Release No. 34-51808

File No. S7-10-04

Regulation NMS

Section IV: Sub-Penny Rule
Section V:Market Data Rules and Plan Amendments

Table of Contents

IV. Sub-Penny Rule

The Commission today is adopting Rule 612 under the Exchange Act⁴⁶³ which will govern sub-penny quoting of NMS stocks. Rule 612 imposes new requirements on any bid, offer, order, or indication of interest that is displayed, ranked, or accepted by a national securities exchange, national securities association, ATS, vendor, or broker-dealer. The Commission is adopting Rule 612 as it was reproposed in December 2004 with only a few minor amendments for clarity.

A. Background

In June 2000, the Commission issued an order directing NASD and the national securities exchanges to act jointly in developing a plan to convert their quotations in equity securities and options from fractions to decimals.⁴⁶⁴ The June 2000 Order stated that the plan could fix the minimum price variation ("MPV") during the phase-in period, provided the MPV was no greater than $0.05 and no less than $0.01 for any equity security.⁴⁶⁵ The June 2000 Order also required NASD and the exchanges to provide the Commission with studies analyzing how decimal conversion had affected systems capacity, liquidity, and trading behavior, including an analysis of whether there should be a uniform MPV.⁴⁶⁶ The Commission stated that, if NASD or an exchange wished to move to quoting stocks in an increment less than $0.01, its study should include a full analysis of the potential impact on the market requesting the change and on the markets as a whole.⁴⁶⁷ Furthermore, the Commission required each SRO to propose a rule change under Section 19(b) of the Exchange Act⁴⁶⁸ to establish its individual choice of MPV for securities traded on its market.⁴⁶⁹ NASD and the exchanges complied with these requirements, and in August 2002 the Commission approved rule changes from all of these SROs to establish an MPV of $0.01 for equity securities.⁴⁷⁰

Between the June 2000 Order and the August 2002 Order, the Commission issued a Concept Release seeking public comment on the potential impact of sub-penny pricing,⁴⁷¹ including its effect on: (1) price clarity (e.g., the potential to cause ephemeral or "flickering" quotations); (2) market depth (i.e., the number of shares available at a given price); (3) compliance with the Order Handling Rules and other price-dependent rules; and (4) the operations and capacity of automated systems.⁴⁷² The Commission received 33 comments on the Concept Release.⁴⁷³ The majority of commenters opposed sub-penny pricing. Some stated that the negative effects of decimal trading would be exacerbated by further reducing the MPV, without meaningfully reducing spreads or securing other benefits for the markets or investors.⁴⁷⁴ These commenters recommended that all securities have an MPV of at least a penny.⁴⁷⁵ A smaller number of commenters believed that the forces of competition, rather than regulation by the Commission or Congress, should determine the MPV.⁴⁷⁶ These commenters suggested that a smaller MPV could improve market efficiency and provide investors with greater opportunity for price improvement. They argued generally that the problems accompanying decimals could be resolved through technology enhancements, rather than through regulation.

In August 2003, Nasdaq submitted a proposed rule change to the Commission to adopt an MPV of $0.001 for Nasdaq-listed securities.⁴⁷⁷ Nasdaq stated that, unless and until a uniform MPV were established, it felt compelled to implement an MPV of $0.001 to remain competitive with ECNs that permit their subscribers to quote in sub-pennies. At the same time, Nasdaq filed a petition for Commission action urging the Commission "to adopt a uniform rule requiring market participants to quote and trade Nasdaq securities in a consistent monetary increment . . . with the exception of average price trades."⁴⁷⁸

B. Commission Proposal and Reproposal on Sub-Penny Quoting

In February 2004, the Commission proposed new Rule 612 that would govern sub-penny quoting as part of the overall Regulation NMS proposal. In the initial Proposing Release, the Commission summarized the conversion of the U.S. securities markets from fractional to decimalized trading and stated its view that, on balance, the benefits of decimalization have justified the costs. The Commission cautioned, however, that if the MPV were to decrease beyond a certain level, the potential costs to investors and the markets could at some point surpass any potential benefits.⁴⁷⁹ To address this concern, Rule 612 as proposed would have prohibited any national securities exchange, national securities association, ATS, vendor, or broker-dealer from displaying, ranking, or accepting from any person a bid, offer, order, or indication of interest in an NMS stock priced in an increment less than $0.01 per share. This restriction would not have applied to any NMS stock the share price of which is below $1.00.

The proposed rule was designed to limit the ability of a market participant to gain execution priority over a competing limit order by stepping ahead by an economically insignificant amount. In issuing the sub-penny proposal, the Commission cited research performed by OEA showing a high incidence of sub-penny trades that cluster around the $0.001 and $0.009 price points. The OEA study concluded that this phenomenon resulted from market participants attempting to step ahead of competing limit orders for the smallest economic increment possible.⁴⁸⁰

In the Proposing Release, the Commission pointed to a variety of additional problems caused by sub-penny quoting, including the following:

• If investors' limit orders lose execution priority for a nominal amount, investors may over time decline to use them, thus depriving the markets of liquidity.
• When market participants can gain execution priority for an infinitesimally small amount, important customer protection rules such as exchange priority rules and NASD's Manning rule⁴⁸¹ could be rendered meaningless. Without these protections, professional traders would have more opportunity to take advantage of non-professionals, which could result in the latter either losing executions or receiving executions at inferior prices.
• Flickering quotations that can result from widespread sub-penny pricing could make it more difficult for broker-dealers to satisfy their best execution obligations and other regulatory responsibilities. The best execution obligation requires a broker-dealer to seek for its customer's transaction the most favorable terms reasonably available under the circumstances.⁴⁸² This standard is premised on the practical ability of the broker-dealer to determine whether a displayed price is reasonably obtainable under the circumstances.
• Widespread sub-penny quoting could decrease market depth (i.e., the number of shares available at the NBBO) and lead to higher transaction costs, particularly for institutional investors (such as pension funds and mutual funds) that are more likely to place large orders. These higher transaction costs would likely be passed on to retail investors whose assets are managed by the institutions.
• Decreasing depth at the inside also could cause such institutions to rely more on execution alternatives away from the exchanges and Nasdaq that are designed to help larger investors find matches for large blocks of securities. Such a trend could increase fragmentation of the securities markets.

In the Reproposing Release, the sub-penny rule was fundamentally unchanged although the Commission made certain minor modifications in response to the comments received on the Proposing Release. These modifications in reproposed Rule 612 would have: (1) based the sub-penny restriction on the price of the quotation rather than the price of the NMS stock itself; and (2) limited a quotation priced less than $1.00 per share to four decimal places.

C. Comments Received

The Commission sought comment on all aspects of reproposed Rule 612. Of the total comments that the Commission received in response to the Reproposing Release, approximately 33 commenters addressed the sub-penny rule. The majority of these commenters supported a restriction on sub-penny quoting.⁴⁸³ One commenter argued that sub-penny quoting would too easily permit market professionals to step ahead of competing limit orders by an economically insignificant amount.⁴⁸⁴ Another commenter stated that "[t]oday, SROs are held to minimum quoting increments, while other market centers are not, and this arbitrage should be eliminated."⁴⁸⁵ A third commenter offered a similar perspective, stating that the sub-penny prohibition "will prevent renegade systems from allowing a minority of traders to exploit the majority" that do not offer sub-penny quoting.⁴⁸⁶

Three commenters argued that, in the absence of a general prohibition on sub-penny quoting, market data systems would be severely taxed.⁴⁸⁷ One commenter – a trade organization that addresses issues relating to market data and securities processing automation – doubted "whether the impact of sub-penny quoting and trading on rising infrastructure costs is adequately offset by market quality benefits to investors and market participants."⁴⁸⁸ A second commenter stated that an industry-wide shift to sub-penny quoting would "forc[e] the industry into another round of substantial capital investments to accommodate the quote traffic."⁴⁸⁹ A third commenter echoed that view, stating that the new rule "will protect industry systems from significant data traffic that has little benefit to investors or to the industry."⁴⁹⁰

A few commenters on the Reproposing Release opposed Rule 612,⁴⁹¹ as did a minority of commenters on the initial Proposing Release.⁴⁹² Some commenters argued that quoting in sub-pennies should be permitted because it increases liquidity, lowers trading costs, and promotes efficient pricing in the equity markets.⁴⁹³ Two commenters believed that government intervention was not appropriate, as market forces should address this issue.⁴⁹⁴ Alternatively, one commenter who objected to reproposed Rule 612 argued that "[t]he appropriate MPV in the equities market is at least [a] nickel or some reasonable, tiered alternative."⁴⁹⁵

One commenter on the Reproposing Release – INET, an ECN that currently offers its users the ability to quote certain NMS stocks in sub-pennies – argued generally that "the various marketplaces . . . are better positioned than regulators to evaluate the most appropriate trading increment."⁴⁹⁶ In addition, INET maintained that the existing penny MPV exacerbates larger market structure problems, such as internalization and payment for order flow,⁴⁹⁷ stating that "the convention of only quoting in pennies creates what is in effect an underground market where better prices are remitted back to certain firms through payment for order flow relationships but not reflected in any quotation."⁴⁹⁸ Furthermore, INET presented specific examples where, it claimed, moving from penny to sub-penny quoting reduced spreads.⁴⁹⁹

After careful consideration of all comments received, the Commission is adopting Rule 612 as reproposed, with only a few minor amendments for clarity. The Commission notes that a large majority of commenters on both the Reproposing Release⁵⁰⁰ and the initial Proposing Release⁵⁰¹ supported a sub-penny quoting prohibition. The comments received have reinforced the Commission's preliminary view that there are substantial drawbacks to sub-penny quoting, and the Commission believes that a uniform rule banning this practice (except for quotations priced less than $1.00 per share) is appropriate. Several commenters agreed with the Commission's view that sub-penny quotations can increase the incidence of quote flickering, which in turn may have adverse effects such as confusing investors or impeding a broker-dealer's ability to fulfill its duty of best execution.⁵⁰²

Moreover, the Commission agrees with the many commenters who believe that Rule 612 will deter the practice of stepping ahead of exposed trading interest by an economically insignificant amount. Limit orders provide liquidity to the market and perform an important price-setting function. The Commission is concerned that, if orders lose execution priority because competing orders step ahead for an economically insignificant amount, liquidity could diminish. As one commenter, the Investment Company Institute, stated, "[t]his potential for the increased stepping-ahead of limit orders would create a significant disincentive for market participants to enter any sizeable volume into the markets and would reduce further the value of displaying limit orders."⁵⁰³

Some commenters argued, however, that investors would suffer harm from the artificially wide spreads resulting from a prohibition on sub-penny quoting.⁵⁰⁴ One commenter stated, for example, that "the primary result of eliminating subpenny trading would be to preserve a minimum profit for market makers, and would result in significantly worse realized prices for the vast majority of market participants not in the business of making markets."⁵⁰⁵ These commenters offered various estimates of the costs of prohibiting sub-penny quoting.⁵⁰⁶

Even assuming that quoting in sub-penny increments would reduce spreads, the Commission continues to believe, on balance, that the costs of sub-penny quoting are not justified by the benefits.⁵⁰⁷ The Commission instead agrees with the commenters who believe that the substantial costs associated with sub-penny quoting – among others, disincentives to liquidity providers whose limit orders are jumped by an economically insignificant amount and the increased incidence of flickering quotes and the resulting regulatory compliance and capacity burdens – make the adoption of Rule 612 appropriate at this time.

Nevertheless, the Commission acknowledges the possibility that the balance of costs and benefits could shift in a limited number of cases or as the markets continue to evolve. Therefore, Rule 612 – as proposed and as adopted – includes a provision setting forth procedures for the Commission, by order, to exempt any person, security, or quotation (or any class or classes or persons, securities, or quotations) from the sub-penny quoting restriction if it determines that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors. The Commission could grant such exemption either unconditionally or on specified terms and conditions.

In the Proposing Release, the Commission requested comment on whether certain securities should be exempted from Rule 612.⁵⁰⁸ In particular, the Commission asked whether sub-penny quoting of exchange-traded fund shares ("ETFs"), which are derivatively priced, raised the same concerns as with other NMS stocks.⁵⁰⁹ Some commenters that addressed this issue argued that the sub-penny prohibition should apply to all NMS stocks, including ETFs.⁵¹⁰ These commenters generally believed that sub-penny quoting raises the same type of concerns for ETFs as for other types of securities.⁵¹¹ Other commenters provided arguments that exemptions for at least certain securities would be appropriate. One commenter that opposed Rule 612 argued that, if the Commission nevertheless did approve the rule, it should provide an exemption for QQQQ and other ETFs.⁵¹² This commenter argued that these securities "uniquely lend[] themselves to subpenny quoting and trading" because "the[ir] derivative nature . . . enables investors to determine their true value at any point in time by calculating the aggregate price of the securities constituting a particular ETF."⁵¹³ Other commenters, while not explicitly recommending that the Commission grant particular exemptions, argued that sub-penny quoting was reasonable for certain securities.⁵¹⁴

As the Commission stated in the Reproposing Release,⁵¹⁵ a basis may exist to exempt QQQQ and perhaps other actively traded ETFs from Rule 612. The Commission will continue to study this matter during the implementation period for Regulation NMS.

One commenter, although not clearly advocating that the Commission use its authority to exempt certain securities from Rule 612, stated that "the Commission may want to employ objective criteria in determining when it is appropriate to trade in sub-pennies."⁵¹⁶ In this regard, another commenter stated: "If the Commission wanted to permit only certain stocks to be quoted and traded in sub-penny increments, the main factor that should be considered is the average spread and the quoted size. If a security always trades with a penny spread and there is tremendous liquidity available on both sides of the market, this is a strong indication that the minimum increment is too wide."⁵¹⁷ The Commission believes that this would be a reasonable consideration in analyzing whether it would be in the public interest and consistent with the protection of investors to grant an exemption pursuant to Rule 612(c). Other factors that the Commission might consider are:

• whether the NMS stock is an ETF or other derivative that can readily be converted into its underlying securities or vice versa, in which case the true value of the security as derived from its underlying components might be at a sub-penny increment;
• large volume of sub-penny executions in that security due to price improvement; and
• low price of the security.

This list is illustrative, not exclusive. The Commission may consider other factors – noted by a petitioner or in its own analysis – if and when it considers whether to issue an exemption.

The Commission wishes to highlight certain aspects of Rule 612, as adopted, that were raised by commenters on both the Proposing Release and the Reproposing Release.

1. Restriction Based on Price of the Quotation Not Price of the Stock

As initially proposed, the restriction on sub-penny quoting would have been triggered if the price of the NMS stock itself were above $1.00. One commenter sought clarification of when an NMS stock would become sub-penny eligible, suggesting a threshold of trading below $1.00 for 30 consecutive business days.⁵¹⁸ A second commenter suggested instead that the prohibition should derive from the price of the order, rather than the price of the stock; in other words, the rule should permit any sub-penny quotation below $1.00 and prohibit any sub-penny quotation above $1.00, regardless of the price where the stock was in fact trading.⁵¹⁹ The second commenter argued that this approach "does not require countless re-classifications of stocks as 'sub-penny eligible' based on fluctuations in their valuation, stock splits, or other price movements."⁵²⁰

The Commission agreed with the second commenter and, therefore, revised paragraph (a) of reproposed Rule 612 to prohibit any bid, offer, order, or indication of interest priced equal to or greater than $1.00 in an increment smaller than $0.01. As the Commission stated in the Reproposing Release,⁵²¹ basing the restrictions on the price of the quotation or order rather than the price of the NMS stock itself would spare market participants the need to track the eligibility of stocks priced near the $1.00 threshold.

Three commenters on the Reproposing Release noted their approval of basing the sub-penny quoting restriction on the price of the quotation rather than the price of the NMS stock itself;⁵²² no commenter objected to this approach. The Commission continues to believe in the rationale for this aspect of the proposal as described in the Reproposing Release. Therefore, the Commission is adopting Rule 612(a) substantially in the form reproposed in December 2004. The Commission is making a non-substantive amendment to clarify the rule. Reproposed Rule 612(a) would have stated that no market participant "shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock equal to or greater than $1.00 in an increment smaller than $0.01." Rule 612(a) as adopted provides that no market participant "shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller than $0.01 if that bid or offer, order, or indication of interest is priced equal to or greater than $1.00 per share." The purpose of this revision is to clarify that the qualification "priced equal to or greater than $1.00 per share" modifies the phrase "a bid or offer, an order, or an indication of interest" rather than "any NMS stock." The adopted text also makes clear that this proviso applies to bids, offers, orders, and indications of interest priced equal to or greater than $1.00 per share. The modifying phrase "per share" was not present in reproposed Rule 612(a).

As a result of Rule 612(a), a broker-dealer may not, for example, accept a sell order in an NMS stock priced at $1.0025 per share, even if the NMS stock currently trades below $1.00.

2. Quotations Below $1.00

The Commission initially proposed a threshold of $1.00 below which the prohibition on sub-penny quoting would not apply and requested comment on whether that threshold was appropriate. The majority of commenters addressing this issue believed that it would be useful for low-priced securities to trade in increments finer than a penny, because a penny would constitute a significant percentage of the overall price. These commenters viewed $1.00 as an appropriate threshold.⁵²³ One commenter stated that there is "real demand for sub-penny trading (and therefore subpenny quoting) in securities trading below $1.00, due to the low trading value of the security."⁵²⁴ However, another commenter, Ameritrade, argued that Rule 612 should not contain an exception for securities trading under $1.00.⁵²⁵ According to Ameritrade, "[t]he appropriate answer to this issue is for the NYSE, AMEX and NASDAQ markets to uniformly enforce listing standards, which generally require a security to trade above $1.00."⁵²⁶

The Commission is adopting the $1.00 threshold as proposed. The Commission agrees with the commenters who believe that sub-penny quotations for very low-priced securities largely represent genuine trading interest rather than unfair stepping ahead. In such cases, a sub-penny increment represents a significant amount of the price of the quotation or order. Accordingly, the prohibition on sub-penny quoting in paragraph (a) of Rule 612 will apply only to bids, offers, orders, and indications of interest that are priced $1.00 or more per share. With respect to Ameritrade's comment, while the Commission believes that SROs must vigorously enforce their listing standards, there are legitimate circumstances where securities may be trading below $1.00; therefore, the Commission believes it is appropriate for Rule 612 to address those circumstances.

Before the Reproposing Release, two commenters suggested that the Commission establish an MPV for quotations below $1.00 per share; both recommended allowing such quotations to extend to four decimal places.⁵²⁷ The Commission agreed with these commenters and added a new paragraph (b) to reproposed Rule 612 that would have prohibited a bid, offer, order, or indication of interest priced less than $1.00 per share in an increment smaller than $0.0001. The Commission believes that, without limiting the number of decimal places used in quotations for very low-priced securities, the problems caused by sub-penny quoting of higher-priced securities, discussed above, could arise. Restricting quotations below $1.00 to four decimal places should avoid these problems. The same two commenters reacted favorably to this aspect of the Reproposing Release.⁵²⁸

The Commission is adopting, as reproposed, the provision limiting a quotation under $1.00 per share to four decimal places. Thus, under new Rule 612, a quotation of $0.9987 x $1.00 is permitted but a quotation of $0.9987 x $1.0001 is not.⁵²⁹

The Commission notes that it has made non-substantive revisions to Rule 612(b) in a manner similar to Rule 612(a). Reproposed Rule 612(b) would have stated that no market participant "shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock less than $1.00 in an increment smaller than $0.0001." Rule 612(b) as adopted provides that no market participant "shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller than $0.0001 if that bid or offer, order, or indication of interest is priced less than $1.00 per share." The purpose of this revision is to clarify that the qualification "priced less than $1.00 per share" modifies the phrase "a bid or offer, an order, or an indication of interest" rather than "any NMS stock." The adopted text also makes clear that this proviso applies to bids, offers, orders, and indications of interest priced less than $1.00 per share. The modifying phrase "per share" was not present in reproposed Rule 612(b).

During the Regulation NMS implementation period, the Commission intends to consult with the administrators of the Plans to help ensure that sub-penny quotations permitted by Rule 612 will be widely disseminated to the public. The Commission believes this is necessary so that the problem of hidden markets – where professionals can see and access more competitive sub-penny quotations that average investors cannot – is fully addressed.

3. Revisiting the Penny Increment

Some commenters, while generally acknowledging problems caused by sub-penny quoting, recommended that the Commission consider increasing the MPV above $0.01.⁵³⁰ One commenter believed that "[t]he Commission should seriously consider experimenting with different tick sizes to help determine the optimal tick policy."⁵³¹ A second commenter recommended that the Commission establish an MPV of a $0.01 for high-volume stocks, $0.05 middle-volume stocks, and $0.10 for the low-volume stocks.⁵³² A third commenter argued that the appropriate MPV in the equities market is at least $0.05 "or some reasonable, tiered alternative."⁵³³ The third commenter previously stated that "sub-penny quoting does little, if anything, to degrade the market from its current state" because "the true damage was done to the market in the shift from a fractionalized environment to a penny spread environment."⁵³⁴

Rule 612, as adopted, sets a floor for the MPV but does not, and is not designed to, determine the optimal MPV. Penny pricing in NMS stocks was established by rules proposed by NASD and the national securities exchanges and approved by the Commission pursuant to Section 19(b) of the Exchange Act.⁵³⁵ While some commenters argue that penny pricing impedes transparency and reduces liquidity, the move to decimals (and specifically the move to a penny quotation increment for NMS stocks) also has significantly reduced spreads and reduced trading costs for investors who enter orders executed at or within the NBBO. As the Commission stated in the Reproposing Release,⁵³⁶ it believes that the establishment of a $0.01 MPV, on balance, has benefited many investors. Accordingly, the Commission did not propose to raise the MPV in connection with Regulation NMS. The Commission's views on this matter have not changed since issuance of the Reproposing Release, and the Commission is not amending Rule 612 to raise the MPV.

4. Sub-Penny Trading

The Commission stated in the Proposing Release that it did not at that time believe that trading in sub-penny increments raised the same concerns as sub-penny quoting. Therefore, the proposed rule would not have prohibited a market center or broker-dealer from executing and printing a trade in sub-penny increments that was, for example, the result of a midpoint or volume-weighted pricing algorithm, as long as it did not otherwise violate the proposed rule. In addition, a broker-dealer could, consistent with the proposed rule, provide price improvement to a customer order that resulted in a sub-penny execution as long as the broker-dealer did not accept an order priced above $1.00 per share in a sub-penny increment. The Commission sought specific comment on this aspect of the proposal.

Every commenter that addressed this issue in response to the Proposing Release agreed that Rule 612 should permit sub-penny trades that result from midpoint and average-price algorithms.⁵³⁷ While most of these commenters believed that the rule should permit broker-dealers to offer sub-penny price improvement to their customers' orders,⁵³⁸ a few commenters urged the Commission to bar this practice.⁵³⁹ The Commission did not revise this aspect of the sub-penny rule in the Reproposing Release. Two commenters that addressed this issue in response to the Reproposing Release also believed that the rule should permit sub-penny trades that result from midpoint and average-price algorithms.⁵⁴⁰ One of these commenters added that sub-penny trades resulting from price improvement also should be permitted.⁵⁴¹

After considering all views expressed on this issue, the Commission is adopting this aspect of Rule 612 as proposed and reproposed. Rule 612 will not prohibit a sub-penny execution resulting from a midpoint or volume-weighted algorithm or from price improvement, so long as the execution did not result from an impermissible sub-penny order or quotation. The Commission believes at this time that trading in sub-penny increments does not raise the same concerns as sub-penny quoting. Sub-penny executions do not cause quote flickering and do not decrease depth at the inside quotation. Nor do they require the same systems capacity as would sub-penny quoting. In addition, sub-penny executions due to price improvement are generally beneficial to retail investors.

5. Acceptance of Sub-Penny Quotations

The Commission initially proposed to prohibit national securities exchanges, national securities associations, ATSs, vendors, and broker-dealers from displaying, ranking, or accepting sub-penny orders or quotations in NMS stocks. One commenter argued that Rule 612 should allow a market participant to accept sub-penny quotations if it consistently re-prices such quotations to an acceptable increment and does not give the sub-penny quotations any special priority for ranking or execution purposes.⁵⁴² A second commenter disagreed, arguing that rounding a sub-penny quotation to the nearest penny may be confusing for investors.⁵⁴³ The Commission agreed with the second commenter and reproposed Rule 612 continued to include a prohibition on accepting and rounding a sub-penny order.

In response to the Commission's statements on this matter in the Reproposing Release, one commenter stated that the Commission should "continu[e] to allow (but, of course, not require) market centers to adjust the pricing of disallowed sub-penny quotations, so long as the unadjusted quotations are not displayed or considered for purposes of ranking."⁵⁴⁴ This commenter argued that adjusting such quotations "is a well-established practice" and that prohibiting the practice "has the potential to create needless confusion and impose additional costs."⁵⁴⁵ Another commenter on reproposed Rule 612 argued similarly that keeping the established practice would not present "any real potential for confusion among investors."⁵⁴⁶

Notwithstanding these comments, the Commission is adopting this aspect of Rule 612 as proposed and reproposed. A market participant, therefore, is prohibited from accepting a sub-penny order or quotation that is not permitted by the rule, even if it rounds the order or quotation to the nearest permissible pricing increment. While the Commission does not believe that a great deal of customer confusion is likely to arise in either case, it does believe that confusion is more likely to result if a broker-dealer, for example, accepted a customer order to buy at $20.001, then rounded and ultimately executed it at $20.00. A customer unfamiliar with Rule 612 could conceivably wonder why his or her order did not have priority above orders to buy at $20.00. A much simpler and more transparent approach is for Rule 612 to prohibit the acceptance of sub-penny orders generally (except for orders priced below $1.00 per share, which may extend to four decimal places), and for the broker-dealer to adhere to the rule by rejecting the customer's sub-penny order to buy at $20.001. The Commission sees no purpose that would be served by allowing the broker-dealer to accept this sub-penny order, since Rule 612 would in any case prohibit the full order from being displayed or considered for ranking or execution purposes.⁵⁴⁷

6. Application to Options Markets

As initially proposed, Rule 612, by its terms, would have applied only to NMS stocks. The Commission requested comment on whether the rule also should apply to options.⁵⁴⁸ Currently, SRO rules require options to be quoted on the U.S. markets in increments of $0.05 and $0.10. Therefore, the problems that could be created by sub-penny quoting currently do not exist in the options markets.

Two commenters believed that the rule should not apply to quoting in options.⁵⁴⁹ One of these commenters, assuming that the rule as proposed would allow options with a premium of less than $1.00 to be quoted in sub-pennies and options with a premium over $1.00 to be quoted in pennies, argued that this approach "would overwhelm the already taxed capacity of existing options quote processing systems."⁵⁵⁰ The Commission did not believe at the time it issued the Reproposing Release that it was necessary for the sub-penny rule to extend to options, nor does it believe so now. The concerns created by sub-penny quoting – present to some extent in the equities markets – currently do not exist in the options markets, where the smallest quoting increment is $0.05. Therefore, Rule 612 will not apply to options. If a national securities exchange seeks to quote options in pennies or sub-pennies in the future, it would first need to propose a rule change to that effect under Section 19(b) of the Exchange Act.⁵⁵¹ The Commission would have an opportunity to consider such a proposal at that time, after publishing notice and obtaining public comment.⁵⁵²

A third commenter,⁵⁵³ while agreeing strongly with the proposed sub-penny rule, argued that the Commission should prohibit the Boston Options Exchange ("BOX"), a facility of the Boston Stock Exchange, from using "sub-increment" pricing (i.e., penny prices below the standard $0.05 and $0.10 increments used for options) in its "Price Improvement Period" ("PIP").⁵⁵⁴ By initiating a PIP auction, a BOX market participant may execute a portion of its agency order as principal in pennies, and BOX market makers can match that price or offer price improvement to those orders in penny increments during the three-second auction. The Commission previously approved the BOX trading rules, including the rules governing the PIP, pursuant to Section 19(b) of the Exchange Act.⁵⁵⁵ The PIP uses pennies in an auction, not in public quotations. Therefore, the Commission does not believe that the PIP raises the same concerns caused by sub-penny quotations of non-option securities and, therefore, that it is not necessary to prohibit the use of pennies in BOX's PIP.

7. One-to-One Negotiating Systems

One commenter – Liquidnet, an ATS whose system allows institutional traders to negotiate large-sized orders – argued that Rule 612 should not prohibit orders priced in half-penny increments for one-to-one negotiating systems.⁵⁵⁶ Liquidnet currently permits a user to submit an order at the mid-point of the spread, which would be at a half-penny increment if the spread were an odd number of cents wide (e.g., $10.00 x $10.03). Liquidnet argues that the "sub-penny pricing abuses that the SEC is trying to prevent are not applicable, because any orders are only seen by the two negotiating parties."⁵⁵⁷ Although the Commission does not believe it is necessary or appropriate to include in Rule 612 an exception for one-to-one negotiating systems such as Liquidnet's, it would consider a request for exemptive relief that would permit one-to-one negotiations of sub-penny trades through an ATS. The Commission will study this issue further during the Regulation NMS implementation period.

8. Implementation of Rule 612

While the majority of commenters supported the sub-penny rule, a few specifically requested that the Commission implement it as quickly as possible.⁵⁵⁸ One of the commenters stated that there are no "significant technological or structural impediments to immediate implementation."⁵⁵⁹ The Commission agrees with this view. Currently, sub-penny quoting that would be prohibited by Rule 612 exists only on a small number of ATSs and in a small number of NMS stocks. Nasdaq and all of the national securities exchanges already have rules that permit quoting only in $0.01 increments. No commenter indicated that converting ATS systems to comply with the rule would impose any significant burdens. In light of this, and the small number of impacted NMS stocks, the Commission believes that only minimal systems changes will be necessary for these ATSs to conform to Rule 612 and has determined that the implementation date of Rule 612 will be August 29, 2005.

The Commission notes that it previously has granted exemptions from existing Rules 11Ac1-1, 11Ac1-2, and 11Ac1-4 under the Exchange Act that, among other things, allow certain exchanges to accept sub-penny orders and quotations and to disseminate them in rounded, penny increments without a rounding identifier.⁵⁶⁰ By their terms, these exemptions – which are not consistent with new Rule 612 – expire on June 30, 2005.

Rule 612 permits, but does not require, a trading center to offer its users the ability to quote in sub-pennies in a limited number of cases. An exchange or association that wishes to offer this ability to its market participants will likely need to amend its rules before doing so. The Commission expects the SROs to consider this matter during the implementation period.⁵⁶¹

V. Market Data Rules and Plan Amendments

The Exchange Act rules and joint-SRO Plans for disseminating market information to the public are the heart of the NMS. Pursuant to these rules and Plans, investors are able to obtain real-time access to the best current quotes and most recent trades for all NMS stocks. As a result, investors of all types large and small have access to a comprehensive, accurate, and reliable source of information for the prices of any NMS stock at any time during the trading day.

The SROs generate consolidated market data by participating in the Plans.⁵⁶² Pursuant to the Plans, three separate networks disseminate consolidated market information for NMS stocks: (1) Network A for securities listed on the NYSE; (2) Network B for securities listed on the Amex and other national securities exchanges; and (3) Network C for securities traded on Nasdaq. For each security, the data includes: (1) an NBBO with prices, sizes, and market center identifications; (2) the best bids and offers from each SRO that includes prices, sizes, and market center identifications; and (3) a consolidated set of trade reports in the security. The Networks

establish fees for this data, which must be filed for Commission approval.⁵⁶³ The Networks collect the applicable fees and, after deduction of Network expenses (which do not include the costs incurred by SRO participants to generate market data and supply such data to the Networks), distribute the remaining revenues to their individual SRO participants. As set forth in the following table, the Networks collected $434.1 million in revenues derived from market data fees in 2004 and distributed $393.7 million to their individual SRO participants:

2004 Financial Information for Networks A, B, and C⁵⁶⁴

The overriding objective of the Rule and Plan amendments adopted today is to preserve the vital benefits that investors currently enjoy, while addressing those particular problems with the current rules and Plans that are most in need of reform. The changes fall into three categories: (1) modifying the current formulas for allocating market data revenues to the SROs to more appropriately reflect their contributions to public price discovery; (2) establishing non-voting advisory committees to broaden participation in Plan governance; and (3) updating and streamlining the various Exchange Act rules that govern the distribution and display of market information.

A. Response to Comments and Basis for Adopted Rules

1. Alternative Data Dissemination Models

In addition to proposing specific rules and amendments, the Proposing Release discussed and requested comment on the Commission's decision not to propose an alternative model of data dissemination to replace the current consolidation model.⁵⁶⁵ The great strength of the current model is that it benefits investors, particularly retail investors, by enabling them to assess prices and evaluate the best execution of their orders by obtaining data from a single source that is highly reliable and comprehensive. But, by requiring vendors and broker-dealers to display data to investors that is consolidated from all markets, the current model effectively also requires the purchase of data from all markets. As a result, the most significant drawback of the current model is that it offers little opportunity for market forces to determine a Network's fees, or the allocation of those fees to a Network's SRO participants. Network fees must be closely scrutinized for fairness and reasonableness, and the revenues resulting from those fees must be allocated to the SROs pursuant to a Plan formula. In addition, individual markets have less freedom to innovate in individually providing their quotation and trade data. On the other hand, the consolidated display requirement can promote competition by assuring that markets, particularly smaller or newer ones, can obtain wide distribution of their displayed quotations.⁵⁶⁶

As noted in section I.A.1 above, vigorous competition among multiple markets trading the same securities is one of the distinctive characteristics of the U.S. equity markets. Thus, the existence of the Networks and the consolidated display requirement has not precluded the NMS from promoting the broad objective of assuring competition among markets.

In the Proposing Release, the Commission specifically considered three alternative models that potentially could introduce greater competition and flexibility into the dissemination of market data: (1) a deconsolidation model, (2) a competing consolidators model, and (3) a hybrid model. It decided not to propose any of these alternative models after consideration of the benefits and drawbacks of each model. The Commission did, however, request comment on whether it should develop an alternative model for disseminating market data to the public, and, in particular, on its evaluation of the strengths and weaknesses of the current model and of the various alternative models for the dissemination of market data.

In response to the Commission's request for comment, a minority of commenters expressed their views regarding the appropriate structure for the dissemination of market information to the public. One group believed that the current model requiring the display of consolidated data in a stock through a Plan processor has produced significant benefits for investors and the markets, although several also strongly recommended that its operation needed to be improved in significant respects.⁵⁶⁷ Another group of commenters, in contrast, asserted that the current system has inhibited competition among markets and that the Plans should be eliminated.⁵⁶⁸ These commenters further suggested deregulation of market data by allowing markets to sell their own data, and by allowing market forces and competition to control the pricing of such data. They advocated a competing consolidators model or a hybrid model.

a. Competing Consolidators Model

Under a competing consolidators model, the consolidated display requirement would be retained, but the Plans and Networks would no longer be necessary. Each of the nine SROs that participate in the NMS, as well as Nasdaq, would be allowed to establish its own fees, to enter into and administer its own market data contracts, and to provide its own data distribution facility. Any number of data vendors or broker-dealers (i.e., "competing consolidators") could purchase data from the individual SROs, consolidate the data, and distribute it to investors and other data users. Of the commenters that urged the Commission to adopt a competing consolidators model,⁵⁶⁹ the NYSE, for example, believed that allowing the markets to withdraw from the Plans would "reestablish the link between the value of a market's dataand the fair allocation of costs amongusers," thereby ending inter-market subsidies and market-distortive initiatives created by the current system."⁵⁷⁰ Similarly, ArcaEx stated that "the best way to reform the [P]lans is to abolish them altogether and to adopt a competing consolidators model."⁵⁷¹

Commission, dated June 10, 2004 ("ASA Letter") at 2; ArcaEx Letter at 4, 12, 14; Brut Letter at 22; Financial Services Roundtable Letter at 7; ISE Letter at 8-10; Nasdaq Letter II at 24-26; NYSE Letter, Attachment at 10-11; Reuters Letter at 2; Specialist Assoc. Letter at 17.

The Commission has considered the comments advocating a competing consolidators model, but continues to question the extent to which the model would in fact subject the level of market data fees to competitive forces. If the benefits of a fully consolidated data stream are to be preserved for investors, every consolidator would need to purchase the data of each SRO to assure that the consolidator's data stream in fact included the best quotations and most recent trade report in all NMS stocks. Moreover, to comply with the adopted Order Protection Rule, each trading center would need the quotation data from every other trading center in a security. As a practical matter, payment of every SRO's fees would be mandatory, thereby affording little room for competitive forces to influence the level of fees. Consequently, far from freeing the Commission from involvement in market data fee disputes, the multiple consolidator model would require review of at least ten separate fees for individual SROs and Nasdaq. The overall level of fees would not be reduced unless one or more of the SROs or Nasdaq was willing to accept a significantly lower amount of revenues than they currently are allocated by the Plans. It seems unlikely that any SRO or Nasdaq would voluntarily propose to lower just its own fees and reduce its own current revenues, and some might well propose higher fees to increase their revenues, particularly those with dominant market shares whose information is most vital to investors. No commenter offered useful, objective standards for the Commission to use in evaluating the separate fees of SROs and Nasdaq. For this and for data quality concerns,⁵⁷² the Commission remains unconvinced that discarding the current model in favor of a multiple consolidator model would benefit investors and the NMS in general.

b. Hybrid Model

In its comment on the original proposal, Nasdaq advocated a hybrid model of data dissemination as a compromise if the Commission believes that it is necessary to retain the Plans.⁵⁷³ Under a hybrid approach, basic elements of the current model (including the consolidated display requirement and the Plans) would be retained for quotations representing the NBBO, but all trade reports and all quotations other than the NBBO would be deconsolidated. Because much less consolidated data would be disseminated under this model, the fees for consolidated data would be reduced commensurately. The individual SROs would distribute their own trade and quotation information separately and establish fees for such information. To obtain the data eliminated from the consolidated system, investors would need to pay the separate SRO fees.

In its proposal, Nasdaq suggested that consolidated data fees should be reduced,⁵⁷⁴ but only in the context of advocating a hybrid model that would drastically reduce the quantity of consolidated data that would be disseminated to investors (i.e., by eliminating from the consolidated systems all trade reports and all quotations other than the NBBO). Nasdaq stated that the Commission should allow competitive forces to determine the individual SRO fees for deconsolidated data because trade reports and non-NBBO quotations are not "essential to investors."⁵⁷⁵

The Commission believes, however, that comprehensive trade and quotation information, even beyond the NBBO, is vital to investors. The Commission remains concerned that an SRO with a significant share of trading in NMS stocks could exercise market power in setting fees for its data. Few investors could afford to do without the best quotations and trades of such an SRO that is dominant in a significant number of stocks. In the absence of a solid basis to believe that full trade and quotation information would continue to be widely available and affordable to all types of investors under a hybrid model, the Commission has determined that the most responsible course of action is to take such immediate steps are necessary to improve the operation of the current consolidation model.⁵⁷⁶

2. Level of Fees and Plan Governance

a. Level of Fees

In the Proposing Release, the Commission emphasized that one of its primary goals with respect to market data is to assure reasonable fees that promote the wide public availability of consolidated market data. Comment was requested on the extent to which investors and other data users were relatively satisfied with the products and fees offered by the Networks.⁵⁷⁷ At the NMS Hearing, several panelists addressed the current level of fees and questioned whether such fees remained reasonably related to the cost of market data.⁵⁷⁸ The Supplemental Release therefore noted the panelists' views and welcomed comments on the reasonableness of market data fees and whether the Commission should modify its approach to reviewing such fees.⁵⁷⁹

Many commenters recommended that the level of market data fees should be reviewed and that, in particular, greater transparency concerning the costs of market data and the fee-setting process is needed.⁵⁸⁰ The Commission agrees. To respond to commenters' concerns, it has sought comment on market data fees in its concept release relating to SRO structure.⁵⁸¹ The release discusses and requests comment on a number of issues raised by commenters in the context of SRO revenues and the funding of self-regulation in particular, whether market data fees are reasonable, whether the Commission should reconsider a flexible cost-based approach as described in the 1999 Market Information Release, and whether market data fees should be used to fund SRO operational or regulatory costs. The Commission also has taken steps to promote more transparency with respect to market data fees and the use of market data revenues through its proposal on SRO transparency.⁵⁸² The proposal would greatly increase SRO transparency by requiring, among other things, that SROs file public reports with the Commission detailing their sources of revenues and their uses of these revenues. Such reports would enhance the public's ability to evaluate the role of market data revenues in funding SROs. For example, proposed amendments to Form 1, Exhibit I would require exchange SROs to disclose their revenues earned from market information fees, itemized by product, and proposed new Rule 17a-26 would require SROs to file electronic quarterly and annual reports on particular aspects of their regulatory activities.

Some commenters suggested that, instead of modifying the Plan formulas for allocating market data revenues, the Commission should impose a cost-based limitation on fees.⁵⁸³ Most, however, adopted a very restricted view of market data costs solely the costs of the Networks to collect data from the individual SROs and disseminate it to the public.⁵⁸⁴ Yet nearly the entire financial burden of collecting and producing market data is borne by the individual markets, not by the Networks. If, for example, an SRO's systems break down on a high-volume trading day and it can no longer provide its data to the Networks, investors would suffer the consequences of a defective data stream, regardless of whether the Networks are able to continue operating.

The commenters' suggested approach to market data fees would eliminate any funding for the SROs that supply data to the Networks, which would have reduced SRO funding by $393.7 million in 2004.⁵⁸⁵ Before imposing such a significant and sudden reduction in SRO funding, the Commission must carefully consider the consequences this reduction might have on the integrity of the U.S. equity markets. When the Commission last reviewed market data fees and revenues in 1999, it noted the direct connection between an SRO's operational and regulatory functions and the value of its market information:

[T]he value of a market's information is dependent on the quality of the market's operation and regulation. Information is worthless if it is cut off during a systems outage (particularly during a volatile, high-volume trading day when reliable access to market information is most critical), tainted by fraud or manipulation, or simply fails to reflect accurately the buying and selling interest in a security.⁵⁸⁶

Moreover, the U.S. equity markets are not alone in their reliance on market data revenues as a substantial source of funding. All of the other major world equity markets currently derive large amounts of revenues from selling market information, despite having significantly less trading volume and less market capitalization than the NYSE and Nasdaq. To illustrate, the following table sets forth the respective market information revenues, dollar value of trading, and market capitalization for the largest world equity markets in 2003:⁵⁸⁷

In sum, the Commission is committed to assuring that investors are not required to pay unreasonable or unfair fees for the consolidated market information that they must have to participate in the U.S. equity markets. On the other hand, we must maintain high standards of SRO performance, without which the data they produce would be worth little. Some commenters suggested that SRO funding should be provided through more specifically targeted fees, such as an additional regulatory fee to fund market regulation costs.⁵⁸⁸ Given the potential harm if vital SRO functions are not adequately funded, we believe that the level of market data fees is most appropriately addressed in a context that looks at SRO funding as a whole. The Commission's review of SRO structure, governance, and transparency provides a useful context in which these competing policy concerns can be evaluated and balanced appropriately.

The Commission does not believe, however, that reform of the current revenue allocation formulas should be delayed until its review of fees is completed.⁵⁸⁹ The distortions caused by these formulas are substantial and ongoing. In particular, it appears that market participants increasingly are engaging in the practice of trade shredding (i.e., splitting large trades into multiple 100-share trades) as a means to increase their share of market data revenues under the current Plan formulas. As discussed below, the adopted formula would represent a substantial improvement because it is designed to eliminate trade shredding and other gaming of the current formulas and because it would more directly allocate revenues to those markets that contribute data to the consolidated data stream that is most useful to investors.

b. Plan Governance

The Commission is adopting, as proposed and reproposed, an amendment to the Plans that requires the creation of non-voting advisory committees ("Governance Amendment"). It provides that the members of an advisory committee have the right to submit their views to the Plan operating committees on Plan matters, including any new or modified product, fee, contract, or pilot program. Most commenters supported the Governance Amendment.⁵⁹⁰ They generally believed that expanding the participation of non-SROs parties in Plan governance would be a constructive step. Only a few commenters disagreed, stating that interested parties currently have the ability to communicate their views on Plan matters or questioning the efficacy of the committees.⁵⁹¹

A number of commenters, however, believed that the proposal did not go far enough to reform the Plans and that even greater participation by interested non-SRO parties in the Plans is needed.⁵⁹² The SIA recommended that the Commission "amend the governance structures of the Plans to incorporate the types of changes that have been implemented recently in corporate governance generally."⁵⁹³ These commenters also raised concerns regarding several other aspects of Plan governance, including current administrative costs and burden, the unanimous vote requirement for Plan action, and the current process for reviewing SRO fee filings and Plan amendments. For instance, the SIA also believed that inconsistencies among the Networks regarding administrative requirements and burdens (i.e., agreements and contracts, billing policies, data use policies, and annual audit requirements) contribute to high market data fees and should be reduced, streamlined, and made uniform.⁵⁹⁴

In many respects, the Commission agrees with the concerns expressed by commenters regarding administration of the Plans. Nevertheless, it is reluctant at this point to require more intrusive changes to Plan governance that might interfere with effective Plan operations. The Plans fulfill significant operational functions with respect to the systems that deliver consolidated data to the public on a daily basis. Moreover, improved governance structures at the SRO level also should contribute to improved governance of the Plans through their selection and guidance of SRO representatives on the Plan operating committees. The Commission therefore believes that the Governance Amendment represents a useful first step toward improving the responsiveness of Plan participants and the efficiency of Plan operations. Expanding the participation of interested parties other than SROs in Plan governance should increase the transparency of Plan business, as well as provide an established mechanism for alternative views to be heard by the Plans and the Commission. Earlier and more broadly based participation could contribute to the ability of the Plans to achieve consensus on disputed issues. With respect to Plan administration, promising private efforts are underway to improve consistency among data providers and to reduce administrative burdens.⁵⁹⁵ The Commission particularly believes that the Plans should give full consideration to the views of industry participants on steps that would streamline the administrative procedures and burdens of the three Plans. Enhanced participation of advisory committee members in Plan affairs should help further this process. The Commission will continue to monitor and evaluate Plan developments to determine whether any further action is warranted.

3. Revenue Allocation Formula

As discussed below, the Commission has adopted the Allocation Amendment with some modifications from the proposal and reproposal.⁵⁹⁶ Given the significant changes from the current Plan formulas, the Commission will monitor the operation of the new formula to assess whether it achieves its goals and whether any further modifications are warranted. As with any other aspects of the Plans, the language added to the Plans by the Allocation Amendment can be adjusted in the future pursuant to the normal process of Commission-approved amendments.⁵⁹⁷

The proposal and reproposal included an amendment to the Plans that would modify their formulas for allocating market data revenues to SRO Participants. The current Plan formulas are based solely on the trading activity of an SRO. The proposed and reproposed formulas were intended to address three serious weaknesses in the old formulas: (1) the absence of any allocation of revenues for the quotations contributed by an SRO to the consolidated data stream; will address exchange data delay intervals, subscriber agreement streamlining, billing and reporting period issues, and unit of count definitions).

(2) an excessive emphasis on the number of trades reported by an SRO that has led to distortive trading practices, such as wash sales, trade shredding, and print facilities; and (3) a disproportional allocation of revenues for a relatively small number of stocks with extremely high trading volume, with a much smaller allocation to the thousands of other stocks included in a Network, typically issued by smaller companies, with less trading volume.

To address these problems, the proposed formula included a number of elements, including a Quoting Share, an NBBO Improvement Share, a Trading Share, and a Security Income Allocation. The Quoting Share and NBBO Improvement Share would have provided an allocation of revenues for an SRO's quotations. In particular, the Quoting Share would have allocated revenues for all quotes, both automated and manual, according to the dollar size and length of time that such quotes equaled the price of the NBBO. It included an automatic cutoff of credit for manual quotations, however, when they were left alone at the NBBO. This cut-off was intended to preclude SROs from being allocated revenues merely for slowness in updating their manual quotations. The NBBO Improvement Share would have allocated revenues to SROs for the extent to which they displayed quotations that improved the price of the NBBO.

At the NMS Hearing, representatives of floor-based exchanges stated their intention to adopt hybrid trading models that would primarily display automated quotations.⁵⁹⁸ In response, the Commission, in its Supplemental Release, stated that the prospect of hybrid trading models presented an opportunity for simplifying the proposed allocation formula.⁵⁹⁹ It noted that the purpose of the automatic cutoff for manual quotations was to minimize the allocation of revenues for potentially stale quotations and requested comment on whether only automated quotes should be entitled to earn an allocation of revenues. The Supplemental Release also noted that the NBBO Improvement Share was significantly more complex than the other aspects of the proposed formula and that it had been proposed largely to counter the potential for an excessive allocation of revenues for manual quotations. As a result, the Reproposing Release included a reproposed allocation formula that eliminated the NBBO Improvement Share and excluded manual quotations from the Quoting Share.⁶⁰⁰ It also allocated revenues equally between the trading activity and quoting activity of Plan participants. Based on additional comments received in response to the reproposal, the Commission is adopting the reproposed allocation formula with certain modifications, as discussed below.

The comments on the proposal and reproposal generally addressed four broad categories of issues: (1) whether the current Plan formulas need to be updated; (2) whether quotations should be considered in allocating revenues; (3) whether the size of trades should be considered in allocating revenues; and (4) whether the allocation of revenues should be allocated more evenly across all of a Network's stocks. These comments are discussed below.

a. Need for New Formula

Many commenters agreed with the Commission that, if the Networks were to continue allocating revenues to the SROs, the current allocation formulas needed to be updated.⁶⁰¹ Many of these commenters also believed that the proposed and reproposed formulas should be modified in several respects, and their specific suggestions to improve the proposed formula are discussed below. In general, however, they agreed with the objectives of the proposal and reproposal to eliminate much of the incentive for distortive trade reporting practices and to begin providing some allocation of revenues for the quotations that SROs contribute to the consolidated data stream.

Other commenters, in contrast, opposed changing the current allocation formulas.⁶⁰² Their specific objections to the proposed and reproposed formulas are discussed below, but they also opposed changing the current formulas for more general reasons. First, some believed that, rather than changing the formulas, the Commission simply should prohibit the particular distortive practices caused by the old formulas and enforce the existing prohibitions against such practices. Commenters also opposed the proposed and reproposed formulas because they believed they incorporated arbitrary judgments about the value of quotations and trades. Finally, those opposed to changing the Plan formulas believed that the proposed formula was simply too complex to be implemented effectively and that its costs exceeded any benefits that were likely to be gained.

The Commission has considered the views of these commenters, but does not believe that they warrant leaving the current Plan formulas in place. First, the Commission intends to continue to enforce the existing prohibitions against distortive trade reporting practices. Rather than attempting to devise new prohibitions that address every conceivable harmful practice, however, it has determined to address directly the formula-driven distortions by adopting revisions to the current formulas. As long as the allocation of market data revenues is based primarily on reporting a large number of very small trades, the incentive for distortive trade reporting will continue. Moreover, as discussed below, the current formulas are flawed in several important respects beyond the incentives they create for distortive trade reporting practices.

The Commission does not believe that the adopted formula incorporates arbitrary judgments about the value of trades and quotes. In this regard, it is important to recognize that any formula for allocating market data revenues would reflect some judgment regarding the contribution of the various SROs' data to the consolidated data stream; otherwise, the revenues could simply be allocated equally among all Plan participants. The Commission's goal in adopting a new formula is to improve on the judgments incorporated in the old Plan formulas to more fully achieve NMS objectives.

For example, the current formula for Network A and Network B treats a 100-share trade the same as a 20,000 share trade in the same stock, even though their importance for price discovery purposes clearly is not equal. All of the current Plan formulas value only the trades reported by an SRO (for Networks A and B, the number of reported trades; for Network C, the average of number and share volume of reported trades), thus treating a quotation as having no value except to the extent it resulted in a trade. Quotations are accorded no value even if they were fully accessible and established the NBBO for a substantial period of time, thereby providing price discovery for trades occurring at other markets that internalize orders with reference to the NBBO price. Such formulas based solely on an SRO's trading activity may have been adequate many years ago when a single market dominated each group of securities, but are seriously outdated now that trading is split among many different markets whose contributions to the public data stream can vary considerably.

The adopted formula reflects fairly straightforward determinations about the kinds of data that, in general, are likely to be useful to investors. For example, a $50,000 quote at the NBBO in a stock is likely more useful to investors than a $2000 quote in the same stock. Similarly, a $50,000 trade in a stock is likely more useful to investors in assessing the trading trend of that stock than a $2000 trade; again, not necessarily in every case, but in general and on average. By more appropriately weighing data that is useful to investors, the adopted formula represents a substantial improvement on the old formulas.⁶⁰³

Commenters on the original proposal generally believed that the originally proposed formula was complex and may have been difficult to implement efficiently.⁶⁰⁴ They particularly noted that the proposed NBBO Improvement Share was difficult to understand and had the potential to be abused through gaming behavior. The Commission agreed with these commenters and has modified the reproposed formula and adopted formula accordingly. Given that only automated quotations will be entitled to earn an allocation under the adopted formula, the originally proposed NBBO Improvement Share, as well as the proposed cutoff of credits for manual quotations left alone at the NBBO, have been deleted from the reproposed formula and remain deleted in the adopted formula. The elimination of these two elements greatly reduces the complexity of the adopted formula and promotes more efficient implementation of the formula. In addition, the 15% of the Security Income Allocation that was allocated to the NBBO Improvement Share in the proposed formula now has been shifted to the Quoting Share to assign an even allocation of revenues between trading and quoting.

Other commenters asserted that it would overly costly and complex to calculate the other elements of the proposed formula.⁶⁰⁵ The Commission does not agree with this assertion. An SRO's Trading Share, for example, will not be materially more difficult to calculate than the current Network C formula, which is based on an average of an SRO's proportion of trades and share volume. The Security Income Allocation uses the square root function which is a simple arithmetic calculation. Some commenters believed that the Quoting Share, which incorporates the total dollar size of the NBBO in a stock throughout the trading year, would result in astronomically high numbers that would be extremely difficult to calculate.⁶⁰⁶ In fact, the largest number of Quote Credits in a year for even the highest price stock with the greatest displayed depth at the NBBO is be very unlikely to reach beyond the trillions, a number well within the capabilities of even the most basic spreadsheet program.⁶⁰⁷ Moreover, the allocation is determined by the proportion of an SRO's Quote Credits in relation to other SROs, not the absolute amount of Quote Credits.

Some commenters suggested that revenue allocations under the formula should be calculated and paid out on a quarterly basis.⁶⁰⁸ Currently, the Networks make estimated quarterly payments subject to a final annual calculation and payment. Commenters believed quarterly calculations and payments would simplify administration of the formula and reduce the potential for disparities between quarterly estimated and annual final payments. The adopted Allocation Amendment does not alter the current Plan provisions for annual final payments. It is important to retain a final annual calculation and payment to minimize the potential for unusual trading activity, or intentional gaming behavior, to inappropriately distort an allocation within a quarter. The annual calculation will be based on numbers that are four times larger than the numbers for a quarterly calculation. These larger numbers will help smooth out the effect of unusual market activity in a particular quarter, as well as increase the difficulty of any attempt at gaming behavior. Of course, all of the formula's calculations can be updated daily, and quarterly estimated payments based on these calculations can continue to be made to SRO participants.

Finally, a few commenters were concerned about the effect of modifying the current allocation formulas on the existing business models and terms of competition for the various markets.⁶⁰⁹ The Commission recognizes that reforming formulas that have remained unchanged for many years could affect the competitive position of various markets. Given the severe deficiencies of these formulas, however, it does not believe that the interests of any particular business model should preclude updating the formulas to reflect current market conditions. The adopted formula is intended to reflect more appropriately the contributions of the various SROs to the consolidated data stream and thereby better align the interests of individual markets with the interests of investors. Moreover, by incorporating a much more broad-based measure of an SRO's contribution to the consolidated data stream, the adopted formula should be less subject to any particular type of gaming and distortion than the narrowly-focused current Plan formulas.⁶¹⁰

b. Quotations that Equal the NBBO

Many commenters supported the proposal to allocate a portion of market data revenues based on an SRO's quotations, particularly if only automated and accessible quotations would qualify for an allocation.⁶¹¹ Some commenters, however, were concerned about the risk of harmful gaming behavior by market participants.⁶¹² For example, Instinet stated that the "fundamental problem with the Commission's proposed formula stems from the inherently low cost for market participants to generate quotation information and the consequent high potential for gaming behavior in any formula that attempts to reward such behavior."⁶¹³ A specific type of gaming that concerned commenters was "flickering quotes" quotes that are flashed for a short period of time solely to earn market data revenues, but are not truly accessible and therefore do not add any value to the consolidated quote stream. Nasdaq discussed a number of other potential gaming behaviors, including posting quotations in inactive markets or for inactive securities so that they are less likely to be executed.⁶¹⁴ Commenters also were concerned that such practices would increase quotation traffic and bandwidth costs, but with little or no benefit for the quality of the consolidated data stream.

The Commission recognizes that abusive quoting behavior is a legitimate concern, particularly given that quotations have not been entitled to an allocation of market data revenues in the past. The adopted formula therefore incorporates a number of modifications to the reproposed formula to minimize the potential for abusive or costly quoting behavior.

First, the adopted formula modifies the language of the reproposed formula to clarify that a quotation must be displayed by the Network processor for a minimum of one full second of time before it is entitled to earn any Quote Credits. This one-second time period is consistent with the one-second time period included in the flickering quotation exception in the Order Protection Rule and is designed to assure that only quotations that are readily accessible can earn Quote Credits. The time stamps assigned to quotations by the Network processors will control this determination. Accordingly, subsecond flickering quotations are excluded from the formula.

Second, the adopted formula modifies the language of the reproposed formula to clarify that, consistent with the approach of the Order Protection Rule, each SRO participant in a Network is entitled to earn Quote Credits only for the SRO's best bid and best offer. Thus, for example, only a single, accessible best bid and best offer for each of the exchange SROs, Nasdaq, and the NASD will be entitled to earn Quote Credits. A best bid and best offer must be accessible by routing an order to a single market destination (i.e., currently, to a single exchange execution system, a single Nasdaq execution system, or a single ADF participant). By limiting the number of separate quotations that are entitled to earn Quote Credits, the adopted formula both reduces the ability of market participants to "shred" their quotes among many different markets and promotes equal regulation of exchange SROs, Nasdaq, and the NASD.

Third, the adopted formula modifies the language of the reproposed formula to clarify that a quotation cannot earn Quote Credits while it locks or crosses a previously displayed automated quotation. This limitation is needed to remove any potential financial incentive for abusive quoting behavior that would be contrary to the purposes of the provisions on locking and crossing quotations set forth in the Access Rule.

Finally, as discussed further below,⁶¹⁵ the Security Income Allocation in the adopted formula modifies the reproposed formula by limiting the total revenues allocated to any particular Network security to no more than $4 per qualified transaction report. This limitation on each security's revenue allocation therefore will apply to both the Trading Share and Quoting Share. In contrast, the reproposed formula limited the allocation only for the Trading Share of a Network security to $2 per qualified transaction report, but shifted the excess balance of revenues to the Quoting Share for such Network security thereby potentially increasing the risk of abusive quoting behavior in highly inactive Network securities. Under the adopted formula, the excess balance above the limitation will be allocated across all Network securities in direct proportion to their share of dollar volume of trading.

With these clarifications and modifications, the Commission does not believe that the Quoting Share of the adopted formula will be unacceptably vulnerable to gaming, particularly because only automated and fully accessible quotations will be entitled to earn a share of market data revenues. The potential cost of displaying such quotations, in the form of unprofitable trades, should not be underestimated. Quotations would earn significant revenues only if they represent a significant proportion of the total size of quotations displayed at the NBBO for a stock throughout the trading year. The risk of losses that could result from the execution of orders against large quotations would be likely to dwarf any potential allocation of market data revenues.⁶¹⁶ With the advent of highly sophisticated order-routing algorithms, accessible automated quotations throughout the NMS can be hit at lightning speed. Some of these algorithms are specifically designed to search the market for displayed liquidity and sweep such liquidity immediately when it is displayed. The market discipline imposed by these order-routing practices should greatly reduce the potential for "low cost" quotations at the NBBO. A market participant would have to be prepared to trade at a price, particularly a price as attractive as the NBBO, before displaying accessible and automated quotations to earn market data revenues. Moreover, any quotations submitted for stocks that are inactively traded (and therefore less likely to attract trading interest) will garner a very small Quoting Share allocation because the size of such allocation will be determined by the proportional dollar volume of trading in a stock.

Finally, commenters were concerned that some quotations might be submitted to "hide in the queue" when a stock already has significant depth displayed at the NBBO.⁶¹⁷ The strategy is risky, however, because of the desire for greater liquidity evidenced by the number of marketable limit orders entered but not filled, particularly for Nasdaq stocks, that was discussed above in section II.A.1.b Typically, the volume of such orders searching for liquidity at the NBBO far exceeds the available liquidity (both displayed size and reserve size). Any quotations attempting to hide in the queue at the NBBO when liquidity seeking orders arrive would necessarily be executed immediately.⁶¹⁸

A few commenters also opposed the proposed Quoting Share because they believed it represented an inappropriate attempt by the Commission to control the quoting behavior of market participants.⁶¹⁹ ArcaEx, for example, stated that the "most important question is how paying for top-of-book quotes on a time- and size-weighted basis or on any other basis encourages beneficial behavior," and questioned whether the Quoting Share would achieve this result. Brut asserted that "[n]ot only would [the proposed formula] increase the potential unnatural trading and quoting behavior, it signifies a desire to use market structure regulation to micro-manage market participant behavior . . . ."⁶²⁰

These commenters appear to have misunderstood the Commission's objective in proposing to update the current Plan formulas. As noted above,⁶²¹ it is unlikely that a marginal increase in market data revenues would significantly alter the quoting behavior of market participants, at least for those not already interested in trading a stock for separate reasons. The potential cost of unprofitable trades would be too high. Rather, the Commission's primary objective is to correct an existing flaw in the current formulas by allocating revenues to those SROs that, even now, benefit investors by contributing useful quotations to the consolidated data stream. Currently, such SROs do not receive any allocation for providing a venue for this beneficial quoting activity. Basing an allocation on the extent to which an SRO's quotes equal the NBBO is an appropriate means to correct this flaw, even if the allocation does not always reflect the precise value of quotations.⁶²²

c. Number and Dollar Volume of Trades

The current Plan formulas allocate revenues based on the number of trades (Networks A and B) or on the average of number of trades and share volume of trades (Network C) reported by SROs. By focusing solely on trading activity (and particularly by rewarding the reporting of many trades no matter how small their size), these formulas have contributed to a variety of distortive trade reporting practices, including wash sales, shredded trades, and SRO print facilities. To address these practices and to establish a more broad-based measure of an SRO's contribution to the consolidated trade stream, the proposed formula provided that an SRO's Trading Share in a particular stock would be calculated by taking the average of the SRO's percentage of total dollar volume in the stock and the SRO's percentage of qualified trades in the stock. A "qualified trade" was defined as having a dollar volume of $5000 or more. The Proposing Release requested comment on whether this amount should be higher or lower, or whether trades with a size of less than $5000 should receive credit that was proportional to their size.⁶²³

Several commenters on the original proposal believed that small trades contribute to price discovery and should be entitled to earn at least some credit in the calculation of the number of qualified trades.⁶²⁴ The Commission agreed and included in the reproposed formula a provision that awards a fractional proportion of a qualified report for trades of less than $5000. The adopted formula also includes this provision. Thus, a $2500 trade will constitute 1/2 of a qualified transaction report. This approach greatly reduces the potential for large allocations attributable to shredded trades, while recognizing the contribution of small trades to price discovery.

Two commenters on the original proposal asserted that the $5000 threshold was arbitrary.⁶²⁵ As noted in the Proposing Release, an analysis of Network A data indicates that approximately 90% of dollar volume and 50% of trades exceed this threshold. The Commission believes that the $5000 figure represents a reasonable attempt to address the problem of shredding large trades into 100-share trades. By providing only a proportional allocation for trades with dollar amounts below this threshold, the ability of market participants to generate large revenue allocations by shredding trades would be greatly reduced. For example, a 2000-share trade in a $25 stock could be shredded into twenty trades in the absence of a dollar threshold for qualified trades, but could be shredded into only ten qualified trades under the reproposed formula. Moreover, when combined with the allocation of 50% of revenues to the Quoting Share and the allocation of another 25% of revenues based on the dollar volume of trades, the $5000 threshold for qualified trades will eliminate much of the potential reward for trade shredding under reproposed formula. In the example of the 2000-share trade in a $25 stock, the incentive for shredding would have been reduced by a total of 87.5% (75% + (50% * 25%). ⁶²⁶

d. Allocation of Revenues Among Network Stocks

The proposed formula included a Security Income Allocation, pursuant to which a Network's total distributable revenues would be allocated among each of the Network's stocks based on the square root of dollar volume. The square root function was intended to adjust for the highly disproportionate level of trading in the very top tier of Network stocks. A few hundred stocks (e.g., the top 5%) are much more heavily traded than the other thousands of Network stocks. The Proposing Release noted that an allocation that simply was directly proportional to trading volume would fail to reflect adequately the importance of price discovery for the vast majority of stocks.⁶²⁷ The Reproposing Release retained this provision in the reproposed formula.⁶²⁸

Of the commenters that addressed this issue, several supported the use of a square root function to allocate revenues among stocks.⁶²⁹ Nasdaq, for example, noted that the "methodology will reduce the disparity between the value of data of the most active and least active securities."⁶³⁰ Other commenters, in contrast, opposed the use of the square root function to allocate revenues among Network stocks.⁶³¹ ArcaEx believed that the proposed allocation method "introduces a steeply progressive tax on liquid stocks to subsidize illiquid stocks" and that the allocation of revenues should remain directly proportional to trading volume.⁶³²

With one modification, the Commission has retained the square root function in the adopted formula to allocate distributable Network revenues more appropriately among all of the stocks included in a Network. Although the extent to which Network stocks are tiered according to trading volume varies among the three Networks, it is quite pronounced in each of them. The use of the square root function reflects the Commission's judgment that, on average and not necessarily in every particular case, information about a $50,000 trade in a stock with an average daily trading volume of $500,000 is marginally more useful to investors than a $50,000 trade in a stock with an average daily trading volume of $500 million. Markets that provide price discovery in less active stocks serve an extremely important function for investors in those stocks. Price discovery not only benefits those investors who choose to trade on any particular day, but also benefits those who simply need to monitor the status of their investment. Efficient secondary markets support buy-and-hold investors by offering them a ready opportunity to trade at any time at a fair price if they need to buy or sell a stock. Indeed, this enhanced assurance is one of the most important contributions of second