules 7.31(p), 
7.31(r) and 7.31(w).
    \59\ See Proposed PCXE Rule 7.32. ArcaEx's provision of 
alternative routing services other than WAVE is akin to Nasdaq's 
efforts regarding SuperMontage to allow Nasdaq members to establish 
order routing arrangements with other market participants, such as 
telephone access or direct links, in addition to, or in place of, 
SuperMontage's routing arrangements. See Securities Exchange Act 
Release No. 43863 (Jan. 19, 2001), 66 FR 8020, 8049 (Jan. 26, 2001) 
(``SuperMontage Release'').
    \60\ Proposed PCXE Rule 7.31(p).
---------------------------------------------------------------------------

    Similarly, a User may wish to rely upon the routing capabilities 
of another entity, rather than its own routing resources or WAVE. 
ArcaEx facilitates such relationships by providing a User with the 
opportunity to enter Fill-or-Return Plus orders into ArcaEx. A Fill-
or-Return Plus order is:
    [a]n order to buy or sell that is to be executed in whole or in 
part on the Corporation, and the portion not so executed is to be 
cancelled, without routing the order to another market center or 
market participant. In the event any portion of the order is not 
executed on the Corporation and must be cancelled, the Archipelago 
Exchange, after canceling the unexecuted portion of the order, shall 
send an administrative message to an ETP Holder designated by the 
order entry ETP Holder informing the designated ETP Holder that a 
portion of the order was cancelled.\61\
---------------------------------------------------------------------------

    \61\ Proposed PCXE Rule 7.31(r).
---------------------------------------------------------------------------

    The administrative message informs the designated ETP Holder 
that an order has not been executed. The designated ETP Holder may 
then use this information to send an order via its own routing 
mechanisms to another market in accordance with the original User's 
instructions.
    Finally, a User may prefer to send PNP Orders to ArcaEx. A PNP 
Order is ``a limit order to buy or sell that is to be executed in 
whole or in part on the Corporation, and the portion not so executed 
is to be ranked in the Arca Book, without routing any portion of the 
order to another market center; provided, however, the Corporation 
shall cancel a PNP that would lock or cross the NBBO.'' \62\ This 
order type provides the User with the ability to use ArcaEx as a 
final order destination when it suits the User's investment needs.
---------------------------------------------------------------------------

    \62\ See Proposed PCXE Rule 7.31(w).
---------------------------------------------------------------------------

    As Nasdaq and Knight note in their comment letters,\63\ certain 
order types which involve a routing element unique to ArcaEx, like 
the Primary Only Order,\64\ require the User to utilize WAVE's 
routing services. As discussed above, however, the rules for trading 
on ArcaEx in no way preclude a User from pursuing trading 
opportunities similar to those provided by ArcaEx orders through the 
routing services supplied by broker-dealers other than WAVE. Users 
easily may do so by entering Fill-or-Return or Fill-or-Return Plus 
orders. Furthermore, no denial of access issues arise with any order 
type, regardless of their routing mechanism.\65\ Every User must 
satisfy identical, objective requirements for submitting each order 
type; the requirements do not vary based on the identity of the User 
or otherwise unfairly discriminate against any particular class of 
Users.\66\
---------------------------------------------------------------------------

    \63\ Knight Letter at 4-5 and Nasdaq II Letter at 11-12.
    \64\ See Proposed PCXE Rule 7.31(x) (``For exchange listed 
securities, [a Primary Only Order] is a market order that is to be 
routed as a market-on-open order to the primary market for 
participation in the primary market opening process'').
    \65\ See Nasdaq II Letter at 11-12.
    \66\ E.g., Section 6(b)(5) of the Exchange Act (the rules of an 
exchange may not be designed to permit ``unfair discrimination''); 
ATS Release at 70874 (standards for access ``should act to prohibit 
unreasonably discriminatory denials of access. A denial of access is 
reasonable if it is based on objective standards.''). See Section 
19(f) of the Exchange Act.
---------------------------------------------------------------------------

ii. WAVE Will Not Enjoy a Competitive Advantage as a Result of its 
Routing Services

    Contrary to the concerns expressed by Nasdaq and Knight,\67\ 
WAVE will not enjoy a competitive advantage over other broker-
dealers as a result of the routing services it provides to ArcaEx. 
In addition to providing only one of the methods by which Users may 
route orders to away markets, as discussed above, WAVE will be 
limited in what trading activities it may perform. WAVE will not, 
for example, conduct proprietary transactions on ArcaEx or in 
securities traded on ArcaEx. Furthermore, information barriers will 
be maintained, as necessary, to ensure that WAVE may not unfairly 
take advantage of knowledge gained as the ArcaEx routing broker.
---------------------------------------------------------------------------

    \67\ See Knight Letter at 5 and Nasdaq II Letter at 9.
---------------------------------------------------------------------------

B. WAVE Will Be Separate and Distinct From ArcaEx

    WAVE and ArcaEx will be separate and distinct corporate entities 
(WAVE, L.L.C., and Archipelago Exchange, L.L.C., respectively). As 
mentioned above, both are wholly-owned subsidiaries of the same 
holding company, Archipelago Holdings, L.L.C., whose officers and 
directors are deemed to be officers and directors of PCX and PCXE 
for purposes of the Exchange Act. As such WAVE and ArcaEx each have 
their own trading systems as well as their own compliance, finance 
and sales functions.

C. WAVE Will Be Assigned to a Designated Examining Authority Other 
Than the PCX

    Nasdaq expressed concerns about the heightened potential for 
conflicts of interest if the PCX were to regulate WAVE.\68\ To avoid 
even the perception of a conflict of interest, PCX agrees that an 
SRO other than PCX should be WAVE's DEA. In particular, PCX and 
Archipelago believe that NASDR is the most appropriate SRO to act as 
WAVE's DEA. Based on discussions with NASDR, PCX understands that 
NASDR has agreed to undertake the DEA responsibilities with respect 
to WAVE.
---------------------------------------------------------------------------

    \68\ Nasdaq II Letter at 6-7.
---------------------------------------------------------------------------

VI. ArcaEx Operates in Compliance With Section 11(a) of the 
Securities Exchange Act

    The Phlx believes that PCX should not abandon priority for 
public customer agency orders over proprietary orders of broker-
dealers in implementing ArcaEx.\69\ The Phlx argues that the 
requirement that broker-dealer orders yield priority, parity and 
precedence to customer orders is a statutory requirement under 
Section 11(a) of the Exchange Act.\70\ The PCX disagrees. As 
discussed in detail in Appendix A, the order execution algorithm of 
ArcaEx complies with the requirements of, and satisfies the policy 
concerns underlying, Section 11(a) without requiring public customer 
priority.
---------------------------------------------------------------------------

    \69\ See Phlx Letter.
    \70\ Id. The Phlx also asserts that customer priority is a 
Congressional directive. The PCX has found no securities law 
requirement that would force ArcaEx to incorporate customer priority 
into its trading algorithm.
---------------------------------------------------------------------------

    Section 11(a) of the Exchange Act prohibits a member of a 
national securities exchange from effecting transactions on the 
exchange for its own account, the account of an associated person, 
or an account in which it or an associated person exercises 
investment discretion (collectively, ``covered accounts''), unless 
an exception applies. In enacting this provision, Congress was 
concerned about members benefiting in their principal transactions 
from special ``time and place'' advantages associated with floor 
trading--such as the ability to ``execute decisions faster than 
public investors.'' \71\ The Commission, however, has adopted a 
number of exceptions to the general statutory prohibition for 
situations in which the principal transactions contribute to the 
fairness and orderliness of exchange markets or do not reflect any 
time and place trading advantages.
---------------------------------------------------------------------------

    \71\ See Securities Exchange Act Release No. 14563 (Mar. 14, 
1978), 43 FR 11542, 11543 (Mar. 17, 1978) (``1978 Release I''); 
Securities Exchange Act Release No. 14713 (Apr. 27, 1978), 43 FR 
18557, 18588 (May 1, 1978) (``1978 Release II''); Securities 
Exchange Act Release No. 15533 (Jan. 29, 1979), 44 FR 6084, 6092 
(Jan. 31, 1979) (``1979 Release''). The 1978 and 1979 Releases cite 
the House Report at 54-57.
---------------------------------------------------------------------------

    The Phlx apparently assumes that the PCX is relying upon the 
Section 11(a) exception set forth in Rule 11a1-1(T) (``the 
proprietary trading rule''), which has, as one of its requirements, 
public customer priority. PCX, however, believes that ArcaEx 
satisfies the requirements of another exception to Section 11(a), 
which does not require public

[[Page 23304]]

customer priority. This alternative exception is Rule 11a2-2(T), 
commonly referred to as the ``effect versus execute'' rule.\72\
---------------------------------------------------------------------------

    \72\ Rule 11a2-2(T) permits an exchange member, subject to 
certain conditions, to effect transactions for covered accounts by 
arranging for an unaffiliated member to execute the transactions 
directly on the exchange floor. To comply with the rule's 
conditions, a member (1) must transmit the order from off the 
exchange floor; (2) may not participate in the execution of the 
transaction once it has been transmitted to the member performing 
the execution; (3) may not be affiliated with the executing member; 
and (4) with respect to an account over which the member or an 
associated person has investment discretion, neither the member nor 
the associated person may retain any compensation in connection with 
effecting the transaction without express written consent from the 
person authorized to transact business for the account in accordance 
with the rule.
---------------------------------------------------------------------------

    The effect versus execute rule imposes four requirements 
``designed to put members and non-members on the same footing, to 
the extent practicable, in light of the purposes of Section 11(a).'' 
\73\ ArcaEx will place all of its Users--both ETP Holders and non-
ETP Holders--on the ``same footing,'' as intended by Rule 11a2-2(T). 
Given ArcaEx's automated matching and execution services, no User 
will enjoy any special control over the timing of execution or 
special order handling advantages, as all orders will be centrally 
processed for execution by computer, rather than being handled by a 
member through bids or offers made on the trading floor. Because 
ArcaEx's open, electronic structure is designed to prevent any ETP 
Holders from gaining any time and place advantages, the PCX believes 
that ArcaEx satisfies the four requirements of the ``effect versus 
execute'' rule as well as the general policy objectives of Section 
11(a).\74\
---------------------------------------------------------------------------

    \73\ See 1978 Release II at 18560.
    \74\ For a detailed analysis of how ArcaEx satisfies the 
requirements of the effect versus execute rule, see Appendix B.
---------------------------------------------------------------------------

    This result is consistent with the Commission's application of 
the effect versus execute rule in similar situations. In the past, 
the Commission and its staff have allowed exchanges to sponsor 
innovative trading systems in reliance on Rule 11a2-2(T), finding 
that such facilities, by design, do not provide any special time and 
place advantage to members.\75\ In particular, where the execution 
is performed by the facility itself through an automated service, it 
has been determined that ``the member would not retain any ability 
to control the timing of the execution or otherwise enjoy the kind 
of special order-handling advantages inherent in being on an 
exchange floor.'' \76\ Like these trading systems, ArcaEx ensures 
that ETP Holders do not have any special or unique trading 
advantages and, therefore, complies with Section 11(a).
---------------------------------------------------------------------------

    \75\ See, e.g., Letter from Larry E. Bergmann, Senior Associate 
Director, Division of Market Regulation, SEC, to Edith Hallahan, 
Associate General Counsel, Phlx, dated Mar. 24, 1999 (``VWAP 
Letter'') (approving Phlx's VWAP Trading System); Letter from 
Catherine McGuire, Chief Counsel, Division of Market Regulation, 
SEC, to David E. Rosedahl, PCX, dated Nov. 30, 1998 (``OptiMark 
Letter'') (approving the PCX Application of OptiMark); Letter 
regarding Chicago Match, from Brandon Becker, Director, Division of 
Market Regulation, SEC, to George T. Simon, Partner, Foley & 
Lardner, dated Nov. 30, 1994 (``Chicago Match Letter''); and 
Securities Exchange Act Release No. 29237 (May 31, 1991), 56 FR 
24853 (May 31, 1991) (approving the New York Stock Exchange's Off-
Hours Trading Facility).
    \76\ See 1979 Release at 6087, n. 35.
---------------------------------------------------------------------------

VII. The Treatment of Discretionary Orders in ArcaEx Complies With the 
Firm Quote Rule

    In its comment letter, Nasdaq questioned whether ArcaEx's 
discretionary orders comply with Rule 11Ac1-1 under the Securities 
Exchange Act, the so-called Quote Rule.\77\ Under the proposed PCXE 
Rules, a discretionary order is defined as ``an order to buy or sell 
a stated amount of a security at a specified, undisplayed price (the 
`discretionary price'), in addition to, at a specified, displayed 
(`displayed price').'' \78\ For all non-marketable discretionary 
orders, the discretionary order will be displayed to all Users at 
the displayed price. No Users will see the discretionary price of 
the orders. An undisplayed, discretionary price order will be 
afforded price priority in the Arca Book, but not time priority 
relative to displayed orders.\79\ As discussed in more detail in 
Appendix B,\80\ the PCX believes that its discretionary orders, not 
only comply with the requirements of the Quote Rule, but also 
provide significant benefits to the markets.
---------------------------------------------------------------------------

    \77\ Nasdaq II Letter at 11.
    \78\ Proposed PCXE Rule 7.31(h)(2).
    \79\ Proposed PCXE Rule 7.36.
    \80\ For a detailed analysis of the benefits of discretionary 
orders in addition to how they comply with the Quote Rule, see 
Appendix B.
---------------------------------------------------------------------------

    The Quote Rule mandates national securities exchanges, subject 
to certain exceptions, to collect and disseminate ``best bids'' and 
``best offers'' from a ``responsible broker or dealer.'' \81\ 
ArcaEx's treatment of discretionary orders complies with the 
requirements of this Rule for a number of reasons. First, an 
important attribute of a bid or offer subject to the Quote Rule is 
that it represents the ``bid price and the offer price communicated 
by an exchange member or OTC market maker to any broker or dealer, 
or to any customer.'' \82\ Accordingly, ``[i]n order to constitute a 
bid or offer, the underlying trading interest must have been 
communicated to at least one potential counterparty.'' \83\ On 
ArcaEx, the discretionary price of a discretionary order is not 
communicated to any Users of the system; only ArcaEx is aware of the 
full potential trading interest of these orders until trades occur. 
Accordingly, because ArcaEx does not publish the discretionary 
aspect of these discretionary orders, they should not be deemed to 
be a ``bid or offer'' within the meaning of the Quote Rule.
---------------------------------------------------------------------------

    \81\ See Rule 11Ac1-1 under the Securities Exchange Act.
    \82\ See Rule 11Ac1-1(a)(4) under the Securities Exchange Act.
    \83\ PCX OptiMark Release at 50046.
---------------------------------------------------------------------------

    Second, discretionary orders allow the investor to express a 
more complex--and more accurate--trading interest than the single 
price and size of a conventional order.\84\ Unlike ``bids'' and 
``offers,'' discretionary orders reflect the fact that there is 
usually more than one price at which an investor is willing to buy 
or sell. Because these discretionary orders represent a 
qualitatively different set of information from the traditional 
price and size information, they are more analogous to indications 
of interest, than bids and offers. Therefore, like indications of 
interest, discretionary orders should be excluded from the 
requirements of the Quote Rule.\85\ The Commission reached a similar 
conclusion in its analysis of OptiMark Profiles, finding that 
``Profiles are analogous to indications of interest or CAP 
orders,\86\ neither of which are displayed in exchanges or on 
Nasdaq.'' \87\ Therefore, the inchoate trading interest of 
discretionary orders should not be treated as a bid or offer under 
the Quote Rule.\88\
---------------------------------------------------------------------------

    \84\ As the Commission has stated repeatedly, the Quote Rule is 
premised on the notion of a bid or offer at one specified price and 
one specified size. See, e.g., Exchange Act Release No. 35030 (Nov. 
30, 1994), 59 FR 63141, 63145 (1994).
    \85\ Rule 11Ac1-1(a)(4) under the Exchange Act.
    \86\ For a description of CAP orders, see, e.g., NYSE Rules 13 
and 123A.
    \87\ See, e.g., OptiMark Release, 62 FR at 50046.
    \88\ This may be especially true for indications of interest 
expressed by those who do not constitute ``members'' or 
``responsible broker-dealers'' within the meaning of the Quote Rule. 
See Order Handling Release, 61 FR at 48311, n. 248.
---------------------------------------------------------------------------

VIII. PCX Will Continue To Participate in the National Market System

    Nasdaq also voiced concern over ArcaEx's integration into the 
Intermarket Trading System (``ITS'') because aspects of the ArcaEx 
trading algorithm appeared to conflict with two basic components of 
the ITS Plan--the pre-opening application \89\ and continuous, two-
sided quotations.\90\ The PCX remains supportive of the national 
market system and intends to continue to comply with the national 
market system plans once ArcaEx becomes operational. Discussions are 
ongoing with the relevant operating committees, among others, 
regarding the integration of ArcaEx into the national market system.
---------------------------------------------------------------------------

    \89\ As described in the proposed PCXE Rules (see Proposed PCXE 
Rule 7.35), ArcaEx has developed an automated opening for its order-
driven market, which is designed to provide efficient price 
discovery, while ensuring investor protection. PCX, based on its 
business judgment, believes the ArcaEx opening mechanism will prove 
effective for its Users. In addition, PCX believes that the opening 
is consistent with, and fosters the goals of, the Exchange Act. In 
that vein, PCX also believes that ArcaEx complies with the pre-
opening application of the ITS Plan.
    \90\ Nasdaq II Letter at 12.
---------------------------------------------------------------------------

IX. PCX Will Maintain All Required Books and Records in the United 
States

    The PCX represents that it will keep all books and records that 
it is required to maintain under the Exchange Act, including those 
related to ArcaEx, in the United States.
* * * * *
    The PCX believes that the proposed rule change is consistent 
with the requirements of the Exchange Act, including Sections 6 and 
11A, and the rule and regulations thereunder applicable to a 
national securities exchange. In particular, the PCX believes that 
the ArcaEx rules are designed to promote just and equitable 
principles of trade, remove

[[Page 23305]]

impediments to and perfect the mechanism of a free and open market 
and a national market system, and, in general protect investors and 
the public interest, as required by Section 6(b)(5) of the 
Securities Exchange Act. For the foregoing reasons, the PCX requests 
that the Commission approve the proposed rule changes regarding 
ArcaEx.
    If you have any questions or concerns, please feel free to call 
Kathryn Beck of the PCX at 415.393.7936, Brandon Becker at 
202.663.6979 or the undersigned at 202.663.6855.

      Sincerely,
Cherie Macauley
cc: Annette Nazareth,
    Robert L.D. Colby,
    Belinda Blaine,
    Larry Bergman,
    Caite McGuire,
    Steve Williams,
    Patrick Joyce,
    John Roeser,
    Marc McKayle,
    Kathryn Beck,
    Dave Rosedahl.

Appendix B--ArcaEx Operates in Compliance With Section 11(a) of the 
Securities Exchange Act

A. Background

    Section 11(a) of the Securities Exchange Act (``Exchange Act'') 
prohibits a member of a national securities exchange from effecting 
transactions on the exchange for its own account, the account of an 
associated person, or an account in which it or an associated person 
exercises investment discretion (collectively, ``covered 
accounts''), unless an exception applies. First enacted as part of 
the Securities Acts Amendments of 1975,\91\ Section 11(a) was 
intended by Congress to address trading advantages enjoyed by 
exchange members and conflicts of interest in money management.\92\ 
In particular, as noted by the Securities and Exchange Commission 
(``SEC'' or ``Commission''), Congress was concerned about members 
benefiting in their principal transactions from special ``time and 
place'' advantages associated with floor trading--such as the 
ability to ``execute decisions faster than public investors.'' \93\
---------------------------------------------------------------------------

    \91\ See Pub. L. No. 94-29, 89 Stat. 110 (June 4, 1975).
    \92\ See Securities Reform Act of 1975, Report of the House 
Comm. on Interstate and Foreign Commerce, H.R. Rep. No. 94-123, 94th 
Cong., 1st Sess. (1975) (``House Report''); Securities Acts 
Amendments of 1975, Report of the Senate Comm. on Banking, Housing 
and Urban Affairs, S. Rep. No. 94-75, 94th Cong., 1st Sess. (1975).
    \93\ See Securities Exchange Act Release No. 14563 (Mar. 14, 
1978), 43 FR 11542, 11543 (Mar. 17, 1978) (``1978 Release I''); 
Securities Exchange Act Release No. 14713 (Apr. 27, 1978), 43 FR 
18557, 18588 (May 1, 1978) (``1978 Release II''); Securities 
Exchange Act Release No. 15533 (Jan. 29, 1979), 44 FR 6084, 6092 
(Jan. 31, 1979) (``1979 Release''). The 1978 and 1979 Releases cite 
the House Report at 54-57.
---------------------------------------------------------------------------

    Where principal transactions contribute to the fairness and 
orderliness of exchange markets or do not reflect any time and place 
trading advantages, they are excepted from the prohibition. Among 
the transactions excepted under Section 11(a)(1) are those by a 
dealer acting in the capacity of a market maker,\94\ bona fide 
arbitrage or hedge transactions,\95\ and transactions made to offset 
errors.\96\ Rule 11a2-2(T) under the Exchange Act provides an 
exception in addition to those delineated in the statute.
---------------------------------------------------------------------------

    \94\ See Section 11(a)(1)(A), 15 U.S.C. Sec. 78k(a)(1)(A). In 
addition to the application of Rule 11a2-2(T), as discussed below, 
ETP Holders who are registered as market makers on the Archipelago 
Exchange (``ArcaEx'') may also take advantage of this market maker 
exemption from Section 11(a), at least for securities in which they 
make a market.
    \95\ See Section 11(a)(1)(D) of the Securities Exchange Act.
    \96\ See Section 11(a)(1)(F) of the Securities Exchange Act.
---------------------------------------------------------------------------

    Commonly referred to as the ``effect versus execute'' rule, Rule 
11a2-2(T) permits an exchange member, subject to certain conditions, 
to effect transactions for covered accounts by arranging for an 
unaffiliated member to execute the transactions directly on the 
exchange floor. To comply with the rule's conditions, a member (1) 
must transmit the order from off the exchange floor; (2) may not 
participate in the execution of the transaction once it has been 
transmitted to the member performing the execution;\97\ (3) may not 
be affiliated with the executing member; and (4) with respect to an 
account over which the member or an associated person has investment 
discretion, neither the member nor the associated person may retain 
any compensation in connection with effecting the transaction 
without express written consent from the person authorized to 
transact business for the account in accordance with the rule.
---------------------------------------------------------------------------

    \97\ The member may participate, however, in clearing and 
settling the transaction.
---------------------------------------------------------------------------

    As described by the Commission, these four requirements--off-
floor transmission, non-participation in order execution, execution 
through an unaffiliated member and non-retention of compensation for 
discretionary accounts--were ``designed to put members and non-
members on the same footing, to the extent practicable, in light of 
the purposes of Section 11(a).'' \98\ If a transaction meets the 
requirements of the ``effect versus execute'' rule, it will be 
deemed to be ``consistent with the purpose of Section 11(a)(1) of 
the Act, the protection of investors, and the maintenance of fair 
and orderly markets.'' \99\
---------------------------------------------------------------------------

    \98\ See 1978 Release II at 18560.
    \99\ See Rule 11a2-2(T)(e) under the Securities Exchange Act.
---------------------------------------------------------------------------

    In the past, the Commission and its staff have allowed exchanges 
to sponsor innovative trading systems in reliance on Rule 11a2-2(T), 
finding that such facilities, by design, do not provide any special 
time and place advantage to members.\100\ In particular, where the 
execution is performed by the facility itself through an automated 
service, it has been determined that ``the member would not retain 
any ability to control the timing of the execution or otherwise 
enjoy the kind of special order-handling advantages inherent in 
being on an exchange floor.'' \101\ Rule 11a2-2(T) thus has been 
applied in a functional manner, taking into account the structural 
characteristics that distinguish the operation of an automated 
trading system from traditional floor activities. This approach 
represents the sensible conclusion by the Commission and its staff 
that implementation of Section 11(a) should reflect the ``continuing 
rapid pace of economic, technological and regulatory changes in the 
markets.'' \102\
---------------------------------------------------------------------------

    \100\ See, e.g., Letter from Larry E. Bergmann, Senior Associate 
Director, Division of Market Regulation, SEC, to Edith Hallahan, 
Associate General Counsel, Phlx, dated Mar. 24, 1999 (``VWAP 
Letter'') (approving Phlx's VWAP Trading System); Letter from 
Catherine McGuire, Chief Counsel, Division of Market Regulation, 
SEC, to David E. Rosedahl, PCX, dated Nov. 30, 1998 (``OptiMark 
Letter'') (approving the PCX Application of OptiMark); Letter 
regarding Chicago Match, from Brandon Becker, Director, Division of 
Market Regulation, SEC, to George T. Simon, Partner, Foley & 
Lardner, dated Nov. 30, 1994 (``Chicago Match Letter''); and 
Securities Exchange Act Release No. 29237 (May 31, 1991), 56 FR 
24853 (May 31, 1991) (approving the New York Stock Exchange's Off-
Hours Trading Facility).
    \101\ See 1979 Release at 6087, n. 35.
    \102\ See id. at 6987.
---------------------------------------------------------------------------

B. Discussion

    ArcaEx represents a new electronic trading facility of the PCXE 
that may be utilized by ETP Holders and their customers to effect 
the purchase and sale of securities.\103\ As discussed in more 
detail below, ArcaEx will place all of its Users--both ETP Holders 
and non-ETP Holders--on the ``same footing,'' as intended by Rule 
11a2-2(T). Given the automated matching and execution services, no 
ETP Holder will enjoy any special control over the timing of 
execution or special order handling advantages, as all orders will 
be centrally processed for execution by computer, rather than being 
handled by a member through bids or offers made on the trading 
floor. Because ArcaEx's open, electronic structure is designed to 
prevent any ETP Holders from gaining any time and place advantages, 
ArcaEx satisfies the four requirements of the ``effect versus 
execute'' rule as well as the general policy objectives of Section 
11(a).
---------------------------------------------------------------------------

    \103\ For a detailed description of how ArcaEx will operate, see 
Securities Exchange Act Release No. 43608 (Nov. 21, 2000). 
Capitalized terms not defined herein will have the meanings given 
them in that release.
---------------------------------------------------------------------------

1. Off-Floor Transmission

    Rule 11a2-2(T) requires the orders for a covered account 
transaction to be transmitted from off the exchange floor. In 
considering the application of this requirement to a number of 
automated trading and electronic order-handling facilities operated 
by national securities exchanges, the Commission has deemed the off-
floor requirement to be met if the order is transmitted from off the 
floor directly to the exchange floor by electronic means.\104\ Like 
these other automated

[[Page 23306]]

systems, orders sent to ArcaEx will be transmitted from remote 
terminals directly to the system by electronic means. Therefore, 
Users' orders electronically received by ArcaEx satisfy the off-
floor transmission requirement for the purposes of the ``effect 
versus execute'' rule.\105\
---------------------------------------------------------------------------

    \104\ Among the systems considered by the Commission are (1) the 
Phlx's VWAP Trading System (see VWAP Letter); (2) the PCX 
Application of OptiMark (see OptiMark Letter); (3) Chicago Match 
(see Chicago Match Letter); (4) the Amex's Post Execution Reporting 
System and the Amex Switching System (see 1979 Release at n. 25); 
(5) ITS; (6) the Multiple Dealer Trading Facility of the CSE; (7) 
the PCX's Communications and Execution System (``COMEX''); and (8) 
the Phlx's Automated Communications and Execution System (``PACE'') 
(see 1979 Release at nn. 19-35 and accompanying text).
    \105\ The Commission has not considered the lack of a 
traditional physical floor to be an impediment to the satisfaction 
of the off-floor requirement. See, e.g., 1979 Release (discussing 
the CSE's NSTS satisfaction of this requirement).
---------------------------------------------------------------------------

2. Non-Participation in Order Execution

    The ``effect versus execute'' rule further provides that the 
exchange member and its associated person may not participate in the 
execution of the transaction once the order has been transmitted. 
This requirement originally was intended to prevent members with 
their own brokers on the exchange floor from using those persons to 
influence or guide their orders' execution.\106\ It does not 
preclude members from canceling or modifying orders, or from 
modifying instructions for executing orders, after they have been 
transmitted; provided, however, that such cancellations or 
modifications are also transmitted from off the exchange floor.\107\
---------------------------------------------------------------------------

    \106\ See generally 1978 Release I.
    \107\ See id.
---------------------------------------------------------------------------

    In analyzing the application of the non-participation 
requirement to automated exchange facilities, the Commission 
specifically noted in regard to the COMEX and PACE systems that (1) 
the ``initiating member relinquishes any ability to influence or 
guide the execution of its order at the time that order is 
transmitted into the system'' and (2) ``[while] the execution of the 
order is thereafter automatic and does not involve any independent 
executing member, the design of those systems insures that members 
do not possess any special or unique trading advantages in handling 
their orders after transmitting them to the floors of the Phlx or 
the PSE.'' \108\ As a result, orders transmitted to the COMEX and 
PACE systems were deemed to comply with this requirement. More 
recently, the Commission reached the same conclusion concerning the 
VWAP Trading System, OptiMark and the Chicago Match, stating that a 
member does not retain the ability to influence or guide the 
execution of an order after the member submits the order to each of 
these systems.\109\
---------------------------------------------------------------------------

    \108\ See 1979 Release at n. 25.
    \109\ See VWAP Letter; OptiMark Letter and Chicago Match Letter.
---------------------------------------------------------------------------

    As with these other trading systems, the orders submitted to 
ArcaEx similarly meet the non-participation requirement. Upon 
submission to ArcaEx, an order will enter the queue and be executed 
against another order in the Arca Book based on an established 
matching algorithm. The execution depends, not on the ETP Holder, 
but rather, upon what other orders are entered into ArcaEx at or 
around the same time as the subject order, what orders are resident 
in the Arca Book and where the order is ranked based on the price-
time priority ranking algorithm. Therefore, at no time following the 
submission of an order is an ETP Holder able to acquire control or 
influence over the result or timing of orders generated. That is, 
unlike a floor broker who currently enjoys a trading advantage 
inherent to being present on an exchange floor for transactions 
being executed on that floor, no ETP Holder may take advantage of 
any non-member User through use of ArcaEx. As a result, the non-
participation requirement is met where ETP Holder orders are matched 
and executed automatically in the ArcaEx.

3. Execution Through Unaffiliated Member

    Although Rule 11a2-2(T) contemplates having an order executed by 
an exchange member who is unaffiliated with the member initiating 
the order, the Commission has recognized in the past that this 
requirement is not applicable where automated exchange facilities 
are used. For example, in considering the operation of COMEX and 
PACE, among other systems, the Commission noted that, while there is 
no independent executing exchange member, the execution of an order 
is automatic once it has been transmitted into the systems.\110\ 
Because the design of these systems ensures that members do not 
possess any special or unique trading advantages in handling their 
orders after transmitting them to the exchange floors, the 
Commission has stated that executions obtained through these systems 
satisfy the independent execution requirement of Rule 11a2-
2(T).\111\ This principle is directly applicable to ArcaEx; the 
design of ArcaEx ensures that ETP Holders do not have any special or 
unique trading advantages in handling their orders after 
transmission. Accordingly, an ETP Holder effecting a transaction by 
utilizing ArcaEx satisfies the requirement for execution through an 
unaffiliated member.
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    \110\ See 1979 Release. See also VWAP Letter, OptiMark Letter 
and Chicago Match Letter.
    \111\ Id.
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4. Non-Retention of Compensation for Discretionary Accounts

    Finally, the exemption in Rule 11a2-2(T) states that, in the 
case of a transaction effected for an account for which the 
initiating member exercises investment discretion, in general, the 
member may not retain compensation for effecting the transaction. As 
a prerequisite to use of ArcaEx, if an ETP Holder is to rely on Rule 
11a2-2(T) for a managed account transaction, the ETP Holder must 
comply with the limitations on compensation as set forth in 
paragraph (a)(2)(iv) of the ``effect versus execute'' rule.

C. Conclusion

    In sum, ArcaEx is designed to, and does, comply with the letter 
and spirit of Section 11(a) of the Exchange Act.

Appendix C--ArcaEx Discretionary Orders Comply With Rule 11Ac1-1 and 
Foster the Goals of the Exchange Act

A. Background

    In its rule filing, the PCX has proposed the use of 
discretionary orders on ArcaEx. A discretionary order is defined as 
``an order to buy or sell a stated amount of a security at a 
specified, undisplayed price (the `discretionary price'), in 
addition to, at a specified, displayed price (`displayed price').'' 
\112\ For all non-marketable discretionary orders, the discretionary 
order will be displayed to all Users at the displayed price. No 
Users will see the discretionary price of the orders. An 
undisplayed, discretionary price order will be afforded price 
priority in the Arca Book, but not time priority relative to 
displayed orders.\113\
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    \112\ Proposed PCXE Rule 7.31(h)(2)
    \113\ Proposed PCXE Rule 7.36.
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B. Discussion

1. Discretionary Orders Comply With the Firm Quote Rule

    Rule 11Ac1-1 under the Securities Exchange Act (``Exchange 
Act''), the so-called ``Quote Rule,'' mandates national securities 
exchanges, subject to certain exceptions, to collect and disseminate 
``best bids'' and ``best offers'' from a ``responsible broker or 
dealer.''\114\ ArcaEx's treatment of discretionary orders complies 
with the requirements of the Rule.
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    \114\ See Rule 11Ac1-1 under the Securities Exchange Act.
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a. The Discretionary Price of a Discretionary Order is Not Communicated 
to Other Market Participants

    An important attribute of a bid or offer subject to the Quote 
Rule is that it represents the ``bid price and the offer price 
communicated by an exchange member or OTC market maker to any broker 
or dealer, or to any customer.''\115\ Accordingly, ``[i]n order to 
constitute a bid or offer, the underlying trading interest must have 
been communicated to at least one potential counterparty. Bids and 
offers are intended to attract other parties to deal with the person 
publishing the bid or offer.''\116\ For example, in the Order 
Handling Release, the Commission deemed the entry of priced orders 
into an electronic communications network (``ECN'') to be bids and 
offers where these orders were widely disseminated.\117\ Such priced 
orders are subject to the Quote Rule because, just like market maker 
or specialist quotations, they are ``entered to elicit other buying 
and selling interest.''\118\ Applying this logic, the Commission 
concluded that OptiMark Profiles were not bids or offers because 
only OptiMark was

[[Page 23307]]

``aware of the potential trading interest until the trade 
occurs.''\119\
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    \115\ See Rule 11Ac1-1(a)(4) under the Securities Exchange Act.
    \116\ Securities Exchange Act Release No. 39086 (Sept. 17, 
1997), 62 FR 50036, 50046 (1997) (``PCX OptiMark Release'').
    \117\ See Securities Exchange Act Release No. 37619A (Sept. 12, 
1996), 61 FR 48290, 48313 (1996) (``Order Handling Release''). See 
also PCX OptiMark Release at 50046.
    \118\ Order Handling Release at 48313.
    \119\ PCX OpitMark Release at 50046.
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    With discretionary orders on ArcaEx, the discretionary price of 
a discretionary order is not communicated to any Users of the 
system. Only ArcaEx is aware of the full potential trading interest 
of these discretionary orders until trades occur. Accordingly, 
because ArcaEx does not publish the discretionary aspect of these 
discretionary orders, they should not be deemed to be a ``bid or 
offer'' within the meaning of the Quote Rule.

b. Discretionary Orders Represent a More Complex Trading Interest Than 
Traditional ``Bids'' or ``Offers''

    Discretionary orders allow the investor to express a more 
complex--and more accurate--trading interest than the single price 
and size of a conventional order.\120\ Unlike ``bids'' and 
``offers,'' discretionary orders reflect the fact that there is 
usually more than one price at which an investor is willing to buy 
or sell. Because these discretionary orders represent a 
qualitatively different set of information from the traditional 
price and size information, they are more analogous to indications 
of interest, than bids and offers. Therefore, like indications of 
interest, discretionary orders should be excluded from the 
requirements of the Quote Rule.\121\ The Commission reached a 
similar conclusion in its analysis of OptiMark Profiles, finding 
that ``Profiles are analogous to indications of interest or CAP 
orders,\122\ neither of which are displayed in exchanges or on 
Nasdaq.''\123\ Therefore, the inchoate trading interest of 
discretionary orders should not be treated as a bid or offer under 
the Quote Rule.\124\
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    \120\ As the Commission has stated repeatedly, the Quote Rule is 
premised on the notion of a bid or offer at one specified price and 
one specified size. See, e.g., Securities Exchange Act Release No. 
35030 (Nov. 30, 1994), 59 FR 63141, 63145 (1994).
    \121\ Rule 11Ac1-1(a)(4) under the Securities Exchange Act.
    \122\ For a description of CAP orders, see, e.g., NYSE Rules 13 
and 123A.
    \123\ See, e.g., OptiMark Release at 50046.
    \124\ This may be especially true for indications of interest 
expressed by those who do not constitute ``members'' or 
``responsible broker-dealers'' within the meaning of the Quote Rule. 
See Order Handling Release at 48311, n. 248.
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c. Inclusion of Discretionary Orders Would Impair the Existing Quote 
Information

    Because the discretionary orders represent a more complex 
expression of trading preferences than traditional orders, any 
attempt to include them in the public quotation stream would 
undermine the Commission's efforts to improve the ``quality of 
published quotations, competition and price efficiency.''\125\ The 
Commission has long recognized that ``quotation information is of 
significant value to the marketplace as a whole insofar as a 
quotation reflects the considered judgment of a market professional 
as to various factors affecting the market, including the current 
price levels and size of buying and selling interest.''\126\ Because 
the discretionary orders do not represent any ``current'' market 
judgment as to a particular transaction price or size, the investing 
public at large would be misled and confused by its inclusion in 
public quotations.\127\ Furthermore, the Commission has previously 
stated that the dissemination of contingent trading interest, like 
discretionary orders, ``would likely be very difficult'' and ``could 
create confusion for investors.''\128\
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    \125\ See Order Handling Release at 48290.
    \126\ See Announcement of Written Requests Sent to Registered 
National Securities Exchanges concerning Availability of Quotation 
Information, Securities Exchange Act Release No. 11288, 40 FR 15015 
(1975).
    \127\ See OpitMark Release at 50046.
    \128\ Id.
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2. The Commission Has Approved the Use of Similar Orders in Other 
Contexts

a. Exchanges Must Be Allowed To Compete on Equal Footing With 
Alternative Trading Systems

    In adopting Regulation ATS, the Commission expressly recognized 
the value of conditional orders and specifically allowed ATSs to 
continue using reserve size orders, negotiation features and other 
similar conditional orders.\129\ Specifically, under Rule 301(b)(3), 
if a portion of a subscriber's order is not displayed to others, 
that undisplayed portion is not subject to the public display 
requirements in Rule 301(b)(3).\130\
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    \129\ See Securities Exchange Act Release No. 40760 (Dec. 8, 
1998), 63 FR 70844, 70866 (Dec. 22, 1998) (``ATS Release'').
    \130\ See Rule 301(b)(3) under the Exchange Act (``An [ATS] 
shall comply with the requirements set forth in paragraph (b)(3)(ii) 
of this section, with respect to any covered security in which the 
[ATS]: (A) displays subscriber orders to any person (other than 
[ATS] employees'').
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    Because a fundamental goal of the national market system is to 
``achieve a market characterized by * * * fair competition,''\131\ 
the Commission previously has recognized the importance of 
facilitating ``opportunit[ies] for registered exchanges to better 
compete with alternative trading systems.''\132\ Therefore, the 
Commission should not prohibit a registered exchange's use of these 
order types when it allows an ATS to use them.\133\ Such an 
unnecessary prohibition creates an unlevel playing field between 
exchanges and ATSs--two trading venues which are considered true 
competitors in today's markets\134\--in opposition to the national 
market system goals.\135\
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    \131\ S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 101.
    \132\ See ATS Release at 70844.
    \133\ See NNMS Release at 3995 (reserve orders ``allow market 
makers quoting in Nasdaq to compete more effectively with 
alternative trading systems that provide a reserve size feature'').
    \134\ In fact, ATS meets the definition of an exchange, but need 
not register as such, provided it complies with Regulation ATS. See 
Rule 3a1-1(a)(2) under the Exchange Act.
    \135\ See generally ATS Release.
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b. ArcaEx's Discretionary Orders Electronically Perform the Same 
Function as Provided Manually in Today's Trading Environment

    In a traditional floor trading environment, broker-dealers enjoy 
the discretion to ``work'' an order to ensure that the customer 
receives the best price for the trade. This special handling permits 
the broker-dealer to respond to the ever-changing state of the 
market. For example, a broker may represent a customer's trading 
interest at one price, given the state of the current market, but be 
prepared to offer the trade at a different price if the market 
moves. To provide an effective trading platform, ArcaEx must be 
permitted to provide an electronic mechanism which replicates some 
of these value-added activities of market intermediaries. Therefore, 
ArcaEx has designed the discretionary orders. This order type allows 
an aspect of the order to respond to the dynamic trading environment 
without the need for manual order handling.\136\
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    \136\ The use of discretionary orders will help to further the 
national market system goal of fostering ``an opportunity for 
investors' orders to be executed without the participation of a 
dealer.'' See Section 11A(a)(1)(C)(v) of the Securities Exchange 
Act. See also PCX OptiMark Release at 50046 (approving OptiMark, in 
part, because it ``would increase the ability of investors' orders 
to interact directly with other investor orders on the PCX'').
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3. Discretionary Orders Benefit Investors in an Electronic Environment

a. Discretionary Orders Enhance Liquidity

    The Commission has emphasized that one of its goals as a 
regulator is to provide ``the deepest, most liquid markets 
possible'' and to ``minimize short-term price volatility.''\137\ 
Discretionary orders can help the Commission reach this goal. By 
providing investors with greater flexibility in the handling of 
their orders, the discretionary orders will encourage greater 
investor participation on the PCX, which, in turn, will increase the 
depth and liquidity of the securities markets.\138\ For example, the 
discretionary orders allow a certain amount of anonymity for a 
trade--something which may be very attractive to various segments of 
the market which would otherwise be disinclined to trade on ArcaEx. 
Therefore, the introduction of the discretionary order is likely to 
attract new market participants, both retail and institutional, 
thereby enhancing liquidity through increased order flow to ArcaEx.
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    \137\ Securities Exchange Act Release No. 43084 (July 28, 2000), 
65 FR 48406, 48407 (Aug. 8, 2000) (``Disclosure of Order Routing and 
Execution Practices Release'').
    \138\ See, e.g., Securities Exchange Act Release No. 42344 (Jan 
14, 2000), 65 FR 3987, 3995 (Jan. 25, 2000) (``Increased 
participation in NNMSS [as a result of the attractiveness of reserve 
orders for large investors] should enhance the depth and liquidity 
of the market for NNM securities, to the benefit of all market 
participants'').
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b. Discretionary Orders Facilitate Investor Protection

    In the past, the Commission has rejected claims that the use of 
conditional order types in electronic trading environments create a 
hidden market to the detriment of investors.\139\ The Commission has 
concluded that ``when orders are not displayed to

[[Page 23308]]

anyone, the Commission's concerns about a two-tiered market--where 
some market participants have information others do not--are 
absent.''\140\
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    \139\ See, e.g., ATS Release at 70867; PCXx OptiMark Release at 
50046 (``contrary to the NYSE's assertion, the [PCX] is not 
operating a hidden market in violation of the Firm Quote Rule'').
    \140\ See ATS Release at 70867.
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    ArcaEx's discretionary orders will not provide any market 
participant with an unfair trading advantage.\141\ All Users will 
see the same orders ranked in the Arca Book, i.e., ArcaEx will 
display to all User those orders which are displayed in the Limit 
Order Process of the Arca Book, but not the working orders in the 
Working Order Process.\142\ No Users will have special access to 
trading interest that is not available to others on ArcaEx. All 
Users have the equivalent opportunity to receive fills based on both 
displayed and undisplayed orders. Furthermore, no Users will be able 
to control or influence the trades resulting from conditional 
trading interest; the trades will only be executed pursuant to an 
established algorithm.\143\ Therefore, discretionary orders fail to 
hurt investors in any way; they only provide benefits to the 
marketplace, as discussed in detail above.
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    \141\ See, e.g., PCX OptiMark Release at 50046 (``The failure to 
disseminate Profile does not provide any other market participant 
with an unfair market advantage as a result of seeing the trading 
interest that is not shown to others. Any User only knows its own 
Profile; it has no special access to other Users' Profiles. 
Moreover, Users have no control or influence in determining the 
outcome of a match, other than through the construction of their own 
Profiles.'')
    \142\ See Proposed PCXE Rule 7.36.
    \143\ See Proposed PCXE Rule 7.37.
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C. Conclusion

    Discretionary orders comply with Rule 11Ac1-1. Moreover, not 
only do such orders not present any potential for investor harm, 
they affirmatively will benefit both investor and market liquidity.

[FR Doc. 01-11472 Filed 5-7-01; 8:45 am]
BILLING CODE 8010-01-U